The Investment Checklist

by Michael Shearn

  To determine the degree to which a business is cyclical or countercyclical, you must first ask which types of economic conditions make it easier for a business to attract customers. If a business does well during an expanding economy yet does not prosper when the economy is shrinking, it is cyclical. For example, the following businesses are cyclical:

  Household furniture

  Apparel

  Appliances

  Vacation travel

  Automobiles

  Homebuilding

  Big-ticket luxury manufacturers

  Residential construction

  These are products that consumers can defer purchasing in tough economic times. The longer a consumer can defer purchasing these items, the more cyclical a business will be.

  Some products and services are less cyclical. Customers buy less, but do not completely defer the purchase—for example, businesses in these industries:

  Advertising

  Medical equipment

  Drugs

  Periodicals

  Insurance carriers

  Dairy products

  Legal services

  Accounting services

  Bakery products

  Countercyclical businesses do well when the economy is contracting; for example:

  Discount retailers

  Private-label products (store brands versus nationally branded products)

  Medical care

  While rare, certain industries operate independently of the economic cycle. In this case the product or service may be more of a necessity; for example:

  Tobacco companies, where customers are addicted to the product

  Pipelines carrying oil and gas

  Student-housing REITs

  Funeral services

  The following sections take a closer look at industries that are recession resistant. If a business is recession resistant then its earnings will not be impacted as the economy enters a recession, thereby making it easier to value.

  Recession-Resistant Businesses

  A recession-resistant business, which is rare, is one where the earnings of the business are less affected by a contraction in the general economy. For example, consider the economic contraction that began in 2007. To understand if a business is recession resistant or resilient, study how it responded to that economic slowdown. Start by reading the MD&A section found in the 10-K. Read about the reasons for changes in the financial statement line items, such as sales, so you can gauge the effect of recessions. Read articles written about the business during the recession as well as historical conference calls. It is highly likely that analysts and journalists will be asking company management how their business is responding to the recession, and management’s answers will yield many insights.

  For example, specialty gas distributor Airgas sells the majority of its products to non-cyclical and counter-cyclical businesses. Many of its products are used for maintenance and represent a small portion of a customer’s total costs. If you look back at previous recessions, Airgas generated relatively flat revenues and earnings before interest, taxes, depreciation, and amortization (EBITDA), indicating that Airgas is a recession-resistant business. In a fourth quarter 2009 conference call, COO Micheal Molinini said:

  25 percent of our sales are the customers impacted by the more traditional cyclicality of industrial manufacturing, while 30 percent of our sales are the customers whose growth profiles tend to outperform GDP. Another quarter of our sales are the customers who use our products primarily for repair and maintenance, and the volumes in that business tend to stay more stable than manufacturing. In today’s economy, the diversity of our customer base has helped soften the impact of the rapid decline in U.S. manufacturing.

  Therefore, by reading a conference call transcript, you would have learned that at least 55 percent of Airgas’s revenues are recession resistant.

  Degree of Recession Resistance

  The degree to which an industry or business is affected by recessions depends on several factors:

  The amount of recurring revenues a business generates (more recurring revenue means less volatility in earnings and more resistance).

  The percentage of the customer’s budget that is spent on that business’s product or service (if a small percentage of the customer’s budget is spent on that business’s product or service, the customer is less likely to drop the product or service).

  The percentage of its customers that are exposed to business cycles and how sensitive they are to these cycles (if a business sells to homebuilders, that business will be greatly affected by cycles in residential construction).

  Past Recessions

  Many industries and businesses are labeled as recession resistant because they were able to survive a previous recession without a large drop in revenues. Be cautious when you see an industry labeled as “recession resistant” because not all recessions are created equal, and each recession impacts businesses in different ways. Be sure to understand if there were complicating factors, such as supply/demand imbalances in previous recessions. Such factors can mask the true effects of a downturn.

  For example, Las Vegas casinos were considered to be recession resistant during the 1980s and 1990s because they had fared better than other businesses during previous recessions. The real reason they did so well was because Las Vegas casino demand was growing and supply was limited during those years. During the recession in 2007, however, there was an oversupply of casinos in the Las Vegas market, which caused Las Vegas casinos to experience their worst operating results ever.

  Be certain to consider location and context as you evaluate supply and demand. Regional casinos, for example, were much less affected by the recession in 2007, mainly because of limited supply. In regional markets, the numbers of slot machines and table games are strictly limited by local gaming regulation. As a result, these markets have less chance of being oversupplied. For example, regional gaming company Penn National Gaming found that even though customers were spending less on their visits, they continued to visit the casinos at the same frequency. By comparison, in Las Vegas, there was both a drop in trip frequencies and in how much customers spent during each visit.

