Valuation Analysis: EBITDA – From the Sublime to the Delusory Use as a Measure of Firm Profitability and Prospective Value by Michael P. Durante Managing Partner BlackwallPartners LLC prepared for University of Oxford Saïd Business School January 2016
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Valuation Analysis: EBITDA – From the Sublime to the
Delusory Use as a Measure of Firm Profitability and Prospective Value
by
Michael P. Durante Managing Partner
BlackwallPartners LLC
prepared for
University of Oxford Saïd Business School
January 2016
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“EBITDA is Earnings Before all the Important Expenses” - Warren Buffett
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Abstract
In this report, the over reliance on EBITDA (earnings before interest, taxes, depreciation and
amortization) as the financial community’s most commonly relied upon measure of cash flow
and hence valuation are explored and debunked using case examples across a myriad of
industries and financial strategies. In each case example, BlackwallPartners reviewed reporting
firm financial statements to determine how recurring both short-term or working capital needs
and long-term capital expenditure needs (“CapEx”) were over multiple reporting periods.
Previous to the explosion in leveraged buy-out transactions (“LBOs”) in the eighties, EBITDA
was a financial measurement rarely used either to measure debt service burden capacity or value.
With the onset of the great bull market in bonds and increased demand for higher yielding (but
necessarily lower quality) fixed income securities, the use of EBITDA became increasingly more
common. The principal promoters of EBITDA were the buyout firms and the Wall Street
brokerage houses which both advised on the transactions as well as sold the high yield securities
that supported the promising buy-out economics. Their advocacy simply was to inflate the debt
service capacity of acquired firms and then its future valuation using a measure only speciously
tied to actual cash flow.
As the report shall demonstrate, the measurement itself offers very limited insight into a given
firm’s real costs to operate and as such deserves much scrutiny as a credible financial
measurement. While conventional accounting, including EBITDA, strives to define for investors
a firm’s “financial performance”, only a more introspective review of a firm’s actual free cash
flow can provide the investor with the figures that should determine fair or reasoned value.
BlackwallPartners defines this as “realizable profit”. And it too often exposes significant
disparity between conventional accounting and cash flow.
Yet, despite the catastrophic end to the LBO boom and bust, EBITDA nonetheless has survived
as a substitute measurement of cash flow and value and actually has seen its use expand with
similar conflicts. Namely, firm managements and the Wall Street analysts and investment
bankers that serve them prefer the measure because, in most cases, it dramatically inflates a
firm’s valuation.
Today, it’s the most widely accepted measurement of both cash flow and thus value used by the
financial community. Its use, at its extreme, even is used to evaluate firms going through
bankruptcy and is commonly used to appraise deeply cyclical industries with short-lived assets.
More recently, EBITDA became very popular in prognosticating the future promised
“profitability” of the “dot coms” which were at the center of the Internet or technology bubble
and bust.
The main premise behind EBITDA’s continued popularity is the notion that in economic
downturns or in a theoretical terminal value analysis, firms can automatically alter continual
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working capital needs and CapEx without consequence to fundamentals and long-term
profitability. However, as this paper shall show such real operating costs are not truly
discretionary in the overwhelming number of cases without materially altering a firm’s ability to
maintain revenue let alone grow; remain competitive; or continue their chosen financial or
business strategy.
There are cases in which EBITDA can be useful but they are limited to firms or industries where
competition is either greatly diminished; the industry is in a late stage of maturity and in fact in
decline; or where technical obsolescence is a non-factor. In short, EBITDA may correlate with
cash flow in situations which either is quite rare or in most cases, highly unattractive to investors.
EBITDA fails to correlate with cash flow in most cases and should not be used by investors to
measure the financial capacity or value of most businesses. There are no short-cuts to quality
financial appraisal and one must do much more work than just EBITDA analysis to arrive at a
fair and reliable valuation of an enterprise.
