Monday, May 11, 2009

Operating Income Is Not Just For Surgeons

Investors will often gauge a business' ability to make money by looking at its operating income over a period of several years. But investors who ignore the line items on the income statement which fall below operating income can miss out on some crucial details. Consider JAKKS Pacific (JAKK), maker of toys and related products for children and pets.

Since net income can fluctuate due to one-time tax benefits and changes in capital structure, operating income can be used to get a better feel for what the assets of a company can generate in the way of profit. JAKK trades for $380 million, while averaging about $80 million in operating income over the last four years. After taking a normal tax rate into account (recall that operating income is before tax), it would have a P/E of around 8. The company also has a net cash position (i.e. negative debt) and working capital of over $300 million, which make its price seem even more attractive.

But the most impressive part of the company's valuation has not yet been taken into account, because it doesn't form part of the company's operating income. JAKK has a video game joint venture with THQ, which earns JAKK approximately $20 milllion per year (up from $7 million five years ago). Placing an arbitrary P/E of 10 on the relevant portion of the venture puts its value to JAKK at $200 million, almost half of JAKK's market cap! Meanwhile, the venture is only carried on the balance sheet at around $60 million, and therefore may be overlooked.

However, prudent investors be warned. This joint venture is subject to an important lawsuit, and the profit sharing agreement between JAKK and THQ is up for renegotiation. Investors can read all about it in the company's notes to the financial statements.

In this case, we saw how income from a joint venture can make a company worth more than its operating income suggests. Previously, we saw how looking at operating income is inadequate for a company that has been structured to pay almost zero tax!

Disclosure: None

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