  The veterinary industry has also been labeled a recession-resistant industry because spending on pet health did not drop during the recession that began in 2007. According to an annual industry survey, veterinary spending increased 3 percent in 2009 against a 2.4 percent drop in GDP. There is evidence that veterinary spending is becoming less discretionary, with people more likely to demand higher-quality vet care and less likely to defer spending during downturns. However, increased demand has also been fueled by changes in pet testing. In the past, most vets diagnosed an animal through touch and direct observation; however, new vets are increasingly taught to use tests as a tool for diagnosis. Before drawing the conclusion that veterinary spending as a whole is recession resistant, consider that recent resistance may have been due to increased testing. This underlying trend may not fuel demand during the next recession so the veterinary industry may not be as recession resistant as investors believe it to be.

  30. To what degree does operating leverage impact the earnings of the business?

  Operating leverage measures the impact of changes in sales on earnings. The higher the operating leverage a business possesses, the more difficult it is to forecast the earnings of the business. For example, a relatively small error in forecasting sales can be magnified into large errors in earnings projections. If sales decrease by 10 percent, then earnings may decrease by 30 percent. This means that businesses that have high fixed costs typically report erratic earnings, which makes them more difficult to value. In contrast, businesses that have low fixed costs and high variable costs present lower volatility in earnings and are simpler to value. For example, a 10 percent growth rate in sales for a variable-cost firm could translate into 10 percent growth in earnings. The earnings are therefore not as volatile as a business with high amounts of operating leverage
.

  Types of Businesses with High Operating Leverage

  The following businesses typically have high operating leverage:

  Businesses that have a high labor component

  Businesses with high capital-expenditure requirements

  Manufacturers with high material and production costs

  Businesses that are required to invest a lot of money in inventory

  These types of businesses include:

  Airlines

  Aluminum manufacturers

  Auto manufacturers

  Bond rating firms

  Chemical manufacturers

  Gaming businesses

  Hotels

  Mining companies

  REITs

  Retailers

  Steel makers

  Supermarkets

  Theme parks

  Universities

  Calculating the Degree of Operating Leverage

  Businesses have varying degrees of operating leverage. Some businesses have low amounts of operating leverage, such as hotel franchisor Choice Hotels, and some have high amounts of operating leverage, such as a theme park.

  To calculate the degree of operating leverage (i.e., how much earnings are influenced by changes in sales), divide the percentage change in operating income by the percentage change in sales. The higher the degree of operating leverage, the more volatile the operating-income figure will be relative to a given change in sales. For example, let’s look at two companies, Boeing and Choice Hotels:

  Boeing has a high degree of operating leverage: For the year ended 2008, Boeing reported in its 10-K that revenues decreased 8.3 percent and operating income decreased 33.9 percent.

  By comparison, also in 2008, hotel franchisor Choice Hotels in its 10-K reported revenue increased 4.3 percent, with a corresponding 1.5 percent increase in operating income, which means it has a lower degree of operating leverage compared to Boeing.

  Let’s examine one business in more detail to understand why it has high operating leverage.

  Case Study: Why Theme Parks Have High Operating Leverage

  A theme park has very high fixed costs and low variable costs. A theme park requires significant capital investment in terms of land and equipment. Each year, a park has to make significant investments in new attractions in order to attract more customers. Fixed costs do not change with the number of customers and a lot of these costs are still incurred even when the theme park is closed. After reaching a certain level of attendance, where a theme park achieves its break-even point, every new customer’s ticket revenue drops straight to the bottom line which contributes to high marginal profit. Therefore, it is in the interest of a theme park to increase attendance.

  Table 6.3 compares the revenue growth and earnings before interest and taxes (EBIT) growth for theme park Six Flags.

  Table 6.3 Revenue Growth Compared to EBIT Growth for Six Flags Theme Parks

  Data source: “Six Flags Emerges from Bankruptcy,” HedgeWorld News via Reuters, May 3, 2010, and Standard & Poor’s Capital IQ.

  This shows how sensitive earnings are in relation to revenue. High operating leverage can make a company vulnerable on two fronts:

  If the business faces any risk of say, reduced revenue, as in the case of Six Flags, it has the additional, amplified earnings risk that accompanies it.

  If the business has high amounts of debt, this combination can be disastrous.

  Be careful if you invest in businesses that have high operating leverage and large amounts of debt. They can go bankrupt quickly, because small declines in revenue are amplified into larger declines in earnings, bringing about an inability to make interest payments.

  To calculate the actual amount of the degree of operating leverage at a business, you need to understand what the break-even sales are for the business. This way, you can determine how a corresponding increase or decrease in revenue will impact the operating income of a business.

  Calculating Break-Even Sales

  Ideally, you would want to understand at what level of sales a business would generate break-even earnings. This way, you would be in a better position to understand at what level of sales operating leverage will start to work against the earnings of the business or in its favor.

  Here’s a method used to calculate break-even sales: If a business generates $1 million of sales and has a 30 percent gross profit margin (GPM) and incurs $200,000 in fixed costs, it will earn $100,000. Therefore, break-even sales would be $666,667 (Sales × 30 percent = $200,000), assuming everything else stays equal. Unfortunately, in the real world, everything else does not stay equal, which makes it difficult to calculate at what level of sales a business will break even.

