The past few days in finance we have been learning about capital structure and how there is an optimal ratio of debt to equity that maximizes stock price. The debt to equity ratio is a fascination subject that I promise to get to in a blog post very soon, but first I want to cover a company, Genco Shipping (GNK) and talk about their operating leverage.
If you’re unfamiliar with the term operating leverage, don’t let it scare you. Operating leverage can be defined as what percentage of the company’s costs are fixed. If a company’s costs are mostly fixed (for example, a lease on a building would be a fixed cost. A company must pay the lease every month.) the company is said to have a high degree of operating leverage. I bring this up because today in my finance class we talked about the company Genco Shipping. You have probably never heard of Genco Shipping. Genco is in the industry of shipping dry goods and heavy metals across the various oceans of the world. Their website is nothing special, and they don’t do home deliveries like UPS or FedEx. Although you have never heard of them, Genco was at one time (very recently) at the top of the world with a stock price around $85 dollars per share. This high market value only lasted until the recession and now Genco sells for about $2.50 per share. But why? Did the financial crisis impact Genco that badly? How Genco is leveraged will help explain their dramatic drop in stock price, and could also provide valuable insight for a good stock buy.
We’ll start by taking a look at Genco’s income statement for the past four quarters. Below you can view Genco’s income statement. Take a look at what I’ve circled in red. These are the company’s costs over the past four quarters. Notice how they are all relatively the same and don’t change much from time period to time period. This means that the costs are fixed. If these were variable costs than the company would scale back whatever is costing so much in order to save money. However, Genco does not have this option.You’ll notice too that the sales of the company have been increasing the past three quarters, from 40 to 46 to 59. More on this a little further down; let’s continue to look into the company.
I have made a little Excel spreadsheet to take this data and make it a little bit more usable. What we see here are rounded numbers of the performance of the company in Quarter 1 and Quarter 3. I have averaged the fixed costs these so that we can use the same amount in each quarter just to make life easier, and we can carry these numbers through our theoretical quarters we’ll get to in a second. Right now you can see I have Quarter 1 and Quarter 3 plotted. Think of these as “Really Bad” and “Bad” quarters. We have noticed that there has been an upward trend in sales the past few quarters, so this should naturally make us curious about “what if” the company broke even or even posted a profit. What would be the stock price? Further more, if the company had a “Good” and “Really Good” quarter, where would that leave the stock price?
In the Excel above we see the stock price if the company breaks even. Now I do know that an earnings per share of >$0 is technically doing better than breaking even, however a revenue of $100 was selected since it’s a nice round number. After all, even with a revenue of $100 the company just barely manages to do better than break even. What we see now is after breaking even, the company has a stock price of about $5.60.
Above we now have some numbers plugged in for a “Good” quarter (which has revenue just over 10% greater than the break even point). Because the company’s costs are all fixed, they do not change even though the company is creating more sales. This leads to a much greater profit margin. For the good quarter the company has a price to earnings ratio of 15 (the market average) which yields the stock price to be just under $18.00. If we take this further and the company has a “really good” quarter than we see the stock price soar to over $60.00. With most companies cost of sales increase as sales increase, keeping the profit margin relatively the same. However with a highly leveraged company, the cost of sales is always going to be relatively the same, so as sales increase, profit margin increases as well.
Let’s conclude this lengthy post by looking again at the sales revenue the past three quarters. Sales revenue has been rising: $40, $46, and $59. Above I have an index chart for the BDIY. The BDIY is a benchmark for dry shipping rates, exactly the industry that Genco is a part of. We could say that this graph shows how much Genco gets paid to ship items. As you can see, the shipping rate has been increasing for most of the year, and it correlates with Genco’s increased revenue each quarter this year. The shipping rate has taken a slight dive recently, but all indexes are vulnerable to some volatility. If the BDIY continues to increase you could see Genco make a comeback, along with their stock price. I do however, also want to mention that this company is a big risk. Interest on debt is almost 40% of their sales for this past quarter. Even though Genco has made better revenues the past three quarters, they have had such a large interest payment compared to sales for such a long time that if shipping rates don’t continue to increase, the company may go bankrupt. The stock closed today at $2.70, if you have some insights to trans-oceanic shipping and feel good about it, it may be worth spending a small sum of money on a few shares and seeing where it takes you in a few quarters.