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Valuation Analysis - EBITDA Shortcomings

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Valuation Analysis - EBITDA from the Sublime to the Delusory Use as a Measure of Firm Profitability and Prospective Value

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Valuation Analysis - EBITDA Shortcomings

  1. 1. 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
  2. 2. Durante Page 1 “EBITDA is Earnings Before all the Important Expenses” - Warren Buffett
  3. 3. Durante Page 2 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
  4. 4. Durante Page 3 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.
  5. 5. Durante Page 4 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. EBITDA = Revenue – Expenses excluding Interest, Tax, Depreciation and Amortization Equity Accounting is a recognized accounting method under GAAP, whereby a firm may assess the profits earned by investments in other unconsolidated companies regardless of whether such profits were actually received in cash or “in kind”. The assumed profits interest is recorded on the firm’s income statement as income, leading to potential differences between a firm’s reported earnings and free cash flow. Equity Free Cash Flow – see Realizable Profit Enterprise Value – or “EV” measures a firm’s ‘total value’ and is expressed as a firm’s market capitalization (market price per share multiplied by the number of fully diluted shares outstanding a.k.a. “equity value”) plus total debts, minority interest and preferred shares less
  6. 6. Durante Page 5 cash and cash equivalents. EV is commonly used in measuring a firm’s value relative to its EBITDA as opposed to a price-to-earnings ratio or “P/E ratio”. Firm Free Cash Flow (FFCF) is the cash flow available to service a firm’s debt with the remainder being realizable profit. Put simply, FFCF is a measure of a firm’s profitability after all expenses and reinvestments. FFCF = EBIT (1-Tax Rate) + Depreciation & Amortization – CapEx – Changes in Working Capital + Net Borrowing Generally Accepted Accounting Principles – or “GAAP” is a common set of accounting standards and procedures that firms use to prepare and report their financial condition to investors and creditors. GAAP are authoritarian accounting standards set by a formal policy making board known as the Financial Accounting Standards Board (FASB) and is regulated by the United States Securities & Exchange Commission (SEC). Realizable Profit is profit which can be distributed to shareholders after all reasonable reinvestment in both current business operations and necessary investment in an enterprise’s expected future growth also known as “equity free cash flow”. Realizable Profit = Net Income + Depreciation & Amortization – CapEx – Changes in Working Capital + Net Borrowing Terminal Value is the anticipated value of an asset (such as a business) at a certain date or point-in-time in the future and measured by multiple period free cash flow discounting i.e. treating the expected future cash flows as if they were perpetual. Working Capital is cash available to a company for day-to-day operations. It is calculated by netting a firm’s current assets against its current liabilities at a single point-in-time (balance sheet). The most common components of working capital include current assets - cash-on-hand, marketable securities, accounts receivable, and inventory; and current liabilities – accounts payable, accrued expenses, short term debt, and the current portion of long-term debt. It is the primary measure of a firm’s liquidity and reflects the health and efficiency of a firm’s operations to include collection of sales receipts, payment to input suppliers, inventory management, and debt administration. The change in working capital, a key factor in accurately measuring cash flow, is measured by calculating the difference between working capital between financial reporting periods.
  7. 7. Durante Page 6 Introduction - An Abridged History of EBITDA EBITDA is a widely accepted measure of a firm’s ‘realizable profits’. There is no legal regulatory requirement for a firm to disclose its EBITDA, but calculating EBITDA is relatively straight forward. One takes a firm’s pre-tax net income and adds-back the period’s interest, depreciation and amortization expenses. It often is referred to by its proponents as a measure of a firm’s “operating profits” and even as a proxy for cash flow. As the report exposes, popular, conventional financial measurement itself offers very limited insight into a given firm’s real operational costs. So, GAAP and EBITDA attempt to define for investors a firm’s “financial performance”, but too often come-up well off a more realistic profit picture. BlackwallPartners defines this more realistic profit as “realizable profit”. As already noted, prior to the explosion in leveraged buy-out transactions (“LBOs”) in the eighties, EBITDA was a financial measurement rarely used neither to measure debt service burden capacity nor 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 rather conveniently and perhaps precariously both advised on transactions as well as sold high yield securities supporting the promising buy-out economics. Their advocacy simply was to inflate debt service capacity of acquired firms and then future valuation using a specious financial measure. In short, a clear conflict of interest. Despite the catastrophic end to the risky 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. The premise behind EBITDA’s continued popularity as a measure of ‘realized profitability’ is the notion that in economic downturns and in the long-run, firms can alter or even suspend their capital expenditures (“CapEx”). However, such real operating costs are not truly discretionary in the overwhelming number of cases. 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 more work beyond EBITDA to arrive at fair and reliable valuation of an enterprise. EBITDA came to the forefront in financial statement analysis in the 1980’s with the boom in LBOs. LBO firms and Wall Street bankers promoted its use as a “back of the envelope” or short-cut to determining a distressed firm’s ability to service the debt created by the LBOs impact on the capital restructuring. In short, did a firm generate enough EBITDA to cover the additional interest over a short period of time on the high restructured debt-load.
