Monday, 27 January 2014

Ebitda- Can We Trust ?

Is Ebitda getting out of hand again? The same performance measure (earnings before interest, taxes, depreciation, and amortization) that corporate raiders cited to justify their takeovers in the 1980s is becoming alarmingly ubiquitous in mainstream corporate America today as an alternative to traditional bottom-line-based financial yardsticks. Your company has lousy real earnings growth? Not enough profits to cover interest costs? Your stock is ridiculously overvalued? No problem! Look at Ebitda, and everything looks okay. Ebitda supposedly gives a clearer picture of a company's operations by stripping out expenses that can distort how the business is really doing. But it can also trick investors into thinking a company is doing better than it really is. Ebitda has gotten so out of hand that Martin Fridson, Merrill Lynch's respected chief of high-yield research, recently went against the grain with a report headlined "Ebitda is not king." While he says it can be useful--especially in analyzing junk bonds--he believes that too many analysts are using it as the starting- and end-points of their analysis. Grouses Robert Olstein, who manages the Olstein Financial Alert fund: "Ebitda is like Alice in Fantasyland. It should be outlawed from securities analysis."

Ebitda has existed since the 1960s but only came into vogue with the leveraged buyouts of the 1980s. It became the valuation method of choice for highly leveraged companies in cable and media, where bona fide profits were hard to come by. The latest Ebitda wave appears to have no boundaries. It has become especially popular at companies with a taste for takeovers.
Coca-Cola Enterprises is one example: In its annual 10-K filing with the SEC, the giant Coke bottler goes so far as to say that "in the opinion of management, cash operating profit"--its term for Ebitda--"is one of the key standards for measuring our operating performance." A spokeswoman explains that Coke Enterprises sees itself as a cash-flow company. But to Jim Chanos, a short-seller with Kynikos Associates, looking at performance measures pretax and before major expenses such as depreciation and amortization is "just a lame excuse to get a lower multiple." Coca-Cola Enterprises trades at roughly 90 times reported earnings, or twice the price/earnings multiple of the Coca-Cola Co. However, it trades at just 14 times Ebitda.
Ebitda can also make a company look as though it has more money to make interest payments. A good example is Coinmach, a large operator of washing machines at apartment houses. In its third fiscal quarter, Coinmach had $6.8 million in operating income and nearly $12 million in interest expenses. The solution? Add back depreciation and amortization, and suddenly the company has $24 million--more than enough to cover the costs. And Coinmach encourages investors to reach that very conclusion. According to its third-quarter 10-Q, "Management believes that an increase in Ebitda is an indicator of the company's improved ability to service existing debt, to sustain potential future increases in debt."
But that assumes Ebitda is the same as cash flow, which it isn't, and Fridson says that saying so is a "scam," especially with big depreciation charges. "A capital-intensive company isn't earning a profit if its assets are wearing down from wear and tear," he says. Kathryn Staley, author of The Art of Shortselling, agrees. When a company has high interest or high depreciation, Staley prefers measures such as operating cash flow--from the cash-flow statement in the annual report, which, unlike Ebitda, is subject to generally accepted accounting principles--and return on assets. Such calculations would no doubt have pricked the Ebitda balloons floated by such notable blowups as Texas Air, Quality Dining, and Harcourt Brace Jovanovich.
Companies that prefer Ebitda, meanwhile, have plenty of caveats in their public disclosures--caveats such as "Ebitda is not intended to represent cash flows" and even (this from Coinmach's 10-K) that Ebitda is not determined in accordance with generally accepted accounting principles and, as a result, "is susceptible to varying calculations." But in the end, when it comes to Ebitda, the only caveat for investors should be caveat emptor.

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