Thursday, December 30, 2010

Average Income Not Always Relevant

When estimating a company's earning power, it's important to look at its annual earnings over the past business cycle, rather than assume that its current earnings are representative of future earnings. In Security Analysis, Ben Graham and David Dodd discussed the need to smooth out fluctuations in annual earnings, and we have looked at some reasons for why that is the case. Sometimes, however, properties of a company have changed, and current earnings may actually be a better gauge of a company's earnings prospects going forward.

Consider Dover Downs Gaming (DDE), a hotel/casino/track operator in Delaware. In addition to corporate tax rates that are already quite high, the state government has been increasing the company's gaming fees and taxes. The fee changes are not minimal, and are not recorded as taxes, and therefore show up as increased operating expenses. Consider the following statement from the recent 10-Q:

"Gaming expenses increased by $8,066,000, or 6.1%, primarily as a result of the opening of our table game operations and significantly higher gaming taxes and slot machine fees that resulted from legislation passed in May of 2009. The impact of this legislative initiative resulted in an increase in our gaming taxes and slot machine fees of approximately $5,600,000 in the first nine months of 2010."

This $5.6 million for the last three quarters is not a trivial amount. It represents about 3.5% of this period's revenues, and as such results in taking a huge chunk out of the company's profit margin. On an annualized basis, these new fees take a significant bite out of the company's operating earnings of around $40 million per year or so in the last four years, reducing the earnings power of this company significantly.

The new fees had such an impact that the company cancelled plans to expand:

"We had previously completed architectural and engineering work related to a Phase 7 casino expansion that would have included, among other things, a new sports book facility and a parking garage. Given the recent decision by the US Court of Appeals for the Third Circuit to limit the extent of sports wagering in Delaware and the higher gaming tax rates that were recently legislated, we decided not to proceed with this project. During the third quarter of 2009, we wrote off $2,177,000 of capitalized costs related to these expansion projects."

While averaging past earnings do smooth out temporary fluctuations in annual earnings, the investor must still keep an eye out for recent changes to the business that render operating earnings obsolete. Adjustments to averaged earnings that take recent changes into effect will often need to be made to improve their predictability in the determination of a company's earnings power.

Disclosure: None


Anonymous said...

First, great blog. I enjoy it very much. On this post, while implicit in your comments, it might be useful to focus on average returns on capital through a cycle as opposed to average earnings (after accounting for any fundamental changes that may impact future earnings and/or returns). That way, growth in the company's capital base is reflected in future expected normal earnings (that's a mouthful).

Saj Karsan said...

Hi Anon,

I agree with you.