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Talking about: operational leverage

Talking about: operational leverage

Operational leverage can have a powerful effect on a company’s earnings, in both a positive and a negative sense. When considering an investment in companies with high operating leverage, you must be comfortable with the company’s ability to manage downside risk.

Operational leverage is the degree to which a company’s cost structure is fixed. Businesses with high operational leverage do well when revenue grows, and poorly when it shrinks.

Servcorp (ASX: SRV) is one company that has a high degree of operating leverage. The company provides premium, temporary office space to clients around the world.

Servcorp typically leases a floor for 10 years, and will spend around $2 million to fit out the office space. The running costs are then largely fixed and stable, as only 5 to 6 staff are required to service the floor.

Servcorp will initially offer material discounts to customers in order to fill the floor space, but are able to exercise pricing power once occupancy exceeds 85 per cent. The sweet spot for the company is when occupancy exceeds 95 per cent, as the demand allows for considerable price appreciation. With a stable cost base, any incremental price increase will have a disproportionate effect on profits.

Servcorp is currently experiencing considerable earnings momentum. From 2010 to 2013, the company’s revenues have increased by 23 per cent, while earnings have increased tenfold. Absent another global crisis, the company seems to be well positioned for this trend to continue.

However, we do not consider that the company has a sufficient competitive moat to protect its earnings during economic downturns. The average lease duration of a customer is between one and two years, which makes it difficult to retain clients when the economy deteriorates. In 2010, Sercorp’s revenues decreased by 26 per cent, but profits fell by 94 per cent.

As you can see, operational leverage can have a powerful effect on a company’s earnings. It is for this reason that a considerable margin of safety is required, both in terms of the company’s discount to intrinsic value, and the size of the company’s competitive advantages.

 

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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