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Glossary of Terms
Accrual Accounting is the accepted accounting method under Generally Accepted Accounting
Principles (“GAAP”) and measures the purported performance and financial condition (health)
of a company by recognizing economic events regardless of when or if cash transactions occur.
The notion is to “match” revenues to expenditures at the time in which the transactions take
place rather than when cash payment is either made or received. GAAP rules provide firm
managements with wide latitude in recognizing revenue and expenses under this so-termed
“matching principle”.
Capital Expenditure or “CapEx” is the cash spent to acquire, upgrade or maintain a firm’s
physical or productive (“earning”) assets such as plant, buildings, equipment or technology etc.
The cost is booked to a firm’s balance sheet and with few exceptions e.g. land, expensed against
income over the useful life of the asset. CapEx refers to long-term earning assets meaning assets
for which the economic benefit is not exhausted within the current period (one year). An
assumption of a liability also is considered CapEx.
Cash Conversion Rate measures the relationship between the true profitability of a business to
its conventional reported profits under GAAP and EBITDA. The ratio simply is a firm’s actual
operating free cash flow (see – “realizable profit”) to either net income or EBITDA.
EBIT is a company’s earnings before interest and tax payments.
EBITDA is a company’s earnings before interest and tax payments as well as depreciation and
amortization expenses. It is compiled from data from a firm’s income statement (periodic) and is
a widely used substitute for cash flow analysis by approximating an enterprise’s so-called
“adjusted operating cash flow”. EBITDA essentially is net income grossed-up to add-back
interest, taxes, depreciation and amortization. EBITDA is not defined under Generally Accepted
Accounting Principles (GAAP), a standard set of accounting conventions for financial reporting;
as such EBITDA calculations vary greatly by and among both firms and industries.
and publicly-made earnings reports) commonly state as Facebook (NASDAQ - FB) e.g. does –
In addition to U.S. GAAP financials, this presentation includes certain non-GAAP
financial measures. These non-GAAP measures are in addition to, not a
substitute to, measures of financial performance prepared on accordance with
U.S. GAAP.
Other firms are more direct as with a major Real Estate Investment Trust “REIT” which warns
investors in its filings –
Non-GAAP financial measures should not be considered an alternative to net
income attributable to common shareholders (determined in accordance with
GAAP) as an indication of our performance.
While other firms are even more open with investors such as a certain resort timeshare operator
which indicated in an offering memorandum that6 –
EBITDA is presented because it is a widely accepted indicator of a company’s
financial performance.
Such warnings by filers raise the concern as to why investment bankers, Wall Street analysts and
investors so readily accept EBITDA as the primary if not only measure of a firm’s profitability.
As noted and put simply, it is to give investors an inflated view of a firm’s realizable profits and
liquidity. And filers can use a host of accounting conventions to manipulate or “manage” the
booking of revenue and the calculation of reported earnings, which underpin the inputs to
EBITDA.
5 EBITDA/Interest: “Friend or Foe?” Moody’s Speculative Grade Commentary, May 1995.
6 Fabozzi, Frank J., Editor and Stumpp, Pamela M., Bond Credit Analysis: Framework and Case Studies (Frank J, Fabozzi Associates 2001)
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Since EBITDA is the “grossing-up” of a firm’s reported earnings, it inherently inflates
profitability and conveniently makes valuation multiples smaller and thus more appealing to
investors.
Case-in-point…
Does Amazon.com (NASDAQ – AMZN) make realizable profits? Does the market place a
rational valuation on the shares? What funds their growth?
Amazon’s management, and analysts who cover the stock for that matter, are fond of using non-
GAAP or “adjusted EBITDA” and “operating cash flow” to measure their profit strength as
opposed to net income or even realizable profit (equity free cash flow). But, looking closer at
Amazon’s financial statements, in whole, tell a very concerning story.
