Casino accounting issues raised by gaming analyst

David Strow

Friday, March 29, 2002 | 11:08 a.m.

Though highly unlikely, there's no guarantee a repeat of the Enron debacle won't occur in the gaming industry, a prominent gaming analyst said in a report released Thursday.

Jason Ader, gaming analyst with Bear Stearns, noted the gaming industry has advantages for investors looking to avoid the next Enron, since earnings reports are generally clean and easy to understand. Moreover, he noted, gaming companies operate under the strict oversight of gaming regulators across the country.

Still, Ader noted gaming companies do have ways to "manage" their earnings in order to meet or beat earnings expectations. While the methods aren't a violation of accounting rules, investors will be much more leery of aggressive accounting these days -- and will "increasingly question aggressive or confusing accounting procedures," Ader wrote. Gaming companies won't be exempt from this increasing scrutiny, Ader said.

"Managing your earnings is something that is easy in the gaming industry," Ader said. "There are accounting flexibilities that allow companies discretion when reporting to meet or exceed estimates."

Investors' best defense, Ader said, is relatively simple -- focus on "EBITDA," not earnings per share, when valuing a gaming stock. EBITDA refers to earnings before interest, taxes, depreciation and amortization, and is usually referred to in gaming as "cash flow."

"It's really easy to manage EPS to the consensus number, but it's really hard, if not impossible, to manage and have an effect on EBITDA or free cash flow," Ader said. "Investors should be much more focused on those two metrics."

Gaming industry executives have been arguing this point for years, saying cash flow is a far more accurate measure of their business. But Ader estimates about 40 percent of gaming companies' stocks are held by "momentum" investors, attracted to companies that meet and exceed EPS.

"Despite the fact that we do not value these companies on a P/E (price-to-earnings) basis, investors remain focused on whether or not a company misses or makes the Street consensus EPS estimate for each consecutive quarter, which has historically provided some incentive for management to present earnings in the best possible fashion," Ader wrote in a Thursday report.

Ellis Landau, chief financial officer of Boyd Gaming Corp., acknowledged beating quarterly estimates is important. It keeps investors happy and can establish a company as a "momentum" stock.

But it isn't productive to use accounting moves to help in that effort, he added -- and he said Boyd doesn't do it.

"It has a purely short-term benefit," Landau said. "Eventually, things will get trued up. We want to create a company that has value and builds value over time for our shareholders."

Another gaming executive said making analyst estimates each quarter simply wasn't a priority.

"We don't worry about making analyst numbers. We worry about getting superior returns on our assets over time," said Glenn Schaeffer, president and chief financial officer of Mandalay Resort Group. "There are people who fixate on quarterly estimates to the penny. That type of investing saw its day, and (the outcome) wasn't pretty."

Even if companies were trying to do this, "I would say the gaming industry, compared to many other industries, has fewer places where people can find ways to make their earnings numbers," Schaeffer said.

But he agreed with Ader's argument that cash flow should be the determining factor in valuing a gaming company.

"Cash flow and cash-based earnings are the best indicators of a company's future health," Schaeffer said. "Nothing's more certain than that in the face of the Enron disaster."

Gaming has one big advantage for post-Enron investors -- it is a cash business with very little inventory. That provides casino operators with little opportunity to massage revenues, Ader pointed out.

Still, that doesn't mean there aren't any opportunities for earnings or cash flow to be "managed," Ader said. They include:

-- Writing off the uncollectible debts of credit gamblers. In 2001, Ader estimated, such write-offs totaled $134 million at Strip casinos, equal to about 2.8 percent of total revenues.

Since the decision to write-off debt is entirely discretionary, a gaming company can easily move a write-off from one quarter to another to smooth earnings, Ader said -- and investors would never know.

"Given the unpredictable timing and nature of credit play, this is one area where investors have to trust that the company is using its best judgment in allocating its (bad debt) reserves," Ader wrote.

To assure investors, Ader urged gaming companies take a consistent approach to writing down bad debt, and provide a clear explanation when debt writedowns fluctuate significantly from quarter to quarter.

"The way we do it is to use standards we've had in place for some time," Landau said. "It's just a matter of how a company approaches and views the integrity of its numbers. In the longer term, (bad debt expenses) catch up to you anyway."

-- Table game "hold," or the percentage of monies wagered that are kept by a casino.

This often swings from quarter to quarter, and can have an effect on a gaming company's earnings. Generally, Ader noted large Nevada gaming companies will disclose when unusually high or low hold affects earnings.

But since hold disclosure is discretionary, it is possible a company could fail to disclose that unusually high hold helped it make analyst expectations, Ader said.

Schaeffer said this isn't done.

"If there's an extraordinary hold percentage, we identify it," Schaeffer said. "If it had a material effect, you say that. More information is better than less."

-- Asset writedowns, or non-cash charges taken to reduce the value of an underperforming asset.

When a company writes down an asset, this greatly reduces depreciation expenses in the future, Ader noted. Though the cash flow performance of the property remains unchanged, a writeoff immediately improves a property's net income, since depreciation expense is reduced.

Generally, investors believe these writedowns are acceptable with historically underperforming properties, Ader said. Still, he said gaming companies should use caution.

"We believe investors will be closely scrutinizing asset impairment (charges) in the future, and any unexpected surprises could because for concern," Ader said.

Though a write-off has a positive effect on future earnings, it can give a negative impression to investors, Landau said -- and as a result, it isn't a move that's taken lightly.

"Your net worth is reduced (with write-offs)," Landau said. "You're admitting and booking a loss in value for your company."

-- Stock options awarded to executives.

Every major gaming company -- and virtually every major public company in America -- awards stock options as part their executive compensation packages. Accounting principles now in use recommend -- but don't require -- that companies treat these options as a compensation expense, just as if they were a cash salary.

But not a single gaming company does. Nor do most American corporations. Ader said he believes that should change.

"When stock options are awarded, there is a cost in terms of dilution to shareholders," Ader said. "We're very much in support of ... expensing stock options."

There would be a noticeable effect, both on net income and cash flow, if stock options were made an expense, Ader said. For example, Ader estimated MGM MIRAGE's 2001 cash flow would have been reduced by $51 million, or 4.7 percent, had it included options as an expense. Harrah's Entertainment Inc.'s cash flow would have fallen $13 million, or 1.2 percent.

But it appears there's little appetite on the Strip for making that change. Accounting is about accuracy, Schaeffer said -- and that's difficult to do with options.

"How do you estimate them?" Schaeffer said. "What's their value? That's the question."

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