Operating leverage and the impact on company earnings per share

The Australian equity market has risen 23.6% over the year and is trading on a price earnings multiple of ~14x for the 2014 financial year. This is not an expensive multiple within a historical context, being close the long term average. The question many investors are asking is ‘Where will the earnings come from to support the market and drive it higher into the future?’. We believe that ‘operating leverage’ is potentially greater than consensus anticipates and could drive earnings and the market higher. At a simplistic level, operating leverage defines the extent to which revenue growth, translates into income growth.

Looking forward, we are in an economic environment where global growth is improving. Australian interest rates are at record lows at 2.50%, the Australian dollar has fallen from its $1.10 peak, the residential housing market is improving with clearance rates well above 70%, business and consumer confidence has rebounded strongly and we now have a majority government. These are the ingredients to suggest that an improvement in sales volumes is likely and the ultimate effect on earnings can be magnified due to operational leverage.

The chart below presents a scenario where consensus sales growth for the median industrials company is expected to be 4.9% and 4.3% in the 2014 and 2015 financial years respectively. Both these figures are significantly below the pre-GFC levels of over 11%. The red dotted line in the chart below illustrates the effect only a marginal additional increase in sales growth of 1.75% and 2.75% respectively would have over the same period. 

 

 

The consequence of this potential increase could result in earnings per share growth almost doubling from 8% (consensus) to ~15% in 2014 and from 10% (consensus) to ~14% in 2015. These potential earnings per share outcomes illustrate the extent of the operating leverage within the industrials sector as a result of their cost reduction programs and highlights the prospect of earnings upgrades.

Indices:

The Australian All Ordinaries Index has moved up increasing by +1.2% since closing last Friday to 02:30 pm today.

                                                                                                                                  

The rest of the world as measured by the MSCI index increased +3.6% in A$ from closing last Friday to end of trade Thursday.

Have a great weekend,

The team at IPS