Operational gearing can have a nasty impact when things go wrong
Rapid growth in e-commerce demand may lead some investors to conclude that transportation companies fulfilling orders would be superb investments. You may think again after analysing the horrific profit warning on 13 June from logistics group Connect (CNCT).
Revenue for its Tuffnells delivery business fell by 12.3% in its third quarter (or down 3.9% over nine months) amid lower volumes, plus costs have risen.
A logistics company is likely to have limited flexibility on cost as it still has to maintain a core service, so it is hard to see Connect making drivers redundant and selling off vans to save money.
The task has always been to increase utilisation of the vans and optimise route density, making sure they are full and not having to travel long distances to make a single delivery.
OPERATIONAL GEARING IMPACT
Let’s take a hypothetical situation of a company called Delivery plc which last year made £300m revenue and had £291m operating costs, giving it £9m operating profit.
Net interest costs were £7.5m which meant pre-tax profit equated to £1.5m. Tax at 19% was £0.3m, leaving it with £1.2m net profit. With 100m shares in issue, earnings per share was 1.2p which twice covered its 0.6p dividend per share.
Revenue then drops by 5% in the current year, taking its sales to £285m. Based on costs remaining the same at £291m, operating profit is wiped out and it makes a £6m operating loss.
Management will now be under pressure to cut the dividend.
This example demonstrates the effects of operational gearing and how they can severely hurt low margin businesses. A small reduction in revenue can have a major impact on earnings strength and is relevant to Connect’s latest update. It’s no wonder that analysts have slashed Connect’s dividend forecast by 80%.
NO ROOM FOR ERROR
The gap between revenue and profit is very small at Connect, hence there is no room for error. It has a 3.4% operating margin according to SharePad. While better than Royal Mail’s (RMG) 2.7% margin, you have to weigh up stark differences between the two companies.
The latter has a plan to boost margins through automation and more efficient operations, plus it has a highly valuable brand and unique market position for letter delivery.
In contrast, Connect has made a number of flawed strategic moves over the years including the purchase of Tuffnells which operates in a commoditised industry and has an undifferentiated service.
There is no loyalty in the parcels delivery industry: failure to perform a good service will see customers switch to a competitor.
Tuffnells’ sudden drop in revenue could well be a result of this situation. It had already warned in May about operational inefficiencies within Tuffnells, flagging a high turnover of depot managers and key operational roles, plus troubles hiring enough drivers.
The lesson here is to treat low margin businesses as high risk investments. Either avoid them completely or keep a close eye on all commentary to spot problems before they elevate into a negative profit shock. Connect’s issues were certainly crystal clear weeks before its warning.