SIMON BROWN: The lessons of operational leverage

I have written before about operational leverage, but after excellent full-year results from AdvTech* that show just how powerful it can be — and not just for mining stocks — I want to revisit the topic.

Operational leverage is usually associated with miners, as they have a fairly set cost base that doesn’t change with commodity prices. If the commodity price rises, revenue goes up and so do profits — but the costs remain the same. The leverage effect is that a 20% rise in the commodity price could potentially increase earnings by 50% or more.

With AdvTech the leverage is that its classrooms are not yet full. When a new pupil arrives at school and slips into a classroom, that adds revenue but no real increase in cost to the school. Hence the extra pupil fee drops pretty much straight into the bottom line.

In February 2020 occupancy in AdvTech schools was 79%, and the operating margin was 17.8%. By February 2024 occupancy had risen to 83% and the operating margin had increased to 20.3%. This increase in operating margin goes straight to earnings, boosting headline earnings per share (HEPS) and the dividend.

With AdvTech’s tertiary offering the effect was even more pronounced, as the operating margin went from 23% in 2020 to 26.3% for the most recent set of results.

The easiest way to spot operational leverage is when results are released. I always check the revenue, HEPS and dividend growth. For AdvTech the latest results show revenue up 13%, HEPS up 19% and the dividend up 45%. This immediately shows that powerful leverage is in effect, as we see the stepped increase from revenue to HEPS and on to the dividend.

Clicks is another stock that for years managed this leverage effect: as revenue would rise, HEPS would increase by a larger percentage and the dividend would be up by even more. Here the leverage is increased foot traffic per store and higher spend per customer. This was certainly helped by the introduction of the pharmacy business, albeit at lower margins. The pharmacy brought in more customers and often they spent on other products besides their medication.

The flip side here, of course, is negative leverage — an equally powerful force in the opposite direction.

Say the AdvTech school loses three pupils. It will have lost the income on those three sets of school fees, but the cost base will not have changed. The exit of three pupils will not mean that fewer teachers or less space is required. So profits get squeezed.

On the way down leverage can move fast and hurt a lot. On the way up leverage (outside of mining, where commodity prices can rocket higher in double-quick time) is generally a slow and gradual process.

But we can spot it happening by simply checking the growth in revenue, HEPS and dividend, while also keeping an eye on the operating margin. In companies experiencing improved operating leverage it should continue for a while, driving profits.

* The writer holds shares in AdvTech