Amazon.com – Adjusted Operating Cash Flow v. EBITDA FY2014 Net Income <$241mil> Add: Depreciation & Amortization 4,746 Add: Stock-based Compensation 1,497 Add: Other Income Statement Items <107> Adjusted EBITDA 5,895 Change in Receivables <1,039> Change in Inventory <1,193> Changes in Accounts Payable 1,759 …Other Assets and Liabilities, net 1,420 Operating Cash Flow 6,842 Capital Expenditures, net <5,065> Repayment of Debt <1,933> Adjusted Operating Cash Flow <156> EV/EBITDA 44x EV/Adjusted Operating Cash Flow Negative EV/Operating Cash Flow Negative Cash Flow Conversion Rate Negative Increase (Decrease) in Debt 6,359
Source: SEC filings; BlackwallPartners estimates
Above, is Amazon’s adjusted operating cash flow break-down. There is no question Amazon is
a most highly innovative company which has grown from just being an on-line bookseller to
becoming the web’s foremost on-line shopping mall and delivery/procurement juggernaut that it
is today. But to stay ahead of the competition in this highly marginalized (commodity)
procurement and fulfillment industry, Amazon must spend every penny of free cash flow it
otherwise would generate. And in fact, Amazon “manages” receivables and payables quite
aggressively to conserve cash. The firm is now over fifteen years old and has yet to produce a
realizable profit despite its $300 billion market capitalization (value).
Management and analysts would have one believe that at 44x “adjusted EBITDA”, shares of
Amazon are not that expensive relative the firm’s historical revenue growth rate. But when, if
ever, will Amazon be able to cease its unending and overwhelming need to fund growth and
innovation in a commoditized industry with a true profit? This is precisely where and how the
use of EBITDA can be highly misleading and dubious for investors.
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Amazon’s realizable profit in 2014 was a loss of $156 million and NOT the adjusted EBITDA of
$5.9 billion or “operating cash flow” it indicated of $6.8 billion in its financial reporting. In fact,
Amazon is forced to fund its growth initiatives (CapEx) by piling on more debt such as the $6.4
billion in debt it added in 2014 to its balance sheet.
Does Twitter (NASDAQ – TWTR) make realizable profits? Does the market place a rational
valuation on the shares? What funds their growth?
Twitter’s management, like Amazon’s, is quite fond of using non-GAAP accounting such as
“adjusted EBITDA” and “Non-GAAP Net Income” to measure their profit strength as
opposed to net income or even realizable profit. In large part, it’s because Twitter has never
earned a realizable profit or even GAAP net income for that matter. That didn’t seem to hamper
investors, who, at its peak, adorned Twitter with a market capitalization (value) near $40 billion.
Again, looking closer at Twitter’s financial statements, however scarce the detail management
prefers to provide, tell a very troubling story.
Twitter – Net Losses v. Adjusted EBITDA FY2014 Net Income <$578mil> Add: Depreciation & Amortization 208 Add: Stock-based Compensation 632 Add: Other Income Statement Items 40 Adjusted EBITDA 302 Change Working Capital 1,513 Capital Expenditures, net <224> Repayment of Debt -0- EV/EBITDA 42x Increase (Decrease) in Conv. Debt 1,376 Cash Flow Conversion Rate Negative Price to Earnings Negative Price to Free Cash Flow Negative
Source: SEC filings; BlackwallPartners estimates
Since there are no rules for how a given firm calculates EBITDA, Twitter defines its “adjusted
EBITDA” (the figure, by which, they prefer investors judge the financial health of the business)
as follows per their SEC filings:
Non-GAAP Financial Measures
To supplement our consolidated financial statements presented in accordance with generally accepted accounting principles in the United States, or GAAP, we consider certain financial measures that are not prepared in accordance with GAAP, including Adjusted EBITDA and non-GAAP net income (loss). These non-GAAP financial measures are not based on any standardized methodology prescribed by GAAP and are not necessarily comparable to similarly-titled measures presented by other companies.
