Wednesday, December 30, 2009

Fixing The Average

When estimating a company's earning power, it's important to look at its annual earnings over the past business cycle, rather than assuming 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 $1,082,000, or 2.4%, primarily as a result of increased gaming taxes and slot machine fees that resulted from legislation passed in May of 2009 that became effective on May 28, 2009. The impact of this legislation resulted in an increase in our gaming taxes and slot machine fees of approximately $3,600,000 in the third quarter of 2009.

This $3.6 million per quarter of increased fees is not a trivial amount. It represents about 6% of the quarter's revenues, and as such results in taking a huge chunk out of the company's profit margin. These new fees eat up about $14 million on an annualized basis, compared to the company's operating earnings of around $40 million per year or so in the last four years!

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 of future earnings power.

Disclosure: None


rayhaan said...

nice article barel!
gotta watch behind the numbers~!
you have in the past mentioned graham and dodds technique of averaging the earnings of the last several years to have a conservative estimate of its earning power over a business cycle,but what is one to do with companies which are incredibly cheap but have a bad earnings record ?how do we determine the earning power?

Saj Karsan said...

Hi Rayhaan,

Determining future earnings when past earnings have been volatile or poor is rather difficult indeed! Analysts spend a lot of time analyzing businesses for this purpose, and their results are not that great. Proceed with caution!