  8. 8. Durante Page 7 As has been aptly summarized by Moody’s senior corporate finance analyst, Pamela M. Stumpp: “It is interesting to observe that management teams often only address that port of the P&L [profit and loss] that suits them best. For example, management of strong companies often refer to EPS [net earnings per share], while management of weaker (or developing) firms address top- line growth and revues. Some companies cite gross or operating margins, which look strong relative amounts lower down their P&L’s. Those with a good EBITDA story speak to this. It is for the analysts to question a company’s motivation for emphasizing one measure versus another. “EBITDA has become so widespread and the concept used synonymously with cash flow so often, that users have apparently overlooked its limitations” 1 And Lisa Smith, author of The Essentials of Corporate Cash Flow, put it poignantly: “Factoring out interest, taxes, depreciation and amortization can make even completely unprofitable firms appear to be fiscally healthy. A look back at the dotcoms provides countless examples of firms that had no hope, no future and certainly no earnings, but became the darlings of the investment world. The use of EBITDA as measure of financial health made these firms look attractive. Likewise, EBITDA numbers are easy to manipulate. If fraudulent accounting techniques are used to inflate revenues and interest, taxes, depreciation and amortization are factored out of the equation, almost any company will look great. Of course, when the truth comes out about the sales figures, the house of cards will tumble and investors will be in trouble. Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash charges (depreciation and amortization) back to net income and includes the changes in working capital that also use or provide cash (such as changes in receivables, payables and inventories). These working capital factors are the key to determining how much cash a company is generating. If investors do not include changes in working capital in their analysis and rely solely on EBITDA, they will miss clues that indicate whether a company is losing money because it isn't making any sales.” 2 David Simons of Forbes, author of “EBITDA Addiction Growing at Dot Coms” was even more direct in his indignation at the height of the dot com boom: “EBITDA isn’t a controlled substance or a law enforcement agency. It’s the standard abbreviation for the financial-analysis term “Earnings Before Interest, Taxes, Depreciation and Amortization.” Among Internet companies, it’s quickly becoming the device of choice to pep up earnings announcements. The devastation of tech stocks unleashed a torrent of complaints about tech companies’ liberal self-definition of what expenses should be included and excluded 1 Fabozzi, Frank J., Editor and Stumpp, Pamela M., Bond Credit Analysis: Framework and Case Studies (Frank J, Fabozzi Associates 2001) 2 Smith, Lisa, Staff Writer Investopedia, “The Essentials of Cash Flow”, Investopedia January 5, 2004
  9. 9. Durante Page 8 in earnings–dubbed “pro forma” by the companies. Extensive media exposés made the label a dirty word. Rather than try rehab, corporate pro forma addicts increasingly are spiking earnings presentations with EBITDA. Last year, before pro forma was sullied, 16% of first- quarter dot-com earnings announcements included EBITDA. This year it’s 24%, with half the companies yet to report. Debt-challenged e-commerce services outfit Beyond.com headlined a March quarter EBITDA loss of $5.7 million. That excludes $1.4 million of negative net interest, or 20% of the total. Last year, when net interest expense was 2% of the cash basis loss, Beyond.com’s first-quarter announcement went with pro forma and didn’t even mention EBITDA. Like pro forma, EBITDA isn’t an accounting standard. But after its invention as a tool of the leveraged buyout mania in the 1980s, EBITDA became well established as a useful financial-analysis measure of telephone, cable, and major media companies. EBITDA and pro forma are similar in that both exclude items deemed to be “non- cash,” such as amortization of goodwill charges created by acquisitions, and payments made in stock. The main difference is that pro forma usually includes interest and gains from equity investments. When dot-coms were flush with cash, touting EBITDA would have omitted interest income that pared losses. This year’s skimpier bank accounts and greater debt burdens make interest income less attractive. In addition, pro forma plumping of bottom lines with gains from sale of stock obtained in marketing and venture capital deals is now history. That also makes it easier to ignore the “Other” income line in return for the cosmetic respectability of EBITDA. However, traditional use of EBITDA in analysis of telecom companies applied to their massive capital investment in long-lived assets such as fiber-optic lines. The huge depreciation charges can hammer earnings for years on end, masking the actual cash flow enabled by the investment. Most Internet companies don’t make heavy capital expenditures. But because definition of EBITDA isn’t enforced by a standards-making body, companies can be as loosey-goosey about it as they have been in concocting pro formas. This quarter’s Egregious EBITDA Award goes to Internet service provider Prodigy Communications .The company’s April 26 announcement of first- quarter results crowed, “Prodigy is reporting positive EBITDA for the first time in its history. Among the “before” items of the $10.5 million EBITDA was $12.8 million of promotional cash rebates. That enormously exaggerates basic business performance. Including the rebates, Prodigy’s EBITDA actually was negative $2.3 million.
