Leverage - of any type - magnifies returns. This is true for both the downside (see $SVU & $CZR in 2012) as well as on the upside (see $S – Sprint doubled! Meh).
The above examples, as well as most talked about levered companies, are levered financially. Meaning their equity is a small portion of their entire enterprise value. So even a relatively small change in the value of the entire company, will cause a large change in the equity.
As I’ve written in the past, when investing in financially levered companies, you have to keep a close eye on the debt of the company. Since it’s the larger component of the enterprise value and bond markets tend to be “smarter” than the equity markets, small moves in the company’s bonds are often followed by larger – more amplified – moves in the equity.
There is another type of leverage that is less talked about & harder to quantify, but - perhaps because of that – probably more lucrative.
Say you have two companies in similar sectors, one company invested in their infrastructure right off the bat… they purchased property, purchased material, built molds etc. while the other took an “invest as we grow” strategy. Once each company reaches their respective break-even points, the first company’s profits will explode higher vs a much slower increase for the other.
There are companies within the same industry that have significantly different amounts of operating leverage, and similar to financial leverage, this works in both directions. If the industry is growing, you would want to invest in the company with more leverage. On the other hand, on the flip side, the fixed costs of the company will be a huge liability if the industry is in a decline.
This exercise is also tremendously useful moving up a level. If the overall economy is going through an expansion phase, you want to invest in assets of industries with higher amounts of operating leverage.
A perfect example of the power of operating leverage is Sirius Satellite Radio ($SIRI). After their merger with $XMSR in 2008 their stock took a beating. This wasn’t so surprising. The company invested billions of dollars in launching satellites, hiring and developing exclusive content etc. that during the “great recession”, with the prospects of subscriber growth dwindling, the company felt the pain of all those fixed costs.
In came John Malone (via Liberty Media ($LMCA)) with what has to be one of the best investments of all time. $SIRI had $3.25B in debt, with almost $200M of that due on 2/17/09. A few days prior to the 17th, literally on the verge of bankruptcy, Liberty loaned the company $550M in exchange for shares convertible into 40% of the common stock. Within the year, $SIRI was able to refinance and repay the loan.
As the economy & revenues started to rebound, some serious operating leverage kicked in. With so few variable costs, almost all of the company’s new revenues from new subscribers and new advertising flowed straight down to the bottom line.
The company went from an adjusted EBITDA loss of $136M in 2008, and a low of $0.05 per share – that’s five cents – on 2/11/09, to an adjusted EBITDA gain of $920M in 2012. At a current $3.13 the stock is up a staggering 62x!
Malone bought more over time and now controls over 50% of the corporation. His original 40% – which had a theoretical negative cost (because the debt was paid back with interest) is worth an astonishing $8.2 Billion!
Now that’s some nice leverage!