Adjusted EBITDA
We define Adjusted EBITDA as net loss adjusted to exclude stock-based compensation expense, depreciation and amortization expense, interest and other expenses and provision (benefit) for income taxes.
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The following table presents a reconciliation of net loss to Adjusted EBITDA for each of the periods indicated:
Like Amazon, Twitter loses money only far worse since they are piling-on debt to create enough
working capital for necessary technology investment without sustainable free cash flow to
support an increasingly levered capital structure. In its latest fiscal year, Twitter’s “adjusted
EBITDA” is entirely comprised of real expenses – namely depreciation of technology subject to
obsolescence and employee compensation conveniently “packaged” as stock-based instead of an
immediate cash outlay. At some point, Twitter’s employees will demand an actual paycheck.
To fund Twitter’s hefty losses (nearly $600 million in the latest fiscal year) and need to reinvest
in technology, the company took-on an additional $1.4 billion in new debt in the form of very
dilutive (to shareholders) convertible notes. In fact, the entire gain in Twitter’s cash and
equivalents now is entirely funded with debt.
This business, in our humble opinion, is terminal. Yet, the company’s management reports to
investors a fantastical “profit” they label “adjusted EBITDA”, which has no relation to the firm’s
actual cash receipts from operations. Investors seem to be catching-on to Twitter’s serious
financial struggles as the market value has been cut by almost two-thirds from its $40 billion
peak. One would suppose the current $12 billion enterprise value of the company is the potential
take-over value if investors still remaining in the shares get very lucky at 42x fictional profits.
Summary of Key Flaws and Shortcomings
EBITDA only gives the appearance of more realizable profits than actually exists by
purposefully ignoring many critical cash outlays (real operating expenditures of a business),
namely neglecting the cash needed for on-going working capital and recurring large capital
expenditures; both very necessary to support current operational reinvestment and new growth
initiatives. The measure also ignores scheduled debt payments and other fixed expenses.
EBITDA Dismisses Working Capital Needs
EBITDA is inelastic to changes in a firm’s all-important working capital, a major source and use
of cash. This lack of reconciliation of actual net cash collections is perhaps the measure’s most
brazen failure as an accurate financial measure since it fails to consider the very real and very
recurring cash demands on a firm’s balance sheet.
Firms can complete a sales cycle for reporting purposes (post revenue and calculate earnings) but
not actually receive their accompanying net cash receipts (accounts receivables less accounts
payable) until a later reporting period. And applying revenue recognition has wide latitude under
accounting “accrual-based” conventions. So, investors need to be highly cognizant that earnings
are not necessarily cash flow and “E” in EBITDA is earnings of course.
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The more capital intensive a firm or industry’s sales cycle, the more likely disconnect between
earnings and cash flow may exist. And revenue recognitions and hence earnings calculating in
turn are subject to potential management manipulation as “co-conspirators”.
For investors, taking measure of changes in a firm’s working capital is critical in identifying a
firm’s realizable profits. Reported earnings and hence EBITDA fail to ensure correlation to cash
collections, a serious potential trap for investors; whereas, realizable profits (actual cash flow)
never mislead.
EBITDA May Fail to Adequately Measure Debt Service Capacity
Not just in theory, but a firm may indicate strong levels of EBITDA but not necessarily the cash
flow to pay interest and pay-down debt principle due to the timing of cash receipts. Hence a
high EBITDA interest coverage ratio is of limited value. Take the example of a company whose
sales cycle is elongated such is the case in the enterprise software industry. Where interest
and/or principle debt payments may be scheduled semiannually by creditors, many a software
technology or technology service firm book revenues at the time of the sale, but may not receive
the cash payments until partial completion or total completion of these protracted projects, some,
of which, can last multiple periods or even years.
