Operating leverage is one of the most important qualities I look for in a Rule Maker business model. During the 1990s, Microsoft (Nasdaq: MSFT) grew profits by an average annual pace of 47.5%, far faster than the underlying 38.1% average annual sales growth. And, since profit growth drives stock prices, that extra octane on the bottom line translated into billions of dollars in shareholder value. How did Microsoft do it? Operating leverage.
EMC's model has begun to demonstrate strong operating leverage by taking a play from the Microsoft economic handbook -- software sales. The networked storage model has opened the door for EMC to sell sophisticated software management tools. Over the past year, EMC has packed more than $1 billion of this software into its data storage boxes. Software sales growth is running at nearly 100% year-over-year. In the most recent quarter, software made up 16.3% of EMC's total sales. That's up from 10.9% only one year earlier. As you can see, software is becoming an increasingly important component of EMC's business model.
This is a very good thing, because the software business has some of the greatest economic characteristics in all the business world. (Zeke discussed these in-depth in his piece earlier this year on The Software Advantage.) One of the most appealing advantages of software is that the cost structure is largely fixed and limited to up-front development costs. Whether you sell one copy or a million, the development costs are the same. So, after you sell enough copies to meet your fixed costs, every additional dollar of software revenue falls straight to the bottom line. Thus, with scale, software demonstrates awesome operating leverage.
Let me step back and better explain the "leverage" in operating leverage. Imagine a lever atop a fulcrum. On one side is revenue, and the other is profit. Here's what operating leverage looks like:
Revenue Profit
^
Hopefully this rough diagram will help you understand the concept. As you can see, the fulcrum is shifted well off-center toward the revenue side. That means if you push down on the revenue side of the lever, the profit side will obviously move up much higher than the corresponding push down. That's operating leverage -- a unit increase in revenue results in a multi-unit increase in profit.Essentially, the operating leverage phenomenon boils down to an analysis of fixed versus variable costs. EMC's traditional storage boxes have a large component of variable costs, such as the box itself, internal circuitry, and hard disk drive. Each of these costs varies proportionally with the number of storage units sold. Thus, EMC's storage boxes alone result in no operating leverage -- because profit increase is proportional to revenue increase. But, along comes a software component to the business, and suddenly EMC's overall cost structure is taking on a fixed element with inherent operating leverage.
In fact, the software side of EMC's business is ramping up so quickly that operating leverage is becoming quite strong. Over the past 12 months, EMC's 26% increase in revenue has resulted in a corresponding 83% increase in free cash flow (FCF). Of course, EMC will need to keep up that pace of FCF growth to justify its lofty price-to-FCF ratio of 202. Pricey though it is, EMC looks to have a wide-open market opportunity.
John Del Vecchio (TMF Fuz) covers EMC for Motley Fool Research. In his most recent quarterly update on the company, he wrote:
"EMC's management believes that the storage market opportunity will exceed $78 billion by 2003. I believe that this number is conservative and understates the total opportunity available in this space, as storage expenditures for large and mid-size firms -- as well as opportunities for smaller firms to utilize outsourced storage systems -- increase. In addition, greater bandwidth and the use of enterprise resource software, databases, and the rapidly expanding customer relationship management (CRM) systems will increase the need for storage."EMC's trailing 12-month revenue is only $7.2 billion. With a conservatively estimated $78 billion opportunity in three years, growth possibilities seem to justify the lofty stock price.
Finally, an update on our portfolio. This past Thursday, we picked up our $2000 of Cisco (Nasdaq: CSCO), as promised the previous Friday. We purchased 32 shares at a cost of $63.36 per stub. The new shares will be reflected in the portfolio's holdings in the next 24 hours. As always, you can check our portfolio's history at the RM Trade History page, which is also located on the upper-right navigation bar of rulemaker.fool.com.
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