stress-free investing, page-8

GrahamLynchBuffet,

Yes, bottom-line growth exceeding top-line growth is a perfectly legitimate outcome.

In finance theory parlance, it’s called Operating Leverage, and it manifests itself whenever an enterprise’s Revenue line grows at a faster rate than the rate of growth in the Fixed Costs.

To best illustrate it in practice, consider the following hypothetical P&L in Year 0 (using the Revenue line based to 100 units, for arithmetic ease):


Revenue = 100
Cost of Goods Sold (CoGS) = 60 (i.e., assume a 40% Gross Profit Margin)
=> Gross Profit = 40

Cost of Doing Business (CoDB) = 10
=> EBITDA = 30

Depreciation and Amortisation (D&A) = 5
=> EBIT = 25

Interest Expense = 10
=> Pre-tax Profit = 15

Tax = 4.5 (30% tax rate)
=> Net Profit After Tax = 10.5


Now, in Year 1, assume the following:

1. Revenue growth = 5%
2. Gross Profit Margin = 40% (unchanged)
3. Growth in Fixed Costs (CoDB) and D&A = 3% (i.e., less than Revenue growth)
4. Interest Expense unchanged (i.e, no change in borrowings or cost of boroowings)
5. No change in tax rate


The pro forma P&L for Year 1 therefore looks as follows:


Revenue = 105
Cost of Goods Sold (CoGS) = 63.0 (i.e., assume a 40% Gross Profit Margin)
=> Gross Profit = 42.0

Cost of Doing Business (CoDB) = 10.3
=> EBITDA = 31.7

Depreciation and Amortisation (D&A) = 5.3
=> EBIT = 26.5

Interest Expense = 10
=> Pre-tax Profit = 16.5

Tax = 4.9 (30% tax rate)
=> Net Profit After Tax = 11.5


Calculating the rates of year-on-year growth of the various lines as one moves down the P&L yields the following:


Revenue: +5.0% (we assumed this)

Gross Profit: +5.0% (no surprise here because GP Margin is unchanged)

EBITDA: +5.7% (higher than growth in Revenue and Gross Profit due to fractionising of fixed CoDB)

EBIT: +5.8% (fractionising slower growth in D&A)

Pre-tax Profit: + 9.7% (faster than EBIT because interest expense is held constant)

Net Profit After Tax: +9.7% (in line with Pre-tax Profit, since tax rate is unchanged)


So, as you can see, under “necessary and sufficient” conditions of top line growth exceeding growth in fixed costs, it is completely logical for Operating Profit (EBIT) and Net Profit to grow faster than Revenue.


And in this case, as you rightly infer, there is a natural uplift in margins.


Apologise if I’m teaching you to suck eggs a bit with this somewhat trite explanation, but I thought the best way to illustrate the phenomenon was by way of a simple numerical example. (Believe it or not, I have met many professional equity analysts who don’t understand this dymanic)



Cam


PS. The example above provides for the situation where there is no change in the interest expense. In reality, companies worth their salt would be generating surplus capital which would be applied to reducing debt, in which case the interest expense would fall, and thereby further ratchet-ing up the NPAT line. This is known as Financial Leverage, as you probably know, and when it acts in concert with Operating Leverage, the impact on the bottom line can be powerful.

PPS. You mentioned that DLX’s margins are unchanged over time. I’m not sure I agree with you on that score. Be careful to adjust at the CodB line for the impost required for the company to transform from a subsidiary of a publicly listed company, to a publicly listed company itself. If one normalises for this, some work I had done concluded that some 200bps of margin enhancement has occurred over the past decade. Certainly, under ORI’s stewardship between 1992 and 1999, rolling, 3-year EBIT margin rose from around 12.8% to 13.7%, and in FY13 vs FY12 – which were relatively “clean” periods, the margin uplift in the heritage DLX business (i.e. pre-the ALS “wart”) was 30bp.