  10. 10. Durante Page 9 Rebates are marketing. “Amortization” in EBITDA usually applies to intangible assets. Fixed assets such as equipment and buildings are depreciated. Intangible assets such as patents and goodwill are amortized. The math concept is the same– pro-rate over a fixed period. Accounting principles do require amortization of Prodigy’s rebates because they are tied to multi-year subscriptions. But that doesn’t justify headlining an earnings release with EBITDA that ignores the rebates. Business accounting amortizes many types of ordinary revenue and expense. When you buy a magazine subscription, the publisher records the up-front payment as income in installments as issues are sent to you. Business insurance premiums paid annually are amortized and charged against income in monthly or quarterly installments. Cellular and satellite TV companies sometimes report marketing-adjusted EBITDA in addition to normal EBITDA. That gives insight into the financial performance of network operations. But they don’t build their entire presentation on it. What’s more, Prodigy doesn’t even own a network. It buys capacity from companies such as McLeodUSA and giant Baby Bell SBC Communications , which owns 43% of Prodigy.Pro forma and EBITDA presentations don’t violate laws or accounting rules as long as the companies also provide financial statements prepared according to Generally Accepted Accounting Principles. The tailored financial statements often include footnotes such as this from Prodigy: EBITDA should not be construed as an alternative to operating income (as determined in accordance with U.S. GAAP), as a measure of the Company’s operating performance, or as an alternative to cash flows from operating activities (as determined in accordance with U.S. GAAP), or as a measure of the Company’s liquidity. In the context of the press release spin, such warnings are like Robert Downey Jr. Robert Downey Jr. wearing a “Just Say No” T-shirt. The absence of standard definition creates inconsistency and confuses comparisons. Next week I’ll highlight more doozies from the first-quarter pro forma follies, and explain why the problem isn’t the companies but the analysts.” 3 As this paper should make clear, EBITDA mostly is theoretical, widely inaccurate and quite precarious to adequately valuing businesses. EBITDA skeptics seem few and far between anymore but some indeed exist and we at BlackwallPartners have been consistent skeptics. And through case examples, this report shall delve well into why EBITDA is so lacking in its substitution for cash flow or profits of a business. But let us first attempt to recall why it was invented in the first place. 3 Simons, David, ”EBITDA Addiction Growing at Dot-coms”, Forbes May 3, 2001
  11. 11. Durante Page 10 There indeed is some incremental value, albeit limiting, in using EBITDA. It can give one a quick snapshot of what an enterprise’s potential profit power would or could be before one must consider the inevitability of the working side of an enterprise – namely making certain the cash generating assets of the firm are kept in good working order; updated; reinvested in for growth; how acquisitions are accounted for etc.; and of course financing all of it. And oh yes, taxes too... Berkshire Hathaway Chief Executive Warren Buffett took EBITDA to task in his letter to investors in 2002… “In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?” 4 Warren Buffett’s longtime business partner at Berkshire Hathaway – Charlie Munger once quipped – “every time you see the word EBITDA substitute it with the words ‘bulls*** earnings’!” While we are nowhere near as colorful as Mr. Munger, I think he gets to the point if not gracefully or poetically. As we shall prove, most reporting firms and industries that most commonly ascribe to EBITDA (read: incentivized to adopt) as their preferred measure of profits or financial success actually use every penny of free cash flow coming in to keep their business going and growing. So, EBITDA is a mere “smoke screen” in the overwhelming number of cases. As Mr. Buffett once explained – “people who use EBITDA are either trying to con you or they’re conning themselves.” He also is believed to have stated – “EBITDA is earnings before all the important expenses. Capital expenditures, interest payments, and taxes are “real” cash outlays. Not counting them indeed is a con job.” 4 Buffett, Warren, Berkshire Hathaway Annual Report to Shareholders, 2002
  12. 12. Durante Page 11 EBITDA: Key Flaws and Shortcomings Reporting Firms’ Warn Investors As noted, this report outlines key flaws in using EBITDA to measure a firm’s realizable profits (cash flow), credit capacity and ultimate value with case examples. Even credit rating agency Moody’s Investor Service has opined on the wide spread use of EBITDA suggesting “the use of EBITDA-based ratios can be inappropriate and misleading” and “relying on them without consideration of other credit measures can be dangerous.” 5 Corporate filers and their external auditors also appear very aware of the potential flaws in presenting investors with EBITDA based measures. The typical disclosure found in official corporate financial reports (Securities & Exchange Commission “SEC” 10-K and 10-Q filings 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)
