Tuesday, December 16, 2008

Owner earnings calculation: An example

After a brief diversion into the world of cricket, we are back to regularly scheduled programming. My voice may be gone completely after the cricket yesterday, but I am luckily still able to type.

Let's look at Steak 'N Shake's numbers for fiscal 2005 and see if we can come up with an estimate for owner earnings. Steak 'N Shake is a chain of Quick Service Restaurants, originally established in 1934.

The 10-K for fiscal 2005 is here:

For fiscal 2005, the company reported $30.222 million in GAAP earnings. Let's look at the statement of cash flows under Operating Activities to see which non-cash charges need adjusting.

Depreciation and amortization charges of $26.945 million will be added back. We will subtract maintenance capex(yet to be determined) to offset this.

A charge for provision of deferred income taxes(beyond my ability to explain this well and perhaps even comprehend completely) of $1.769 million will be added back. 

Provision for restaurant closings of $1.4 million. What does this amount represent? The company states that it decided to close 2 underperforming restaurants in fiscal 2005. The $1.4 million represents represents the difference between the carrying value of the assets on the balance sheet and the undiscounted future cash flows that would have accrued from keeping the assets in operation. The answer to whether this non-cash charge should be added back is subjective. In general, asset write-downs reflect poorly on management's capital allocation abilities.  On the other hand, these assets will be sold (the 10-K says so) for cash that may be deployed effectively elsewhere. Given that there was a bigger write-down in fiscal 2003 for $5.2 million, I am loathe to give management the benefit of doubt re. the deployment of cash from the asset sales. In fact, management is more than likely destroying value by retaining all the earnings of this business. More on that later. On balance, this charge is still a balance sheet impairment and so we'll add these charges back to reported earnings. I won't quibble however if this charge wasn't added back.  

Non-cash stock compensation expense amounted to $1.798 million. I consider this a true "economic" expense(try withholding it in future periods from the people who were going to receive it and see how many want to continue to work there), so this amount won't be added back either. 

There was a loss on disposal of property amounting to $.65 million. Again, this is a balance sheet impairment and is unlikely to have a material effect on earnings. We'll add this amount back.

The adjustments from non-cash charges to earnings of $30.222 million are as follows:

Depreciation and amortization: + $26.945 million
Provision for deferred taxes: +$1.769 million
Provision for restaurant closings: +$1.4 million
Loss on disposal of property: +$.65 million

This gets us to $60.986 million in cash flows prior to maintenance capex. How do we estimate maintenance capex? Let's look in the 10-K for some clues.

The Investing Activities section of the cash flow statement tells us that $63.622 million was spent in capital expenditures for fiscal 2005. The growth capex for this business comes from opening new restaurants. From the 10-K, we know that 19 new restaurants were opened in 2005. The 10-K also tells us that the company expects to open 26 new open restaurants in fiscal 2006 at an average cost of $2 million. Aha! Perhaps the 2004 10-K will tell us how much, on an average, the new restaurants that were opened in fiscal 2005 were expected to cost. Here's the link to the 2004 10-K:


Sure enough, under the section titled Liquidity and Capital Resources, we find that the average cost of the new restaurants to be opened in fiscal 2005 were expected to be $2 million. We now have an estimate of growth capex (19 new restaurants * $2 million = $38 million). Therefore, an estimate of maintenance capex is $25.622 million (63.622-38). 

We can now come up with an estimate of owner earnings: $60.986 million - $25.622 million = $35.364 million. This is about 17% higher than the reported GAAP earnings of $30.322 million. Additional adjustments are possible in this case, but this works as an illustration of how to get to a first estimate of owner earnings.

Often wrong but seldom in doubt,

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