Retail stocks have taken a hit lately as visitors to malls continue to decline. But why are the retail companies so sensitive to mall traffic? In this article, we’ll take a look at American Eagle Outfitters and the concept of operating leverage.
When investors buy stocks, they usually look for companies that can increase their earnings rapidly for a big gain in the stock price. Unfortunately, most companies with high growth rates already have sky-high valuations to match. These are often companies at the forefront of new technology like Tesla or successful business concepts expanding to new territories like Panera. With prices so high, a small misstep can lead to a big drop as shareholders in Shake Shack can attest. But there is another way to invest in fast earnings growth – the turnaround play.
The turnaround play is not for the faint of heart as many companies struggle to get back on the right footing. However, it can be a fertile hunting ground for a savvy investor with the specialized domain knowledge to determine whether a company is facing a temporary challenge or a permanent decline. Although risky, the returns are high if the investor is right. This is because of operating leverage and the relationship between revenue growth and earnings growth.
Different types of costs
Every company has fixed costs and variable costs. Retailers, for example, have rent as a fixed cost. No matter how much or how little the company sells in the store, they will always have to pay the rent. But once the retailer sells enough product to cover the fixed costs, additional sales will only need to cover the variable costs. For example, the cost of each item the retailer sells. Any extra revenue beyond the point of covering the fixed costs have a large impact on earnings.
Operating leverage at American Eagle Outfitters
American Eagle Outfitters is a specialty retail store that sells clothes to college aged students. The company sells classic pieces of clothing like jeans under their various brands. Since the stock price declined recently along with most of the other companies in the industry, it might be a good candidate for a turnaround.
Let’s take a look at their revenues, operating income, and earnings per share for the past few years.
|Summary of Operations||
|Total Revenue (in thousands)||
|Operating Income (in thousands)||
|Earnings Per Share||
As you can see from the table, a small increase of 10% in revenue from $3.3 billion to $3.6 billion can cause operating income and earnings per share to double. This shows that you don’t need fast growth in revenue to have fast growth in earnings. However, operating leverage also works the other way. A 10% decline from $3.3 billion to $3 billion can have disastrous results for the bottom line. An investor looking at American Eagle Outfitters will need to dig deep into the drivers of value for the company to make an informed decision.
Another strategy for your toolkit
Many investors chase after expensive growth stocks and get hurt when the companies disappoint. As we have seen, this doesn’t have to be the case. A successful company turnaround with operating leverage can be a good alternative. Not only do the earnings increase in a turnaround, but the valuation multiple does as well.