  13. 13. Durante Page 12 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.
  14. 14. Durante Page 13 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.
  15. 15. Durante Page 14 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.
  16. 16. Durante Page 15 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 recurring cash outlays, hence inflating realizable profits.
  17. 17. Durante Page 16 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
  18. 18. Durante Page 17 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-
  19. 19. Durante Page 18 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
  20. 20. Durante Page 19 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 11 Operating Cash Flow <47> EV/EBITDA 19x EV/Operating Cash Flow Negative Cash Flow Conversion Rate Negative Stock Issuance <16> Debt Issuance 62 Cash Flow from Financings 51 EBITDA Yield 5% Operating Cash Flow Yield Negative Source: SEC filings; BlackwallPartners estimates “Recreational Vehicle Maker C” accrues very large dollar warranties (future liabilities) despite having to fund the reserve at the time of the sale (see “accrued expenses” above). The effect is to substantially overstate the profitability of the business per GAAP and EBITDA metrics. The firm “pays” for this perpetual cash flow short-fall through financings. Actual debt also is understated as well due to the use of an off-balance sheet financing structure (securitization of consumer loans on the recreational vehicle purchases), which also comes with unidentified on
  21. 21. Durante Page 20 the GAAP income statement credit losses. Even without adjusting for credit losses (that are accounted for in the off-balance sheet structure), the cash conversion rate for Maker C is negative due to the need to finance the aforementioned constant working capital deficiency and thus the valuation risk of the stock is, of course, high if one relies on conventional accounting metric instead of realizable profit analysis. This is the “levered sales-finance model” and it can disintegrate rather quickly on investors into bankruptcy on any fundamental mishaps, especially credit underwriting related blunders. BlackwallPartners either shorts or avoids such business models as a standard practice due to the inherent business model risks. In fact, the “levered sales finance” model is one of our favorite “hunting grounds” for potential short sales. Companies that capitalize expenses generally must fund such cash outflows below the operating line, most commonly through perpetual financings. Financing repetitive working capital shortfalls overstates profitability and increases the risk to already overstated fundamentals in a downturn. Most problems are not uncovered until a fundamental problem arises and this explains the rapid “melt-down” in stocks of companies which employ aggressive expense capitalization techniques. Working Capital vs. EBITDA in Asset Sensitive Industries As previously noted, some critical, material and recurring sources and uses of cash related to working capital-intensive industries are properly reported in the operating section of the cash flow statement, but ignored by EBITDA. And others are not picked-up by traditional financial statements at all due to the use off-balance sheet accounting techniques such as unconsolidated joint ventures, subsidiaries and leases As the next few case examples will highlight, EBITDA can be a materially inaccurate measure of operating cash flow for asset-intensive intensive industries. For the asset-intensive business model, changes in working capital related to the management of key assets and liabilities such as inventory, receivables and payables etc. are too critical a drain on working capital to ignore when evaluating the business, yet GAAP or EBITDA or both do just that. In the most egregious cases, some reporting firms use off-balance sheet financing arrangements to manage such working capital intensity, which traditional financial statement analysis otherwise would overlook. Receivables securitization is among the more common techniques as are off-balance sheet leases for occupancy (commercial real estate) and operating systems (technology firms). And if perpetual shortfalls from working capital related items (balance sheet) is present, then a company may have fundamental issues related to revenue recognition that need to be explored with management. For example, “channel stuffing” is a technique used to record sales on the income statement by redirecting receivables to other potentially inappropriate parts of the balance sheet. A thorough reconciliation of working capital from period to period usually can pick-up on this.