EBITDA Fails to Account for Necessary Reinvestment in Operations
EBITDA is highly questionable even for industries with long lived assets (because it also ignores
upkeep, retooling and repair cash outlays), but it is highly questionable as a measure of financial
strength for industries with short lived assets (short sales cycles) and high working capital
growth needs. Industries growing rapidly or going through constant technical change
(obsolescence) are particularly vulnerable. The Amazon.com case highlighted earlier is a good
example of EBITDA failing to account for the firm’s necessary reinvestment in operations and
sustained growth objectives. And the latter high growth objective plays a critical role in how
investors value Amazon presently (very high multiples of reported earnings and adjusted
EBITDA).
Almost all businesses have constant pressures to reinvest cash flow into routine maintenance of
existing earning assets, which under accounting conventions falls under CapEx and not expensed
to a firm’s income statement in “real time”. So, EBITDA fails to recognize these real and
Examples of Cash Outlays Ignored by EBITDA analysis...
Inventory management for merchandizing and manufacturing related firms
Receivables management for sales-finance driven businesses e.g. durables
Depreciable equipment in manufacturing and some services businesses
Off-balance “rents” such as real estate occupancy or operating system leases for real estate
intensive and technology systems sensitive operations
Certain benefits and compensation for professional services firms e.g. stock-based
compensation
All are examples of real operating costs (or cash flow dilution) which GAAP and EBITDA often
ignore, and dismissing them when valuing a business is well – delusional or if stated a softer way
a form of cognitive dissonance. It’s akin to analyzing one’s household budget and ignoring the
mortgage, grocery and electric bill in extreme cases and there shortage of these on Wall Street.
The “Cash Conversion Rate”
Wall Street analysts and portfolio managers use EBITDA routinely without qualifying its use.
Among the most respected business evaluators, Berkshire Hathaway’s Buffet once stated that
EBITDA as “earnings before all the important expenses.”
Evaluating actual cash flow or what BlackwallPartners prefers to call realizable profit is a
better way (read: more accurate way) to measure how financially productive a business truly is.
So why, then, is attempting to accurately report free cash flow so unpopular a measure for
reporting firms, their investment bankers and the sell-side analysts who cover the stock? The
fact that EBITDA is just easier to calculate seems too veneer to be believable of course. As
already opined, we suspect there is another reason – to inflate purported profitability and hence
make valuations appear more reasonable or attractive to investors than they factually are.
BlackwallPartners’ applies a cash flow matching model across all long and short investments.
It’s a model taught to every rookie Federal Reserve banking analyst or regulator. While the
model was designed for credit analysis, we think it’s not applied often enough to equity
investing.
We scrutinize cash flows in an effort to reduce the following risks presented by the use of
conventional accounting, which, of course, underpins the calculation of EBITDA:
1. Broad flexibility in GAAP for reporting profits can be used to widen the differences
between reported profits and cash flow
2. In some instances the requirements of GAAP result in misleading operating cash flow and
profit reporting
3. Unusual cash receipts and payments can lead to unsustainable fundamentals
The key metric we utilize when evaluating the true profitability of a business is the “cash
conversion rate”, typically realizable profit-to-EBITDA. This ratio is akin to truth serum when
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evaluating the quality of a business, especially relative to GAAP and EBITDA measurements of
valuation.
Case Examples
Acquisitions: For acquisition-intensive business strategies (a.k.a. “roll-ups”), treat
acquisitions the same as “replacement” CapEx and not “growth” CapEx
Firms which rely upon voluminous and rapid-fire acquisitions to maintain GAAP EPS growth
(via purchase accounting treatment) are more commonly referred to as “roll-ups”. Roll-ups
always seem to hold favor with investors due to their seemingly endless growth optics. Purchase
accounting under GAAP allows firms to record the cash flow impact below the operating line
(see 2 under conventional accounting risks aforementioned). However, for these firms,
acquisitions are the operations of the business, hence EBITDA is a highly inaccurate measure of
realizable profit.
