By
Anders Bylund
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March 30, 2011
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Operating leverage can be a very powerful thing. With a cost structure geared toward a high proportion of fixed costs and few variables in the mix, strong sales almost automatically translate into higher profit growth. Companies in a position to benefit from this are typically the kind of businesses that can give you a breakeven point -- a revenue level above which the business will make a profit and where red ink goes along with sales below that mark.
While technology might not have the same level of operating leverage as say, a steel mill, some businesses still exhibit similar traits. Chip designer Advanced Micro Devices (NYSE: AMD ) is one example, and Green Mountain Coffee Roasters (Nasdaq: GMCR ) is another stock that could exhibit strong operating leverage thanks to high-margin K-Cup sales that continue long after consumers bought less profitable coffee machines.
So far, so good; when applied to the right business models, high operating leverage can predict tremendous ebbs and flows as revenue-producing fortunes wax and wane.
But the concept is often applied to all the wrong companies. You really shouldn't expect profits to jump sky-high in a business with lots of moving parts between the top of bottom lines, even if sales suddenly skyrocket. Many a high-growth company is set up to pump additional cash right back into the growth engine, which leads to stable but unexciting profits even when business is booming.
Two recent examples of misdirected operating leverage hopes irk me in particular: Red Hat (NYSE: RHT ) and Netflix (Nasdaq: NFLX ) have been taken to task for slow earnings growth in the face of superb sales. And here's why I know it's wrong:
- In Red Hat's case, well, CEO Jim Whitehurst told me so himself. Whitehurst aims for maximum revenue growth and only improves operating margins by a measured pace in order to appease leverage-hungry analysts. He calls it "a negotiated settlement with Wall Street" and would really prefer to leave margins alone and just focus on growth. So you'll see Red Hat's operating margins expanding by about 1% year over year, come rain or shine or a blizzard of dead frogs. That's just how it's going to be.
- Netflix CEO Reed Hastings doesn't put it quite as bluntly, but he's working with the same kind of model. Any cash left over after paying fixed business costs is not trickling down to the bottom line in a display of unfettered operating leverage, but gets reinvested in either additional marketing campaigns, new streaming media licenses, or some combination of the two. So earnings look timid, torpid, and stagnant even as Netflix tacks on another million subscribers per quarter, but the company is building an even stronger platform for continued growth instead.
You have to remember that these companies are still young and small by the standards of their respective industries and still have years of Greenfield growth ahead of them. The operating leverage will come somewhere down the line when the rapid growth era comes to an end, but flipping that switch today would put severe limits on the final size of these businesses. That would be a real shame.
Add Red Hat and Netflix to your watchlist right now, and you'll get a front-row seat to how this drama plays out over the years.
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