  22. 22. Durante Page 21 Conversely, unusual cash inflows in working capital related assets and liabilities can indicate off- balance sheet ventures and financing structures. In these cases, EBITDA will ignore working capital and thus is a wholly inadequate measure of realizable profit. Farm Equipment Maker D – Operating Cash Flow v. EBITDA FY Net Income $32 mil Add: Depreciation & Amortization 106 EBITDA 138 Change in Receivables 104 Change in Inventory <42> Change in Payables 40 Accrued Expenses <45> Other Assets and Liabilities, net <39> Less Capital Expenses <23> Transfer of Receivables to Off-Balance Sheet Entity <109> Operating Cash Flow <40> EV/EBITDA 16x EV/Operating Cash Flow Negative Cash Flow Conversion Rate Negative EBITDA Yield 6% Operating Cash Flow Yield Negative Off-Balance Sheet Commitments 652 GAAP Debt 848 Adjusted Total Debt 1500 GAAP Debt-to-Tangible Equity 1.7x Adjusted Debt-to-Tangible Equity 3.0x Source: SEC filings; BlackwallPartners estimates “Farm Equipment Maker D” accrues operating expenses but must fund (with cash) the reserve for such future liabilities at the time of sale, a problematic and perpetual timing issue with its business model that generates significant departure between cash flow and conventional accounting metrics. But, the even more glaring standout is that Maker D funds almost 80% of GAAP operating cash flow (i.e. EBITDA) by transferring assets to off-balance sheet structures, which on are partially owned by the reporting entity and thus unconsolidated for accounting purpose. They are financings nonetheless and materially alter the real cash flow statement when factored-in. The effect is to substantially understate leverage in the business (by two times) and constant reliance on financings to meet working capital shortfalls is inherently risky. The cash conversion rate is negative and as such, this highly “strained” business model cannot be adequately valued using EBITDA. Under EBITDA, Maker D appears to be valued at a potentially palatable 16x, but realizable profit actually is negative. Investors must be particularly cognizant of off-balance sheet financing arrangements as they decrease accounts receivable and lower indicated debt levels, thereby artificially increasing 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.
  23. 23. Durante Page 22 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 EV/EBITDA 8x EV/Operating Cash Flow 67x Cash Flow Conversion Rate 11% EBITDA Yield 13% Operating Cash Flow Yield 1% Source: SEC filings; BlackwallPartners estimates “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.
  24. 24. Durante Page 23 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 EV/EBITDA 14x EV/Operating Cash Flow 169x Cash Flow Conversion Rate 8% EBITDA Yield 7% Operating Cash Flow Yield <1% Source: SEC filings; BlackwallPartners estimates “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
  25. 25. Durante Page 24 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 EV/Adjusted EBITDA* 18x EV/Operating Cash Flow 438x Cash Flow Conversion Rate 4% Adjusted EBITDA Yield 6% Operating Cash Flow Yield 0% GAAP EPS $1.30 Adjusted EBITDA Per Share $2.45 Operating Cash Flow Per Share $0.10 Cash Flow Dilution Per Share >90% GAAP EPS Growth Rate +19% Cash Flow Per Share Growth Rate Negative Change in Common Shares FD +5% Source: SEC filings; BlackwallPartners estimates *Sell-side analysts use Net Income plus Depreciation, Amortization and Deferred Taxes for a cash flow substitute. “Professional Services Firm G” converts a worrisome just 4% of its adjusted EBITDA* into real operating cash flow or realizable profit. This creates a nightmarishly overvalued stock at 438x actual cash flow. In effect, firms using options in lieu of cash compensation experience exacerbated operating costs for their staff because buying-back stock at inflated market prices to battle ‘share creep’ from vesting options and converting warrants issued to employees is a colossal destroyer of cash. Investors are missing this aspect of stock-based compensation. However, there is no mistake in cash flow per share metrics. This may be the biggest “miss” from a lack of detailed cash flow statement analysis by Wall Street today. It’s rampant in high growth-oriented industries and ignoring its true costs universally accepted by analysts, portfolio managers and other investors. From a conventional accounting perspective, the effect of many stock-based compensation- centric financial models is that material levels of actual staff expense, a clear operating cost, is capitalized and thus ignored on the income statement. The cash costs show up in the cash flow statement below the operating line upon option vesting in the financing section of the cash flow statement at a future date. These firms prove to be less profitable than indicated by GAAP and EBITDA metrics as a result. Professional services and technology firms are most at risk to this type of capitalized operating expense issue.