Roofing Materials Distributor A – Operating Cash Flow v. EBITDA FY Net Income $18 mil Add: Depreciation & Amortization 11 EBITDA 29 Change in Receivables 24 Change in Inventory <33> Change in Payables 16 Accrued Expenses <1> Other Assets -0- Other Liabilities 1 Capital Expenses <5> Acquisitions <280> Operating Cash Flow <248> EV/EBITDA 11x EV/Operating Cash Flow Negative Cash Conversion Rate Negative (Increase) Decrease in Debt 197 Stock Issuance 52 Cash Flow from Financings 249 Acquisition Goodwill-to-Book Equity 105% Debt-to-Capital 60% Debt-to-Tangible Equity Negative
Source: SEC filings; BlackwallPartners estimates
The truth is that “Roofing Materials Distribution Firm A” must spend excessively for
accounting–based profit growth. Acquisitions are a highly capital intensive business strategy
and thus there is no actual cash flow conversion from the business without collapsing the growth
model itself. In fact, working capital for the firm only is satiated by cash flow from forever debt
issuance (cash flow from financings) to fund acquisitions. In short, Firm A is on a cash flow
from financing (not operations) treadmill, whose plug can get pulled by a myriad of factors at
any time including the firm’s increasing debt-laden balance sheet (not the negative tangible
equity e.g.) to mere investor sentiment shifts in the debt capital market itself.
As the case study example shows, Firm A has negative operating cash flow because the cash
outlays for any given period’s latest acquisition(s) greatly exceed the period’s EBITDA. This is
where the heightened valuation risk lies for investors. Investors place high multiples on “roll-
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ups” based upon the sustainability of growth, itself a cash destroyer under this business model.
The paradox is that to create a realizable profit, the firm must stop growing and thus the
valuation must correct to the significantly lower organic growth rate of the underlying industry
or broader economy, which could mean even no growth at all. So risk of overpaying here is
substantial.
History shows that product or distribution-based acquisitions incur real cash costs which are
almost never economically as scalable as CapEx related to organic growth initiatives. EBITDA
and realizable profit will be miles apart in these strategies. This is why the majority of “roll-ups”
eventually become “blow-ups” for stockholders. Investors ignore the cash flow and balance
sheet deterioration until at some point the firm runs out of accounting-based growth because
acquirable properties become either too scarce and/or pricing gets too competitive or the
aforementioned other factors pull the plug on non-operating sources of working capital. These
firms all suffer from the same issues - rising debt leverage, low operating cash support to
necessary investment in growth and integration-related problems from mismanagement.
Auto Parts Distributor B – Operating Cash Flow v. EBITDA Quarter Net Income $12 mil Add: Depreciation & Amortization 3 EBITDA 15 Change in Receivables <2> Change in Inventory <14> Other Assets and Liabilities, net 5 GAAP Operating Cash Flow 4 Capital Expenses <9> Acquisitions <29> Operating Cash Flow <37> EV/EBITDA (annualized) 18x EV/GAAP Operating Cash Flow 180x EV/Operating Cash Flow Negative Cash Flow Conversion Rate Negative EBITDA Yield 6% Operating Cash Flow Yield Negative Cash Flow from Financings 37
Source: SEC filings; BlackwallPartners estimates
“Auto Parts Distributor B” also must spend excessively for accounting–based profit growth.
Their business is inventory intensive and they need to buy-up junkyards in order to find more
inventory of used auto parts. The inventory intensity itself is a major drain on working capital
and thus the business itself converts a mere 10% of EBITDA into above the line or operating
cash flow (realizable profit). As a result, the GAAP-based operating cash flow multiple is an
eye-popping 180x at market and Distributor B’s realizable profit is negative when the real costs
of CapEx and acquisitions are deducted. By properly adding-in the costs of CapEx and
acquisitions, one can see Distributor B must fund these material and recurring operating cash
flow shortfalls by issuing stock and debt (non-operating cash flow). The risk, obviously, of over-
paying for this company is very high. In fact, the valuation of this stock is at best whimsical and
due simply to poor business model analysis and accounting research on Wall Street.