  Further complicating things, it is difficult to calculate the exact amounts of fixed and variable costs: Even management has difficulty calculating exact amounts. The reason for this is that most fixed costs are more flexible than they appear because equipment can be sold, a labor force can be resized, leases can be renegotiated, or certain production lines can be shut down. For example, hotels over the last decade have been able to change their break-even cost for occupancy. For example, break-even occupancy for hotels declined steadily between 1986 and 2000.8 In 1986, a hotel had to have an average occupancy of 66.4 percent to break even. By 2000, this amount changed to only 47.4 percent. Why the drop? Because hotels shifted their revenue mix to focus on high-margin room revenues. They cut costs related to accounting, telephones, and other back-of-the-house staffing, and they lowered debt levels. These changes enabled them to break even if a hotel was only half full.

  Instead of calculating an exact amount for break-even level, you can calculate rough estimates for the businesses you’re considering investing in: After all, a rough approximation is better than no approximation. Let’s start by examining how to identify fixed and variable costs using the 10-K report so you can estimate break-even sales.

  Identifying Fixed Costs

  A fixed cost is a cost that does not change with the number of outputs. For example, with a stainless steel manufacturer, certain machinery needs to be kept running even if it is not making anything. Heaters must be constantly kept running even if the plant isn’t making steel because if they were turned off, the equipment would disintegrate. Also, fans that handle pollutants must always be kept on because turning the motors on and off can damage them. These costs remain the same whether the steel mill makes one batch of steel or 10 batches. If demand for steel drops, these plants must continue to operate, and when sales drop, that contributes to a large decrease in earnings.

  Identifying Variable Costs

  Variable costs are costs that change in direct proportion to changes in revenue. If a business sells more items, costs increase, and if sales decrease, then costs will decrease. The types of businesses with the highest variable costs are franchisors.

  An example would be real estate brokerage firm Coldwell Banker, which sells franchise rights to use its brand. When Coldwell Banker’s franchised brokers sell properties, the company receives a fee from the sale proceeds. Coldwell Banker then pays for national advertising and marketing from the proceeds of sales, and so tends to incur costs only in relationship to transactions.

  To begin learning more about how to identify fixed and variable expenses and how to calculate them, two examples are presented below. The first is Southwest Airlines, which has a high fixed-cost structure and low variable costs; the second is Choice Hotels, (a franchisor of hotel brands such as Comfort Inn, Comfort Suites, and Clarion), which has high variable costs and low fixed costs. Both examples illustrate how you can use the balance sheet and income statement to help you identify the fixed and variable expenses. Let’s start by reviewing the balance sheet.

  Reviewing the Balance Sheet

  Start by looking at the fixed assets as a percentage of total assets of the business. A business that has a large percentage of long-term assets compared to total assets typically has a high fixed-cost structure.

 
At Choice Hotels, total assets are $340 million as of December 31, 2009. The total long-term assets are $64 million, of which $43 million are net property, plant, and equipment, and $21 million are long-term investments. Total long-term assets are 19 percent of total assets, which implies that Choice Hotels has a low level of fixed costs.

  In contrast, as of the end of 2009, Southwest Airlines had total assets of $14.27 billion. Its total long-term assets are $10.39 billion, made up of net property, plant, and equipment. Total long-term assets are 73 percent of total assets, which implies that Southwest Airlines has a high level of fixed costs.

  Reviewing the Income Statement of Southwest Airlines to Identify Fixed and Variable Costs

  Next, review the income statement and begin with the total selling, general, and administrative expenses (SG&A). The SG&A section is where the majority of fixed costs are typically found. To walk you through this process, let’s use the 2009 income statement of Southwest Airlines as an example. The breakdown (in millions) is shown in Table 6.4.

  Table 6.4 2009 Operating Expenses of Southwest Airlines

  Total Operating Expense Breakdown Amount (in millions)

  Salaries, wages, and benefits $ 3,468

  Fuel and oil $ 3,044

  Maintenance materials and repairs $ 719

  Aircraft rentals $ 186

  Landing fees and other rentals $ 718

  Depreciation and amortization $ 616

  Other operating expenses $ 1,337

  Total operating expenses $10,088

  Next, use the MD&A of the 10-K to classify whether expenses are fixed or variable. The examples shown below (in quotation marks) are from the 2009 Southwest Airlines 10-K:

  Salaries, wages, and benefits—Fixed Costs: “Salaries, wages, and benefits expense per ASM (Available Seat Miles) was 9.6 percent higher than 2008, primarily due to the fact that the Company’s unionized workforce, who make up the majority of its Employees, had pay scale increases as a result of increased seniority, while the Company’s ASM capacity declined 5.1 percent compared to 2008.” In addition, the notes section of the 10-K states, “Approximately 82 percent of the Company’s Employees are unionized and are covered by collective bargaining agreements.” You can therefore conclude that most of the salaries, wages, and benefits are fixed.