Lots of companies are saying they have ‘operating leverage’ — that’s just code for firing people

Trader Talk

The stock market is holding up well because it believes three things are happening: 1) a vaccine is coming, 2) there will be almost infinite stimulus from the Federal Reserve, and 3) the second quarter was the worst quarter for corporate profits and those profits will slowly improve.

But there’s a subtext to much of that belief that corporate profits will be improving: The Street believes many corporations are going to fire a lot of people and replace them with technology that will make the companies more efficient and improve profits.

This has been going on for years, or course. Companies are always trying to become more efficient, and increasingly that means firing people and replacing them with technology.

But the Covid crisis is likely accelerating that trend.

There’s a fancy accounting term that is being used a lot these days to describe this trend: “operating leverage.” Simply put, it means that if you can reduced a variable cost, such as labor, you can make more money once sales recover.

A lot more money.

That’s why analysts and strategist love using the term. It’s like a magic pixie dust: Saying “operating leverage is improving” implies more profits, and the company is heading in the right direction.

Usually, the right direction means firing a lot of people.

Mike Wilson, Morgan Stanley’s chief U.S. equity strategist, told Bloomberg a short while ago that there is the potential for a “tremendous” increase in operating leverage when the economy recovers from the Covid-19 pandemic. “When you go into a recession, cost-cutting is the focus,” he said, noting that the improved “efficiency” from firing people will go right to the bottom line.

A good example is today’s announcement from L Brands, which announced it was firing 850 people, or 15% of its office personnel. The retailer, whose brands include Victoria’s Secret and Bath & Body Works, said this would deliver $400 million in savings and improve profit margins.

The stock is up 30% today.

 Expect more layoffs in corporate America.

Why? Because people are expensive.

It’s important for investors to understand how corporations get from top-line revenues to the bottom line earnings.

One of the most important issues a company faces is controlling costs. There are many kinds of costs, but they fall into two broad buckets: fixed costs, such as insurance, rent and interest payments; and, variable costs like energy, labor, materials.

Fixed costs don’t change, regardless of how much product a company pumps out. Variable costs are a problem: They can vary depending on how much product a company produces. Much of the game in the corporate world involves controlling or reducing variable costs because by definition they make it difficult to model future costs and by extension make it more difficult to forecast profits.

Labor is usually the largest single cost a company has. Because there are many different pay grades, people come and go, you have to hire and fire depending on the economy and how well your company is doing. Labor is a variable cost — it can fluctuate.

Suppose, though, you can replace a lot of people by using technology — by using robots, or by using software that can do the work of many people or make existing workers more efficient. Technology is closer to a fixed cost, so if you can substitute technology for people you can substitute a variable cost (people) for something closer to a fixed cost (technology). There’s an additional bet that over time that cost of technology will decline, not increase as the cost for a human would. Over time, this will translate into a bigger bottom line.

That’s operating leverage: When you reduce variable costs and turn them into fixed costs, if revenues go up, you make more profit.

Here’s an example of operating leverage.

Suppose a company has $10 in revenues per share and $1 in operating income. Its profit margin is 10%.

Let’s say the company decides to fire 50% of its labor force and replace its people with technology. In the next quarter, the company reports an increase in revenues per share from $10 to $12, and its operating profit goes to $1.50. Assuming all other items are fixed, that increase in profit came from firing people. It’s profit margin has now gone to 12.5% ($1.50/$12), instead of 10%.

That’s operating leverage — they’re making more profit by controlling a variable cost — and they got it by firing a lot of people and replacing them with technology.

Pretty neat trick, eh?  Of course, one of the principles of capitalism is to improve efficiency — and reducing variable costs is one of the main ways companies become more efficient over time.

Sure, Wall Street loves this because it increases profits. But let’s not use fancy terms like “operating leverage” as a comfortable, neutral term to conceal what is really going on: firing a lot of people.

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