4 Stocks with Leverage - Investment Ideas

Think about the last time you stayed in a hotel. How much did you pay? How much did it actually cost the hotel to have you stay there that night?

Sure, it cost a lot of money to build and furnish the room, but the company has already incurred those expenses. The actual incremental costs are low. You might use some additional water and electricity - and they'll have to pay someone to clean up your mess afterward - but unless you're Charlie Sheen that shouldn't take much.

In other words, your stay there is almost pure profit for the hotel company. The reason: operating leverage.

A Small Change Can Make a Big Difference

Companies with high operating leverage tend to be capital-intensive businesses with a lot of fixed assets, or overhead. Fixed expenses like property, plant, and equipment generally won't fluctuate with sales volume. Thus, a modest increase in sales can mean huge growth in profits, as each additional dollar of revenue falls almost straight to the bottom line.

Take XYZ Corp for example. The company sells widgets that require expensive machinery inside of expensive plants to manufacture. Their variable costs are relatively low. In Year 1, the company makes $2 million in sales and has $200,000 in net income. In Year 2, demand picks up a bit and there is a modest 5% increase in sales. Operating income, however, grows by a whopping 40%.

In contrast, companies with variable cost structures will have low operating leverage. These tend to be labor-intensive businesses or retailers that can adjust the bulk of their expenses as demand changes. These businesses can weather economic downturns easier by cutting staff or reducing inventory, but when things turn around they will have less upside potential.

High Volatility

The profits of high-leverage companies tend to be amplified as demand fluctuates with the business cycle. Hence, their share price will be highly volatile. These companies will experience low or negative profits and a falling share price when times are bad (like in 2008-early 2009), but explosive profit growth and rapidly rising share prices when things turn around (late 2009-???).

As the global economic recovery gains traction, these high-leverage businesses are expected to see excellent profit growth.

Eaton Corp (ETN) is your typical cyclical stock. The company is an industrial conglomerate operating in capital-intensive areas like electrical components, hydraulics, aerospace, and trucking/automotive.

In 2009, when the global economy was suffering, the company saw a 23% drop in sales. Due to its high leverage, operating income plunged 65%. Things have been turning around for Eaton, however. For the third quarter of 2010, the company saw a healthy 18% increase in sales over the same quarter in 2009 and an impressive 70% increase in operating income.

Analysts have been raising estimates following the strong quarter, sending the stock to a Zacks #1 Rank (Strong Buy). The Zacks Consensus Estimate is calling for 115% EPS growth in 2010 and 26% growth in 2011.

The stock tends to fluctuate with the business cycle, as seen in its 5-year chart:

The stock is up over 50% year-to-date, but valuation looks attractive. Shares trade at 16.6x forward earnings, a discount to the industry average of 18.3x. Its price to book ratio of 2.2 is in-line with its peers. The stock also offers a 2.5% dividend yield.

Honda Motor (HMC) is another company with high operating leverage. The Japanese company is famous for its automobiles, but also manufactures motorcycles, ATVs, generators, and lawn mowers, among other things.

In fiscal year 2009, sales were down 17% while operating income fell 80%. For the second quarter of 2011, sales were up 9% while operating income grew an incredible 149%.

Analysts have revised their estimates much higher for 2011, sending the stock to a Zacks #2 Rank (Buy). The Zacks Consensus Estimate for 2011 calls for 311% EPS growth over 2010.

Shares for Honda have been slightly less volatile over the last 5 years:

The stock is up about 10% year-to-date, and valuation looks very attractive. Shares trade at 11.1x forward earnings, a discount to the industry average of 16.4x. Its PEG ratio is a mere 0.3.

CSX Corp (CSX) also carries a lot of fixed assets and has relatively low variable costs. The southeastern railroad company serves as a bellwether to the overall economy.

The company was relatively successful in managing its costs during the downturn in 2009, but shares still plunged over 65% from May 2008 to their nadir in March 2009. In the third quarter of 2010, CSX reported a 16% increase in revenue and a stellar 39% increase in operating income.

Analysts have also been raising their earnings estimates significantly higher for CSX. The Zacks Consensus Estimate is calling for 40% EPS growth in 2010 and 17% growth in 2011. It is a Zacks #1 Rank (Strong Buy) stock.

Shares of CSX are near their pre-recession levels:

The stock is up over 20% year-to-date, but valuation is quite reasonable. The stock trades at 15.0x forward earnings, well below the peer group multiple of 19.5x. It has a PEG ratio of 1.3. The stock offers a dividend yield of 1.7%.

Caterpillar (CAT) is another company that will tend to struggle during economic contraction and thrive during recovery and expansion. The company makes large earth-moving equipment and recently announced it will be acquiring mining equipment maker Bucryus for $8.6 billion.

In 2009, CAT saw a 37% decrease in revenue and an 88% drop in operating income. Things have begun to turn around though. For the third quarter of 2010, CAT saw a 53% increase in sales and a 329% jump in operating profit.

Analysts have been raising their estimates significantly higher off the strong quarter. The Zacks Consensus Estimate is calling for 83% EPS growth in 2010 and 44% growth in 2011. It is a Zacks #1 Rank (Strong Buy) stock.

Caterpillar's stock has also moved in tandem with the business cycle:

It has risen more than 40% so far this year, but valuation is still reasonable. Shares trade at 20.4x times forward earnings, a slight premium to the industry average of 18.3x. Its PEG ratio is 1.5. CAT has a dividend yield of 2.2%.

Proceed with Caution

Keep in mind that if the economic recovery stalls and we slip back into another recession, these companies will be left with high expenses and little demand for their products. That will spell trouble for their share price.

In other words, leverage is a two-edged sword.

Todd Bunton is the Growth & Income Stock Strategist for Zacks.com.

 
CATERPILLAR INC (CAT): Free Stock Analysis Report
 
CSX CORP (CSX): Free Stock Analysis Report
 
EATON CORP (ETN): Free Stock Analysis Report
 
HONDA MOTOR (HMC): Free Stock Analysis Report
 
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