“Does management think the tooth fairy pays for capital expenditures?” - Warren Buffett (Trades, Portfolio)
“I think that, every time you saw the word EBITDA, you should substitute the word “bullshit” earnings.”- Charlie Munger
We’ve always been amused by Warren Buffett (Trades, Portfolio) and Charlie Munger’s commentary on how things are just blindly followed on Wall Street. One particular financial metric, EBITDA (Earnings Before Interest Tax Depreciation and Amortization), has been often used by analysts and companies when in correspondence with shareholders. Although EBITDA does have its positives as being a “quick and dirty” proxy of cash flow, debt coverage, and operational comparability, the two great investors remind us that EBITDA has its drawbacks. We should be weary of companies that put a strong emphasis on this financial metric because they are either up to something or trying to perform slight of hand tricks on investors. We feel that investors can benefit more from our acronym of EBITDA which is Expect Before Investing To Dare Assumptions.
To dare what is taken for granted we need to understand what EBITDA is and where it came from. The following video is a description of EBITDA and some of the drawbacks that even a kid could understand. Warren and Charlie would be proud. We’ll follow up with a few more historical examples of EBITDA manipulation and how it blew up in everyone’s face.
A few more historical examples of EBITDA manipulation:
WorldCom
The long-distance telecom company admitted that they manipulated their EBITDA in 2002. From 1999 to the first quarter of 2002 the company began reporting normal expenses as capital costs. Those capital costs created an asset that then could be depreciated over time. By doing this WorldCom inflated their EBITDA figure $3.8 billion higher when it should have been negative.
We want to also highlight that this period was after the termination of the Sprint PCS merger. Interesting to note is that the WorldCom shareholder presentation before the proposed Sprint PCS merger highlighted positive EBITDA and EBITDA growth as one of the key financial metrics. We guess that after the termination of the deal and the strong declining trend in EBITDA caused the management to inflate EBITDA. Their debt in 1999 was 2.14x EBITDA, so lenders and shareholders would have quickly become nervous as that multiple would have grown significantly as EBITDA truely declined.
Global Crossing Ltd and Qwest Communications
These two telecommunication companies also utilized similar manipulation of EBITDA, although using different techniques. Global crossing was beginning to falter, so executives devised a way to boost both companies’ revenue and EBITDA through capacity swaps with Qwest. These capacity swaps were simply selling a service or product - and booking revenue - and then turning around and receiving like amounts of assets from the same customer. While they did this, they treated those purchases as capital costs instead of operating expenses. This allowed both companies to inflate their revenues and also their EBITDA numbers.
So, what can we take from all of this? Make sure what is most important with management. If EBITDA is a major focus in investor presentations and shareholder letters when management speaks of earnings, that might be a red flag. Second, we must be careful when valuing companies specifically focusing on EBITDA ratios. Depreciation and Amortization while non-cash costs are still real. Capital expenditures and working capital are also real too, so using Warren Buffett (Trades, Portfolio)’s owners earnings is a better estimate of the cash that should be coming to share holders; thus better for valuation purposes.
Challenge what is commonly accepted. EBITDA has it’s uses but Expect Before Investing To Dare (your and everyone else’s) Assumptions.