  26. 26. Durante Page 25 Obviously, using actual cash flow is a better measure of how much real profit a company is able to generate and should be inherent to stock valuation. Nevertheless, it’s not widely practiced by Wall Street, which is more prone to momentum investing and applying false valuation measures to propel investing trends in the short run. Conclusion With the myriad of differing and even contravening earnings figures presented by reporting firms, the overreaching question for investors is which one best represents what BlackwallPartners prefers to call “realizable profits” (sustainable free cash flow) as we’ve defined. As the report demonstrates, the use of popular, conventional measurement offers very limited insight into a given firm’s real costs to operate and as such is of limited use. While conventional accounting, including EBITDA, strives to define for investors a firm’s “financial performance”, it too often leads to incorrect conclusion. 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. Realizable Profit is profit which can be distributed to shareholders after all reasonable reinvestment in both current business operations and necessary investment in an enterprise’s expected future growth also known as “equity free cash flow”. Realizable Profit = Net Income + Depreciation & Amortization – CapEx – Changes in Working Capital + Net Borrowing As we have demonstrated through case examples and in-depth financial statement analysis, EBITDA fails to correlate with cash flow by the very firms and industries who prefer to espouse its use. It should not be used by investors to measure the financial capacity or value of most businesses. Nor should GAAP earnings given the wide latitude by which companies can adopt such pronounced accounting measures including too often the occurrence of manipulation or suspicion of manipulation. There are no short-cuts to quality financial appraisal and one must do much more work than just EBITDA analysis or merely accept GAAP to arrive at a fair and reliable valuation of an enterprise. Fortunately, there is a clear-cut choice for more informed and likely more successful equity value appraisal and it is sustainable free cash flow or “realizable profit”. Albeit we did not focus this report on credit analysis per se in favor of equity valuation technique, the very same can be said of credit analysis. And the proper tool is equity free cash flow’s grossed-up cousin to cover cash flow available to all investors both debt and equity or “firm free cash flow”.
  27. 27. Durante Page 26 Firm Free Cash Flow (FFCF) is the cash flow available to service a firm’s debt with the remainder being realizable profit. Put simply, FFCF is a measure of a firm’s profitability after all expenses and reinvestments. FFCF = EBIT (1-Tax Rate) + Depreciation & Amortization – CapEx – Changes in Working Capital + Net Borrowing Reporting firms report and their investment bankers purport adjusted earnings figures including various versions and perversions of EBITDA NOT because they are the most accurate way to value a company or assess its credit viability. They do so merely and only because the measures are more favorable to them. They paint a prettier picture. Reliable valuation technique doesn’t end with realizable profit analysis of course. A firm’s sustainable growth (and that of its industry), as well as how defensible (wide) its cash profit margins (proprietary business or a commodity industry e.g. or idiosyncratic risks) also play a material role in informed valuation. Prevailing market sentiment, politics, the overall economy, and, of course, opportunity cost (usually measured by the spot yield-to-maturity on the riskless bond) also play a critical role at any point-in-time and can systematically impact entry and exit timing. We cannot give investors a “catch-all” or impervious way to balance sustained realizable profit, profit margin strength and defensibility and overall market opportunity and the aforementioned systematic variables when determining an appropriate value for a business. What we can share is the model that BlackwallPartners’ researchers and stock pickers have used successfully over a long period of time. We buy (long) stock in companies which have proven (over time), recurring revenue and realizable profit growth which exceeds the growth rate inherent in both its industry and the overall economy. The higher and more reliable the recurring nature of a firm’s sales and cash profits assuage idiosyncratic risk. And then we attempt to purchase the stock at a discount to or below that sustainable cash profit (realizable profit) growth. Upon apprehension, a reporter purportedly asked notorious bank robber William “Willie” Sutton, Jr. ‘why he robbed banks?’ Sutton wryly responded – “Because that’s where the money is”
