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Commodities: Be wary of operating leverage - Views on News from Equitymaster
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  • Sep 10, 2004

    Commodities: Be wary of operating leverage

    Any avid observer of the steel sector boom in recent times could not help but rave about the impressive turnaround story of sector behemoth, SAIL, in FY04. And this Euphoria was not without reason. Helped by a strong 27% growth in topline, it had posted a more than four fold jump in EBIT, signifying strong growth at the operating level. In contrast, rival Tata Steel's performance was rather muted with a 64% growth in EBIT on the back of a 23% growth in topline. If we consider another commodity sector, cement, and consider two major players ACC and Gujarat Ambuja, here also, while the topline growth of both the companies was rather similar with 15% and 13% rise respectively, growth at the EBIT level for ACC was 61% as compared to 21% for Gujarat Ambuja.

    Looking at these numbers one would be tempted to root for SAIL and ACC respectively as favored companies to invest in on account of higher growth at the EBIT levels. However, this does not represent the true picture. The reason that SAIL and ACC have shown higher growth is because of their significantly higher operating leverages than their counterparts. Operating leverage is nothing but the sensitivity of a company's earnings to a given change in sales.

    % change EBIT % change Sales Operating leverage (x)
    SAIL 334.0% 27.0% 12.5
    Tata steel 64.0% 23.0% 2.8
    ACC 60.6% 14.8% 4.1
    Gujarat Ambuja 20.7% 13.0% 1.6

    The above table shows the operating leverage for four leading commodity with FY03 and FY04 as the financial years under consideration. As is evident, at 12.5 times, operating leverage is highest for SAIL followed by ACC, which has an operating leverage of 4.1x. Now what could be the probable reason behind the stark difference in leverages? The reasons could be two-fold. One, the realisations for the companies might be different and second, the companies might be having disparate cost structures.

    As far as the first reasoning is concerned, by virtue of being commodity companies, one can without any significant error safely assume that realisations would more or less be same across a particular sector. This brings us to the second reason, the cost structure. Here it should be noted that higher the company's fixed cost the higher would be its operating leverage. Thus it would not be wrong to assume that SAIL and ACC have a higher proportion of fixed cost as a percentage of total cost as compared to Tata Steel and Gujarat Ambuja.

    How does an operating leverage impact the financial performance of a company? It should be noted that high operating leverage could prove to be a double edged sword for a company. In times of strong demand it can lead to significantly higher percentage change in profits, whereas when demand falls and sales slump it can affect profits adversely. In other words, in a cyclical industry like commodities, higher leverage can lead to even higher volatility in earnings.

    On the other hand, companies with low operating leverage can weather the storm in a much better way and are likely to withstand the slump in sales with relatively lesser damage. Also, from an investor's point of view, investing in a stock with rather low operating leverage is likely to result into higher stability in earnings. So, next time one invests in a commodity stock, do not forget to look into this parameter.



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