(a) Analysis of earnings stability

Here the level of the breakeven point in absolute terms matters much less than the company’s position relative to its breakeven point.

When a company is close to its breakeven point, a small change in sales triggers a steep change in its net income, so a strong rate of earnings growth may simply reflect a company’s proximity to its breakeven point.

Consider a company with the following manufacturing and sales characteristics:

Its breakeven point stands at 4000 units. To make a profit, the company therefore has to sell at least 4000 units.

The following table shows a comparison of the relative increases (or reductions) in sales and earnings at five different sales volumes:

This table clearly shows that the closer the breakeven point, the higher the sensitivity of a company’s earnings to changes in sales volumes. This phenomenon holds true both above and below the breakeven point.

Consequently, breakeven analysis helps put into perspective a very strong rate of earnings growth during a good year. Rather than getting carried away with one good performance, analysts should attempt to assess the risks of subsequent downturns in reported profits.

For instance, Air France and easyJet posted similar sales trends but different earnings trends during 2015 because their proximity to breakeven point was very different. Question 8 on page 175 will ask for your comment on this table:

Likewise, the sensitivity of a company’s earnings to changes in sales depends, to a great extent, on its cost structure. The higher a company’s fixed costs, the greater the volatility of its earnings, as illustrated by the following example.

Marks & Spencer, the UK retail group, has the lowest fixed costs of the three and Compagnie des Alpes the highest as it operates ski resorts and leisure parks. A 0.4% increase in Compagnie des Alpes’s turnover drives its earnings up by 10%, whereas a similar increase in sales leads to a much smaller increase in Marks & Spencer’s operating income (1%). The situation of Reckitt (consumer products) stands in between the two extremes of retail (very limited fixed costs) and leisure (the largest proportion of fixed costs).

In case of a slump in activity, Compagnie des Alpes’s results will decline faster than Marks & Spencer’s due to Compagnie des Alpes’s much higher proportion of fixed costs. The operating leverage of Compagnie des Alpes is high and that of Marks & Spencer is low.

(b) Assessment of normal earnings power

The operating leverage, which accelerates the pace of growth or contraction in a company’s earnings triggered by changes in its sales performance, means that the significance of income statement-based margin analysis should be kept in perspective.

The reason for this is that an exceptionally high level of profits may be attributable to exceptionally good conditions that will not last. In such conditions good performance does not necessarily indicate a high level of structural profitability. This held true for a large number of companies in 2000.

Consequently, an assessment of a company’s earnings power deriving from its structural profitability drivers needs to take into account the operating leverage and cyclical trends, i.e. are we currently in an expansion phase of the cycle?

(c) Variance analysis

Breakeven analysis helps analysts account for differences between the budgeted and actual performance of a company over a given period.

The following table helps illustrate this:

This table shows the collapse in the company’s earnings of 20 is attributable to:

• the fall in sales (−25%);
• the surge in fixed costs (+20%);
• the surge in variable costs as a proportion of sales from 83.33% to 86.7%.

The cost structure effect accounts for 50% of the earnings decline (4 in higher fixed costs and 6 in lower contribution margin), with the impact of sales contraction accounting for the remaining 50% of the decline (10 lost in contribution margin: 30 against 40).

(a) Industrial strategy

A large number of companies operating in cyclical sectors made a mistake by raising their breakeven point through heavy investment. In fact, they should have been seeking to achieve the lowest possible operating leverage and, above all, the most flexible possible cost structure to curb the effects of major swings in business levels on their profitability.

For instance, integration has often turned out to be a costly mistake in the construction sector. Only companies that have maintained a lean cost structure through a strategy of outsourcing have been able to survive the successive cycles of boom and bust in the sector.

In highly capital-intensive sectors and those with high fixed costs (pulp, metal tubing, cement, etc.), it is in companies’ interests to use equity financing. Such financing does not accentuate the impact of ups and downs in their sales on their bottom line through the leverage effect of debt, but in fact attenuates their impact on earnings.

When a company finds itself in a tight spot, its best financial strategy is to reduce its financial breakeven point by raising fresh equity rather than debt capital, since the latter actually increases its breakeven point, as we have seen. As an example of this 
policy, commodities giant Glencore raised equity in September 2015 and ArcelorMittal in early 2016.

If the outlook for its market points to strong sales growth in the long term, a company may decide to pick up the gauntlet and invest. In doing so, it raises its breakeven point, while retaining substantial room for manoeuvre. It may thus decide to take on additional debt.

As we shall see in Chapter 35, the only real difference in terms of cost between debt and equity financing can be analysed in terms of a company’s breakeven point.

(b) Restructuring

When a company falls below its breakeven point, it sinks into the red. It can return to the black only by increasing its sales, lowering its breakeven point or boosting its margins.

Increasing its sales is only a possibility if the company has real strategic clout in its marketplace. Otherwise, it is merely delaying the inevitable: sales will grow at the expense of the company’s profitability, thereby creating an illusion of improvement for a while but inevitably precipitating cash problems.

Lowering the breakeven point entails restructuring industrial and commercial operations, e.g. modernisation, reductions in production capacity, cuts in overheads. The danger with this approach is that management may fall into the trap of believing that it is only reducing the company’s breakeven point when actually it is shrinking its business. In many cases, a vicious circle sets in, as the measures taken to lower breakeven trigger a major business contraction, compelling the company to lower its breakeven point further, thereby sparking another business contraction, and so on. See Blackberry or Yahoo as examples.

(c) Analysis of cyclical risks

As we stated earlier, there is no such thing as an absolute breakeven point – there are as many breakeven points as there are periods of analysis. But first and foremost, the breakeven point is a dynamic rather than static concept. If sales fall by 5%, the mathematical formulas will suggest that earnings may decline by 20%, 30% or more, depending on the exact circumstances. In fact, experience shows that earnings usually fall much further than breakeven analysis predicts.

A contraction in market volumes is often accompanied by a price war, leading to a decline in the contribution margin. In this situation, fixed costs may increase as customers are slower to pay; inventories build up leading to higher interest costs and higher operating provisions. All these factors may trigger a larger reduction in earnings than that implied by the mathematical formulae of breakeven analysis.

Consequently, breakeven point increases while sales decline, as many recent examples show. Any serious forecasting thus requires modelling based on a thorough analysis of the situation.

During the Spanish property slump of 2008, a mere slowdown in growth halted the speculators in their tracks. Crippled by their interest expense, they were compelled to lower prices, which led to speculation of a fall in the market (purchases were delayed in expectation of an additional fall in prices).

Businesses such as shipping and paper production, which require substantial production capacity that takes time to set up, periodically experience production gluts or shortages. As readers are aware, if supply is inflexible, a volume glut (or shortage) of just 5% may be sufficient to trigger far larger price reductions (or hikes) (i.e. 30%, 50% and sometimes even more).

Here again, an analysis of competition (its strength, patterns and financial structure) is a key factor when assessing the scale of a crisis.