  28. 28. Durante Page 27 About the Author Michael Durante has spent over twenty-five years in high finance. Mr. Durante began his career with U.S. Federal Reserve, serving as a bank holding company inspector and bank examiner. While with the Federal Reserve, he also spent time training in the central bank’s Loan & Discount Department, better known as the “Discount Window” as a credit analyst. He completed all Board of Governors of the Federal Reserve training schools including Commercial Banking; Credit; Capital Markets; and Financial Accounting, including training in forensic accounting. While in the a field, Mr. Durante worked on numerous large financial institution exams and inspections including Chase, Bank One, KeyCorp, National City, Fifth- Third, PNC Financial and Mellon (BNY Mellon) et al. He also participated on the joint- regulatory agency Shared National Credits (“SNICs”) review team, which audits the nation’s largest loan syndications including credits originated by Chase, Citibank, Wells Fargo, and Bank of America et al. Following the Federal Reserve, Mr. Durante spent almost a decade on Wall Street as an institutional equity analyst, most notably with Salomon Brothers, then the highest ranked financial services research firm. During his tenure as an institutional equity analyst, he covered both large, complex banks such as First Chicago, Wells Fargo, The Northern Trust Company, PNC Financial, Mellon, and U.S. Bancorp to name a few. He also covered key non-bank financials also known as “shadow banks” and was named to the Wall Street Journal’ ‘All-Star Analyst’ team as well as voted onto Institutional Investor Magazine’s ‘Best of the Street’ equity analyst survey. He covered non-bank financial firms such as MBNA (now BofA), Capital One, Household International (now HSBC), CIT, Beneficial (HSBC), AmeriCredit (now General Motors Financial), First USA (JPMorganChase) and The American Express Company et al. Practicing in specialty finance and electronic payments solutions, Mr. Durante was a member of the investment banking team from Salomon that sold the AT&T Universal Credit Card business to Citibank, the largest credit card portfolio sale of its time, and worked on numerous equity and debt offerings during his career for financial firms such as MBNA, Bank One, Capital One, CIT, The Money Store, Ford Motors’ Associates First Capital, Quicken Loans, Household Auto Finance and AmeriCredit et al. Mr. Durante joined institutional investment firm, John McStay Investment Counsel following Salomon Brothers. At McStay, Mr. Durante became the firm’s youngest ever partner and managed roughly $2 billion in equities related to finance, payment systems and financial technologies for institutional investors worldwide. He was an early adopter in investing in leading financial technology firms such as PayPal (eBay), Fair Isaac and Alliance Data Systems et al. He started his first hedge fund in 2004, which eventually became BlackwallPartners LLC focusing on financials, financial technologies and electronic payments. His career audited annual alpha is 18% relative the S&P 500 financials index.
  29. 29. Durante Page 28 Mr. Durante was the first to write an opinion letter to the U.S. Securities & Exchange Commission warning of the inherent flaws in so-called ‘mark-to-market’ accounting (Fair Value Measurement) and helped prepare testimony delivered by former Federal Open Market Committee member Dr Robert D. McTeer, Jr. before the U.S. House of Representatives’ hearings on Fair Value Measurement in the after-math of the Financial Crisis. Mr. Durante remains a critic of the overly broad use and misuse of the accounting measure. Mr. Durante has been a guest contributor to Forbes Magazine’s forbes.com/economics; the National Center for Policy Analysis economics blog; guest on CNBC; and quoted in the Wall Street Journal; Forbes; Fortune; and the American Banker et al. He is a member of the Economics Society of the London School of Economics; the Royal Economic Society; and the American Economic Association. He is a member of the Vanderbilt University Alumni Association; the London School of Economics Alumni; the Oxford Business Alumni; and a member of St. Hugh’s College, Oxford. He has studied finance and economics at Vanderbilt, where he holds a B.A. in Economics, the London School of Economics, where he did post graduate studies in Economics and Corporate Finance, and Oxford University, where he holds a Master’s (PgD) in Financial Strategy from Oxford’s Saïd Business School.