The “roll-up” or acquired growth business model is a classic example of serial negative operating
cash flow covered by financings. By relying on financings to cover the strategy’s need to
constantly spend to meet accounting-based profit growth, the risks should seem obvious to
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investors. But they go unnoticed at just 18x EBITDA as is the case with Distributor B. Paying
multiples for such business models based upon GAAP and EBITDA is hence foolhardy.
Capitalized Expenses: Capitalizing operating expenses is often always a red flag
Beware of material expense accruals and unusually large charges through the investing section of
the cash flow statement! Capitalized operating costs most often are reported as a build-up of
accruals under GAAP’s “matching principle”, which results in a drain on working capital in
operating cash flow or large cash outflows in the investing section of the cash flow statement.
Thus, they are erroneously ignored by EBITDA calculations and missed by many analysts and
portfolio managers.
BlackwallPartners adjusts operating cash flow to add-back capitalized operating expenses to
realizable profit because GAAP’s “matching principle” is theoretical and has nothing to do with
the timing of actual cash outlays and receipts. And in almost every case, the capitalized
expenses also are recurring and not just one-time events. A good example is the common
accrual or capitalization of a technology firm’s software development costs, product warranties
and other future liability reserves, capitalized interest and most stock-based compensation
structures. These expenses recur in every reporting period and thus weigh on working capital
(perpetual short-term cash needs to run the business). We see only one benefit to a reporting
firm capitalizing clear operational related costs - to overstate the reported profitability of the
business. And therein lays the valuation risk.
Recreational Vehicle Maker C – Operating Cash Flow v. EBITDA
Quarter Net Income $11 mil Add: Depreciation & Amortization 14 EBITDA 25 Change in Receivables 18 Change in Inventory <18> Change in Payables 1 Accrued Expenses <71> Other Assets and Liabilities, net 1 Less Capital Expenses <14> Investment in Off-Balance Sheet Finance Sub
operating cash flow metrics limited to GAAP financial statements including EBITDA.
BlackwallPartners “unwinds” such off-balance sheet transactions by adjusting balance sheet
items to increase receivables and short-term debt. Many of these “arrangements” are structured
as joint ventures and treated as unconsolidated subsidiaries for accounting purposes. Thus, they
are easily missed by analysts and portfolio managers. Over valuation risk is quite alarming and
all too common unfortunately due to the understatement of leverage financing asset intensive
(balance sheet) working capital needs.
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GAAP and EBITDA also materially understate CapEx for asset-intensive firms which use off-
balance sheet structures for other operational costs such as occupancy (real estate) and
technology utilization leases et al. BlackwallPartners strips out the impact of operating leases
from our cash flow analysis and adds back off-balance sheet commitments into debt and
enterprise value to more adequately address potential value.
Satellite Television Network E – Operating Cash Flow v. EBITDA 2005 Net Income $1515 Add: Depreciation & Amortization 798 EBITDA 2313 Change in Receivables <4> Change in Inventory 80 Change in Payables <7> Accrued Expenses 151 Other Assets and Liabilities, net 219 Deferred Taxes <540> Less Capital Expenses <1506> Cash Flow pre Leases 268 Change in Off-Balance Sheet Leases <192> Operating Cash Flow 76
“Satellite T.V. Network E” is highly CapEx intensive and converts only 11% of its EBITDA into
realizable profit after adjusting for off-balance sheet satellite leases. So, it’s not a very profitable
business after all. The actual cash yield on the investment is only 1% at market. Valuing
EBITDA for a business like this is highly inaccurate and the risk of overpaying substantial. Yet,
almost every analyst following this stock and this industry at large focuses solely on EBITDA
for valuation, even though it really trades at 67x actual cash flow, a highly unattractive valuation.
