Michael Durante EBITDA Shortcomings

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.

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

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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.

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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.

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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

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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.

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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

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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

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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)

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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


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

recurring cash outlays, hence inflating realizable profits.

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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


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


“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

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


“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

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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.

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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


“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.

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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

EV/EBITDA 8x EV/Operating Cash Flow 67x

Cash Flow Conversion Rate 11% EBITDA Yield 13% Operating Cash Flow Yield 1%


“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

EV/EBITDA 14x EV/Operating Cash Flow 169x

Cash Flow Conversion Rate 8% EBITDA Yield 7% Operating Cash Flow Yield <1%


“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

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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

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%


*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.

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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”.

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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”

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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.

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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.

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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

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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.

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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

Michael Durante EBITDA Shortcomings

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