  30. 30. Durante Page 29 Acknowledgements I would like to express my sincere gratitude to all those who have supported and guided my financial services, valuation and financial accounting research efforts over the span of my now better than twenty-five year career as a Wall Street equity analyst, investment banker and both institutional equity and hedge fund manager. Some of those firms, organizations and their exceptional people include the Federal Reserve, Salomon Brothers and John McStay Investment Counsel. I want to thank my long-time business partner, close friend and confidant David Houston, MBA. In addition to being the Chief Operating Officer of BlackwallPartners LLC, Dave also is an Adjunct Professor at the University of Texas at Dallas’ Naveen Jindal School of Management, where he teaches numerous courses to MBA students on hedge fund and alternative asset strategies. I also wish to recognize my good friend, frequent research companion and guider Dr Robert D. McTeer, Jr., PhD. Bob spent thirty-seven years within the Federal Reserve System holding such positions as the chief economist of Federal Reserve Bank of Richmond and later President of the Federal Reserve Bank of Dallas and a fourteen-year member of the Fed’s critical decision- making body – the Federal Open Market Committee under legendary Federal Reserve Chairman Alan Greenspan. I too started out my career under the ‘Greenspan Fed’. I must show gratitude to my Financial Strategy cohort at Oxford, whose broad diversity of background, culture and business experience made much of the difference during my time at Oxford with their vibrant contributions to our daily debates. I do and shall forever miss the banter. Twitter, LinkedIn and other erstwhile social media is no substitute to interpersonal contact and direct deliberation. Finally, I must acknowledge the incomparable expertise, advice and direction of the academic staff (and support staff) of the University of Oxford’s Saïd Business School. The list is long and quite distinguished but these particular individuals deserve special recognition: Dr Kazbi Soonawalla, PhD, my advisor on this study, is a Senior Research Fellow in Accounting at Saïd Business School and a Tutorial Fellow in Management at Keble College, Oxford Dr Howard Jones, PhD, Senior Research Fellow in Finance at Saïd Business School and Fellow at Keble College, Oxford Dr Richard Whittington, PhD, a Professor of Strategic Management at Saïd Business School, where he is a member of the Strategy Entrepreneurship and International Business Group. He also is the distinguished Millman Fellow in Management at New College, Oxford Dr Ken Okamura, MA, MSc, PhD, CFA is a Research Fellow at Saïd Business School’s Centre for Corporate Reputation
  31. 31. Durante Page 30 Dr Han Ozsoylev, PhD, Lecturer in Financial Economics at Saïd Business School and an academic member of the Oxford Institute of Quantitative Finance Olivier Sibony is a Director at management consulting firm McKinsey & Co., where he is a co- leader of McKinsey’s Global Strategy Practice. He is a frequent author in the McKinsey Quarterly and Harvard Business Review.
  32. 32. Durante Page 31 References 1. Durante, Michael P., “The Big Lie”, Western Reserve Capital Management (predecessor to BlackwallPartners LLC), July 18, 2006 2. Fabozzi, Frank J., Editor and Stumpp, Pamela M., Bond Credit Analysis: Framework and Case Studies (Frank J, Fabozzi Associates 2001) 3. Smith, Lisa, Staff Writer Investopedia, “The Essentials of Cash Flow”, Investopedia January 5, 2004 4. Smith, Lisa, Staff Writer Investopedia, “EBITDA: Challenging the Calculation” and McClure, Ben, “A Clear Look at EBITDA”, Investopedia March 26, 2006 5. Buffett, Warren, Berkshire Hathaway Annual Report to Shareholders, 2002 6. Simons, David, “EBITDA Addiction Growing at Dot-coms”, Forbes May 3, 2001 7. Argersinger, Matthew, “How Companies Fake It (With Cash Flow), DailyFinance July 27, 2011 8. O’Kelly, Jude, ”EBITDA – A Misleading Earnings Measure”, CoreEarnings.com May 2013 9. Gavin, Ted, CTP, “Top Five Reasons Why EBITDA Is A Great Big Lie”, Forbes December 28, 2011 10. Gavin, Ted, CTP, “The Great EBITDA Myth”, ABF Journal, September 2002 11. Luciano, Robert, EBITDA as an indicator of earnings quality”, SIA Journal December 3, 2003 12. EBITDA/Interest: “Friend or Foe?” Moody’s Speculative Grade Commentary, May 1995 13. Bajkowski John, EBT, EBIT, EBITDA: Will the Real Earnings Figure Please Stand Up?, AAII Journal, August 2002

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