How do you take your earnings, normalised or reported?

Stephen Bennie | Castle Point Funds 

When you’ve been in and around the share market for nearly 3 decades, you’ve heard many different types of corporate language and messaging, some insightful, some less so. But you also become aware of one commodity which is as rare as hen’s teeth, and that is, companies whose senior executives or directors apologise to shareholders for poor decisions or lapses of judgement. There seems to be a corporate code of silence when it comes to dealing with an error of judgement; whatever else happens, never say sorry. I must admit that while it’s not surprising, it’s concerning, because if you don’t own a mistake there is a higher chance of repeating the mistake or at least a close version of it.

For example, Ryman Healthcare appear quite capable in the future of re-entering the US Private Debt market. Despite the high cost to shareholders of their first venture into that market, no public acknowledgment of misjudgement appears to have been made. Which must leave shareholders wondering if a repeat could more readily occur in the future.

Another favourite way for companies to skirt around acknowledging a mistake is to announce a “one-off loss”. It’s the corporate equivalent of playing down the financial impact of major misjudgement. A classic “one-off loss” would be an acquisition that has fallen well short of expectations. In this classic scenario let’s say that an acquisition 5 years ago cost $250m and was paid for in cold hard cash. However, 5 years on its become abundantly clear that the pesky private equity crew you bought it off had put lipstick on a pig. It’s become clear that on a good day the acquisition could now only be sold for $100m. A write-down is required to reflect this dawning of reality. This is where corporate dark arts creep in and a “one-off loss” is about to be reported. Now the apparent beauty to a corporate of a “one-off loss” is that while it reduces that year’s reported Net Profit after Tax, it is a non-cash adjustment and most investors will concentrate more on normalised Net Profit after tax, which ignores the “one-off loss”.

There are two issues to consider regarding why a classic “one-off loss” should not be so easily ignored. Firstly, while it may be non-cash in the period when the write down occurs, $150m of shareholders cash was thoroughly toasted 5 years ago i.e. real money not pretend dollars. An error has been made and has cost shareholders a chunk of change, this should be taken seriously. At least the company will have apologised to its shareholders for the bad acquisition, well, probably not. The second issue to consider is how often “one-off losses” are going through a company’s annual accounts. If it is a regular or semi-regular occurrence, looking at normalised profit not reported profit is perhaps not a smart move by investors. Tellingly, Benjamin Graham, author of the holy grail book on investing “The Intelligent Investor”, tended to not look through special charges, also known as "one-off losses”, when he assessed the value of a business. He believed that they should not be dismissed as non-cash and should be incorporated when assessing the value of a business.

Recently SkyCity Entertainment Group (SkyCity) issued a variation on the classic “one-off loss” play. Their little spot of bother, for alleged non-compliance with Australian Anti-Money Laundering and Counter Terrorism Financing laws (AML Act), with, another mouthful that is, the Australian Transaction Reports and Analysis Centre (AUSTRAC) has been rumbling away in the background since last year. SkyCity is not the only casino on the AUSTRAC naughty step, The Star Entertainment Group (Star) are also in trouble with them for similar reasons and earlier this year their exchange regulator, ASIC, determined that Star needed to make some sort of provision for the potential fine from AUSTRAC4. And this month SkyCity also announced their decision to make a provision for a potential fine. Their best guess led to a provision of NZ$49m for the potential future fines. In their announcement SkyCity did make a starkly chastening statement though, explaining that “each contravention of the AML Act has a maximum civil penalty of between A$18m and A$22.2m per contravention and AUSTRAC alleges that SkyCity made an innumerable (the word that SkyCity uses) number of breaches, it is not possible to determine a maximum penalty”. Take a pause and consider that statement; the maximum amount appears to be a number that can’t be worked out on a Hewlett Packard calculator. Clearly there is some potential that the NZ$45m provision turns out to be on the light side.

To cover another base in their recent announcement, SkyCity also wrote down the value of their Adelaide casino license by NZ$49.7m due to lower expected future earnings. As in the classic “one-off loss” scenario this impairment is non-cash in the current period as it was cash spent unwisely years earlier. The other good news for shareholders is that the provision for the potential future fines is also a non-cash item for the current period. Just in case investors think for a second this is a bad outcome, SkyCity helpfully explained in their announcement that normalised earnings are unaffected by these non-cash items.

Extract from recent SkyCity announcement

"The above-mentioned provision and impairment are non-cash, and do not impact normalised earnings for SkyCity's FY23 financial statements. SkyCity confirms that its Group FY23 normalised earnings remain in line with the guidance provided on 24 May 2023 of NZ$300 - $310 million normalised EBITDA."

Source: NZX

It appears that most investors are currently playing the game and allowing SkyCity to play the classic “one-off loss”, nothing to see play, given the share price is virtually unchanged post the announcement. And that may be the right stance to take but I’m confident that if Benjamin Graham was still with us and assessing the value of SkyCity, he would likely be looking at the reported earnings not the normalised earnings.

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All prices and analysis at 9 September 2023.  This document was originally published in Livewire Markets on 30 August 2023. This information has been prepared by Castle Point Funds, a New Zealand based boutique funds management firm.

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