Tech investors beware, operating leverage has a dark side

Many online businesses benefit from fixed costs, but the downside for profits can be extreme. 

On Monday, iSelect's (ASX: ISU) share price fell 50% after management halved its 2018 profit forecast due to falling sales leads. A year ago this stock was hitting all-time highs, having doubled in three years. How did it end so badly?

Investors rightfully love growth and this comparison website was worth salivating over: iSelect's revenue had grown 54% in the three years to 2017. Operating profits, on the other hand, were up 300%. 

The company managed this feat thanks to something known as operating leverage. It works like this: for businesses with significant fixed costs, any increase in revenue doesn't lead to a proportionate increase in expenses, so profits can grow faster than sales. 

iSelect has a large customer support centre that grows and shrinks depending on demand, but many of the business's costs are fixed, such as marketing costs and the programmers building the website itself. It doesn't matter whether a thousand people use the iSelect website or a million do, those programmers are still at their desks. 

Between 2014 and 2017, the company added $65m in revenue. After accounting for direct sales costs, gross profit increased $19m over that time. But here's the kicker – admin expenses only rose $3m. A $19m increase in gross profit and $3m increase in admin costs meant operating profits skyrocketed from $6m to $22m. 

Operating leverage is great when revenue is growing, but it also means that losses are supercharged if sales start to shrink. Myer (ASX: MYR) learnt this the hard way – a 5% decline in sales over the past five years led to a 60% decline in operating profits because the costs of running a department store are roughly the same whether you sell a million T-shirts or half a million. 

Now iSelect is learning that same lesson – the cost of running a website is pretty similar whether you have a million viewers or half a million.

Watch the downside

The pitfalls of operating leverage have never been more relevant. Increasingly, the stock market is filled with online businesses that have a high proportion of fixed costs and significant operating leverage. Conversely, the bricks-and-mortar companies they're often displacing, such as retailers, also have significant fixed costs. Investors should buckle up for more extreme profit movements, both positive and negative.

This has big implications for valuations and stock prices. Many investors value stocks by projecting profit growth and using price-earnings ratios. 

Slow growing businesses with little operating leverage tend to get moderate price-earnings ratios – take Primary Health Care's (ASX: PRY) network of GPs, for example, with a price-earnings ratio of 20 and profits that should grow in the mid-single digits. REA Group (ASX: REA), on the other hand, has been growing earnings at 20% a year for a decade, so investors are willing to pay a much higher multiple of 30 times earnings. 

The trouble is that for many of these fast-growing digital businesses, any slowdown or decline in revenue will be exaggerated by the time it gets to the bottom line. 

No-one will be paying a price-earnings ratio of 30 if there are a few consecutive years of falling profits, so investors would be hit by a triple whammy – a small decline in revenue would cause a large decline in profits and investors would likely pay a lower multiple for those earnings. The share price would be clobbered. 

This shouldn't spook you out of high-growth stocks that have benefited from operating leverage – it's a blessing when things go right, and for many of these businesses it should continue to go right. But with exaggerated downsides, it does mean paying close attention to your exposure, which is why no tech stock on our coverage list has a recommend portfolio weighting above 6%.

Intelligent Investor is loading up the van and going on tour in April and May, with events on the NSW central and north coast, the QLD mid-north coast and in PerthAdelaideMelbourneSydney and Canberra. If you'd like to hear us talk about building a portfolio to weather any storm, book your spot here.

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