Using EBITDA as a substitute for cash flow even among “clean” accounting for asset-intensive
industries is problematic as it leads to overvaluation risk. BlackwallPartners rarely goes long
an asset-intensive firm, but we often find short candidates among these business models due to
the heightened execution risk to such capital intensive business models and the higher likelihood
for overvaluation due to accounting convention overstatement of profitability. These types of
stocks tend to get overvalued towards the end of long, strong economic runs. They tend to be
highly levered (such periods usually are accompanied by “junk” bond euphoria) and the business
risk and valuation issues become evident in following economic downturn.
As Buffett once cleverly said – “only when the tide goes out do you discover who’s been
swimming naked”. BlackwallPartners politely disagrees. Focusing on realizable profit
analysis instead of conventional accounting metrics can identify the presence of a bathing suit
regardless of incoming or outgoing tides.
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Railroad F – Operating Cash Flow v. EBITDA FY Net Income $1026 mil Add: Depreciation & Amortization 1175 EBITDA 2201 Change in Receivables <201> Change in Inventory <22> Change in Payables 224 Other Assets 12 Other Liabilities 138 Less Capital Expenses <2169> Operating Cash Flow 183
“Railroad F” also is highly asset intensive (in this case depreciable CapEx) and converts an
astonishingly poor 8% of EBITDA into realizable profit. So, it’s not a “good” business. The
actual cash yield on the investment is under 1% at market. Valuing EBITDA for a highly asset-
intensive industry like railroads is absurdly naive and in this case paying 169x actual operating
cash flow for Railroad F should alarm an investor. “Only 14x EBITDA” says the sell-side
brokerage firm analyst. 169x actual cash flow…sobering! Our review of railroads indicates
their CapEx is consistently high in every reporting period due to the significant wear and tear on
the equipment.
Stock-Based Compensation and People Intensive Business Models
EBITDA and other cash flow substitutes do not capture the operating costs for firms that substitute
stock options and warrants etc. for cash compensation across an inordinately high percentage of their
employees. These types of compensation models are most often found in early-stage, high growth
opportunities like technology and biotechnology. But they also are found even in the more mature
firms in these sectors. Why? The early-stage firms cannot afford to pay cash to employees as most
are losing money and the more mature ones get addicted to the overstatement of their reported profits
and fear valuation retribution.
While motivating employees with stock ownership has positive attributes for investors, it does
overstate the profitability of a business under conventional accounting conventions. Two items
not found in EBITDA must be reconciled to get an accurate picture of realizable profit - deferred
tax liabilities (accrued taxes related to non-cash compensation which must be funded in the
present) and stock repurchases in the open market (a large use of cash to manage GAAP dilution
from perpetual new stock issuance to employees). Specifically, the latter negatively impacts
realizable cash flow on a per share basis (dilution) and is the most common oversight by analysts
and portfolio managers.
Analysts tend to stop above the operating line when evaluating firms with high stock-based
compensation. Since we are dealing with share count issues with stock-based compensation
(share count dilution) in the first place, per share operating metrics are critical. If the number of
fully diluted shares is not declining for a firm with a broad stock-based compensation strategy
Durante
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despite an aggressive stock repurchase program, then one should be concerned. Significant cash
flow per share dilution likely is taking place as economic value is being transferred to employees
(funded below the operating line) at the expense of public stockholders. And few investors seem
to realize they are being diluted. The effect is doubly problematic because not only is cash flow
per share (economic value) being destroyed; the impact below the operating line also overstates
the above-the-line growth rates used by Wall Street to discount the valuation. This leads to
serious overvaluation risk for investors.
Professional Services Firm G – Operating Cash Flow v. EBITDA* FY Net Income $26 mil Add: Depreciation & Amortization 1 EBITDA 27 Change in Deferred Taxes 22 Adjusted EBITDA* 49 Change in Membership Fees <6> Change in Deferred Revenue 9 Less Capital Expenses <4> Purchase of Treasury Stock <44> Operating Cash Flow 2