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Operating profit of a company is arrived at using the sales revenue and total cost figures. The latter can be broadly classified as fixed and variable costs. Fixed costs include depreciation, rent of buildings or equipment, employee salaries, cost of electricity and insurance costs. Variable costs include direct labour costs, sales commission and cost of raw material.
While fixed costs have no relation to sales volume, the variable costs have a direct proportional relationship to sales revenue. Variable costs, also termed per unit costs, tend to increase with an increase in sales volume and vice-versa. For example, if the variable cost is Rs 2 per unit, producing 10,000 units will create a variable cost of Rs 20,000, and 6,000 units will create a variable cost of Rs 12,000.
The relationship between sales revenue, fixed and variable costs creates the prospects of increased profitability by deriving the benefits of operating leverage. The magnitude of operating leverage, defined as high or low, is critical in determining such benefits. High operating leverage occurs in companies that have a higher proportion of fixed costs relative to variable costs. On the other hand, low operating leverage arises in companies where the total cost structure consists of high variable costs relative to the fixed costs.
A firm with high operating leverage can generate larger operating profits through incremental sales. If the sales are high enough to cover the fixed costs, each additional unit sold contributes to the operating profit. On the other hand, in the case of a company with low operating leverage, the larger sales will not significantly improve profitability as the variable costs increase proportionately with sales volume. However, high operating leverage is equally risky if the firm is unable to increase its sales volume to cover its fixed costs, creating a negative impact on profit margins.
The degree of operating leverage (DOL) is a statistic that is employed to determine the magnitude of operating leverage. It is calculated by dividing the percentage change in EBIT (earnings before interest and taxes) by the percentage change in sales revenue. If the sales revenue in year 1 and year 2 is Rs 1,000 crore and Rs 1,500 crore respectively and EBIT in year 1 and year 2 is Rs 500 crore and Rs 850 crore respectively, then the DOL at the end of year 2 is worked out as 1.4. This implies that for every 1% change in sales, the EBIT change by 1.4%.
A total of 836 companies with a market cap greater than Rs 500 crore were analysed to find those with high operating leverage. Consolidated data for the past 3 financial years with the latest year being 2018-19 was considered and sales revenue and EBIT variables were extracted. Using this data, the DOL was calculated for the past 2 years. Similarly, the average DOL was calculated for the respective industries for the defined time frame. Those companies with DOL more than the industry DOL in both years were filtered out. Further, companies with a DOL value greater than 1 in both years were only considered.
As high DOL is helpful if the company is able to increase its sales in the future, Bloomberg's estimated sales growth for 2019-20 and 2020-21 were included. Moreover, estimated EBIT growth for 2020-21 was also considered. Only those companies with estimated sales growth for 2019-20 and 2020-21 at more than 5% were selected. An additional filter of EBIT growth for 2020-21 at more than 5% was included.
To look at the future potential, companies that are covered by at least five Bloomberg analysts and with oneyear future price potential greater than 10% were finally filtered out. Let us look at the six companies that passed all the defined filters comprehensively.
THE COMPANY IS into designing, manufacturing and marketing lighting products and consumer durables. It has maintained a leadership position in the fans and lighting segments and is aiming for an increased share in water heaters, air coolers and kitchen appliances. Strategies like product innovation, cost optimisation, premiumisation and wider distribution network have helped Crompton Greaves in maintaining market leadership.
Analysts expect the margins to improve in the future as there is limited scope of further price erosion in the lighting segment. The segment has witnessed increased competition in the past where new players have employed disruptive price strategies to gain market share. Strong return profile, improving margin prospects, capability to generate free cash flows, economies of scale, increased automation and improved sourcing terms from the suppliers are the key growth catalysts for the company going forward. According to Bloomberg consensus estimates, Crompton is likely to deliver a RoE of 38.6% and 36.4% respectively in 2019-20 and 2020-21 compared to BSE500 index that is expected to deliver average RoE of 10.1% and 12.8% respectively in the same time period.
