How Operating Leverage Benefitted Intellect Design

First off, some background about Intellect Design:

Intellect Design is an IT company, which specifically develops and sells digital fintech (financial technology) products to banks, financial services, and insurance companies. Their customers therefore include banks, NBFCs (non-banking financial companies), central banks, brokerages, stock exchanges, wealth management firms, and so forth.

In simple words, Intellect’s products are aimed at helping their clients expand their customer base, improve customer engagement, and streamline their customer services.

How does Intellect Design generate revenue?

One, Intellect charges “license fees” to its customers for using their softwares. Two, it further charges “customization fees” for rolling out software and customizing them as per its clients’ needs. Three, in some cases it may charge an “annual maintenance fee” for maintaining the software and making upgrades available. The fourth source of revenues is “subscription fees” for use of software on cloud deployment.

A look at Intellect Design’s price chart

What explains this exponential rise after 2018?

Firstly, note how the stock price failed to break above Rs 300 for almost three years – from 2015 to 2018. Something changed post 2018.

That thing is operating leverage.

What is operating leverage? In simple terms, most companies face two costs. One is “variable costs” which increase in proportion to sales. Higher the sales, higher the variable costs – think of raw material expenses, for instance.

The other is “fixed costs”. These are costs that reduce (on a per unit basis) when the sales increase. For instance, say, rent expense. This is expense that the company has to pay irrespective of good times or bad, isn’t it?

But during good times when the sales are high, the company essentially earns higher margins because the rent expense does not increase proportionally – it is fixed (unless of course the company reaches 100% capacity and must add another plant).

This benefit of higher margins owing to greater sales but fixed costs remaining the same is called the benefit of “operating leverage”.

For Intellect Design, this operating leverage kicked in after 2018.

From 2015 to 2018, the company spent (invested) about Rs 1200 crores cumulatively on product development, sales and marketing, brand building, and gaining analyst endorsements.

As per the company it takes about 3 years for them to transition from building a product around an identified market need to selling it to customers. The benefit of this investment in product development – in the form of revenues -- kicked in after 2018.

Here’s a screenshot from Intellect’s annual report from FY 2019 (page 158).

Source: Annual Report FY19, Page 158

In the picture below, notice how Intellect’s costs were higher than its revenues in year 2016-17. From FY18 and FY19, the costs began reducing as revenues increased. This is owing to operating leverage.

The investments the company had made earlier started paying off. The stock price simply followed.

Source: Investor Presentation FY19

You may also see this in the company’s quarterly financials adisplayed below.

Notice how the EBITDA margin (or operating margin) increased every quarter -- from 15.7% in March 2020 to 25.1% in March 2021.

This is also mirrored in PAT (profit after tax) margin, which doubled from 11.5% in March 2020 to 20.7% in March 2021.

Notice also how the higher EBITDA margins and PAT margins are flowing to ROCE (return on capital employed). In FY21, the company's ROCE increased sharply to 13.6%.

This, by the way, is on the back of reduction in long term debt to almost nil, reducing the finance cost. See below.

Notice the fall in the company's finance costs over the quarters (click the quarterly financials image below to expand for better viewing) -- from a high of Rs 5 crore in Dec 2019 to a low of Rs 1 crore in March 2021. This has contributed to higher PAT margins, since lower finance costs boost profits.

Finally, do watch this recent interview of Intellect's Chairman and MD Arun Jain in ET Now, discussing how the company has finally moved from "industrialisation" phase to "monetisation" phase. In other words, from investing on product development earlier to making money from it now.

This is operating leverage in action.

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