The Viewpoint: Operational gearing friend or foe?

Operational gearing – a double-edged sword

The idea of operational gearing is one which is reasonably well understood, but powerful, nonetheless. Incremental changes in sales once you have covered a business’s fixed costs drop through to profits dramatically. It is however very much a double-edged sword – if sales fall and the cost base doesn’t then you see any sales reduction magnified in its impact on a company’s profitability.

Operational gearing maybe again become a friend, rather than an enemy

Perhaps the most dramatic example of negative operational gearing which most current investors will have experienced came during the Covid-19 lockdowns. All at once many businesses saw not just reductions in sales, but sales collapsing almost to zero – think of airlines running no flights, cinemas showing no films or restaurants serving no meals. Such businesses swung into large losses as they still had many of their costs, but had no income to cover those costs, leaving some businesses struggling for survival.

UK housing market – a prime example

A somewhat more subtle but recent example has been what we have seen in the UK housing markets. Residential property markets have had a lot to deal with in the last couple of years, with interest rates climbing steeply and the government’s help to buy scheme ending. The impact on housing transactions has been profound. Having consistently been somewhere about 1.2 million per annum for many years, housing transactions dropped to around 1 million in 2023-24. New houses built per annum also dropped from around 170k to around 135k. To see what that meant for companies exposed to the housing market, let’s examine brick manufacturer Ibstock and housebuilder Taylor Wimpey. Taylor Wimpey saw their full year 2023 sales drop by 21% compared to 2022 and their profits by 50%. In recently released interim results, Ibstock reported sales down 20% 2024 on 2023, and profits down 60%. The profit falls were despite both companies doing what they could to be more efficient, operate leanly and reduce their cost bases. When we speak to many building related companies there is a sense that they are in good shape, but are waiting for the oxygen of an improvement in their underlying end market.

Housing market recovery is likely

2024 has seen a new government for the UK, and one which is keen to reinvigorate the housing market and build significantly more new homes. While this may not be easy and the planning system may take time to unblock, they will likely be helped by a better picture in terms of mortgage costs and affordability. Inflation has moderated, allowing interest rates to be cut and average wages are still showing some growth. At some point volumes in the housing market are likely to recover. The country does have a housing shortage and there is likely to be a fair bit of pent-up demand for people to move or buy their first homes. When that does happen the businesses which have had to hunker down and manage their cost bases through the tough times may find that a these put the higher volumes through their leaned down facilities their profits recover quickly. Operational gearing maybe again become a friend, rather than an enemy.   

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.