THE COMPANY IS in the business of retailing a range of household and consumer products through departmental stores in various formats. The Indian retail industry is expected to grow at a fast pace supported by rising incomes, increased consumer spending, entry of foreign players, favourable demographics and growing urbanisation. The long term agreement with Amazon provides significant trigger as it enables Future Retail access to Amazon's online platform to expand the reach of its stores and consumer brands. The deal will also benefit Amazon as it can utilise the strong store-infrastructure network of Future Retail as pick-up points for its online sales.
According to a latest report by Antique Stock Broking, the agreement will drive synergies through Future Retail's expertise in distribution, customer acquisition and marketing initiatives.
THE COMPANY OPERATES amusement parks in Kochi, Bengaluru and Hyderabad and the Wonderla resort in Bengaluru. The company is focusing on improving its revenue stream by enhancing the share from the non-ticket revenue segment. Unfavourable weather and seasonality affected revenue performance in the September quarter. However, the management has expressed confidence that the footfall will improve across all locations in the upcoming quarters. The management is planning to set up new parks and the ample cash balance will help in meeting the capex requirements without any significant challenges. Kotak Securities is optimistic on the future potential of theme parks in India and maintains long term positive on the company and its management for running the business efficiently despite challenges.
THE REAL ESTATE company is primarily engaged in residential and contractual projects. The company has witnessed a gradual recovery in pre-sales that has grown 1.2% year-on-year and 8.3% quarter-on-quarter in the third quarter of 2019-20. The sales volume in Bengaluru remains healthy helped by the release of new towers at the Sobha Real Pavilion project. The new launches were subdued in the December quarter and the company is focusing on monetising its existing projects. The management has guided for 10.5mn sqft of new launches over the next 4-5 quarters and most upcoming new launches are in the below Rs 2 crore bracket where demand remains healthy. The strong launch pipeline will help 2020-21 numbers and raises hopes of better bookings ahead. Elara Capital believes the stock's underperformance is due to concerns of weak presales and increase in net debt. However, the correction is overdone and weak collections on the residential side is more due to RERA implementation, which should improve. Also, pickup in new launches should aid in pre-sales, although gradually. The brokerage house believes the company has to scale up new launches across its non-Bengaluru markets to improve its pre-sales run-rate. According to Bloomberg consensus estimates, the company is likely to deliver revenue and adjusted EPS growth of 15.4% and 16.4% respectively in the December quarter.
THIS IS A SUBSIDIARY OF Heidelberg Cement Group, Germany that manufactures cement, concrete and building materials. The company delivered decent operating performance in the September quarter helped by better than expected realisations. It has been a key beneficiary of improvement in demand-supply dynamics of the Central region and such dynamics will continue to remain positive with no new supply expected in the region. Analysts expect return ratios to improve in the future due to healthy operating efficiencies, plans of organic/inorganic expansions, cost optimisation and a likely balance sheet deleveraging. The management expects cement demand to be driven by increase in government spending on roads, railways, metros, civil aviation, irrigation and rural and affordable housing projects. According to Bloomberg consensus estimates, the stock currently trades at a 30% discount in terms of its 2019-20 estimated PE relative to the average estimated PE of the BSE500 index.
THE COMPANY AND its subsidiaries collectively known as the Taj Group is primarily engaged in the business of owning, operating and managing hotels, palaces and resorts. The management is confident of bright prospects of the hospitality sector and aims at delivering a RevPAR (revenue per available room) performance ahead of the industry over the next few quarters despite soft demand that has persisted since the beginning of 2019. Factors like asset-light growth, renovations with a return of capital approach and leveraging alternate funding platforms are significant growth drivers for the company going forward.JP Morgan believes the domestic macro environment may continue to weigh on near-term stock performance, but Indian Hotels seem well on track to achieve mid-teens growth in operating earnings given its margin improvement plan.
Stock and index values have been normalised to a base of 100. Current price as on 28 Jan.
Source: ACE Equity & Bloomberg.
Copyright Bennett, Coleman & Company Limited Feb 3, 2020