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Once upon a time, most companies treated revenues, cash flow, and net income as the sacred measures of performance -- the numbers on which investors should focus. Then about a decade ago, media and technology outfits adopted their own performance benchmark -- a variation on cash flow known as EBITDA, or earnings before interest expense, taxes, depreciation, and amortization. Telecoms followed suit, and over the years the industries that embraced EBITDA began to promote it as a more appropriate measure of earnings than net income.
The rationale behind EBITDA was that it reflects what's happening in core operations, while stripping out expenses that are, in theory, extraneous. The accountants who came up with this idea inevitably worked for companies that took on large amounts of debt to fund acquisitions. They argued that taxes vary so much, depending on acquisitions and losses in prior years, as to distort net income. Moreover, they posited that depreciation of assets -- which rises in the wake of frequent mergers -- doesn't involve any real outflow of cash and, therefore, shouldn't be allowed to artificially lower profits.
BEAUTIFIED EARNINGS. And what of interest expense on billions of dollars in debt? That doesn't really reflect how a company's sales are going, at least to some accountants. Says James Owers, professor of finance at Georgia State University's Robinson College of Business: "EBITDA is what the operational managers hand off to the CFO to pay the taxes and the interest on the debt."
Turns out it's one other thing, too: a vehicle for shifting the attention of investors from a company's overly burdensome debt and chronic charges against earnings. In fact, numerous accounting and finance professionals are suddenly starting to view EBITDA with suspicion, seeing it as a gimmick to dress up earnings performance, says Gary J. Previts, an accounting professor at Case Western Reserve University in Cleveland. First Call/Thomson Financial Managing Director Chuck Hill and billionaire investor Warren Buffett have argued that EBITDA's primary purpose is to pretty up financial results.
EBITDA "can drift from the realm of reality"
Pamela Stumpp, manager director of Moody's Investors Service, says emphasis on EBITDA is often misleading because it can overstate cash flow and tell investors little, if anything, about earnings quality while ignoring changes in working capital that might point to a company spending beyond its means. EBITDA "can drift from the realm of reality," says Stumpp, who wrote a widely circulated report on its shortcomings in 2000. "It shouldn't be used as the principal determinant of cash flow." Yet some companies treat EBITDA as though it should be held in higher regard than cash flow.
JUST SAY "IBIDDA." Granted, AOL Time Warner (AOL
) and others that use EBITDA still report parent-company net income and other essential numbers, as required by the Securities & Exchange Commission. But too often, critics say, they highlight EBITDA as the golden yardstick. AOL Time Warner issues earnings guidance only in terms of EBITDA. And it breaks down the performance of each operating unit solely by its EBITDA. AOL Chief Executive Richard Parsons utters the acronym so often in earnings calls that he has developed a fancy way of saying it: "Ibidda."
Investors will hear Parsons say it plenty on Jan. 29. That's when AOL Time Warner reports fourth-quarter results -- which, it has already said, should show EBITDA of roughly $8.8 billion in 2002, up about 5% to 6%. That sounds a lot better than the $53 billion net loss AOL is expected to report, vs. its net loss of $4.9 billion in 2001. The huge number for 2002 will reflect a $54 billion writedown based on the excess that AOL paid for Time Warner assets over what they were really worth. Even excluding the outsize noncash charge, AOL had income of only about $927 million -- or less than 10% of its EBITDA, according to estimates from CIBC World Markets analyst Michael Gallant.
In 2003, AOL will probably take another writedown of goodwill, this time to reflect the diminished value of its America Online business. Analyst Youssef Squali at First Albany expects this second charge to exceed $10 billion. But that won't show up in AOL's EBITDA estimate for 2003.
MATTERS OF INTEREST. And of course, the EBITDA calculation excludes AOL's huge debt burden, notes Robert Burgoyne, a financial adviser in Ellicott City, Md. With $28 billion in long-term borrowings, AOL Time Warner likely paid more than $1.7 billion in interest in 2002 and could lay out the same amount in 2003. Given that it has interest payments equal to 20% of EBITDA, its favored method for expressing earnings simply ignores one of its largest expenses.
Certainly, it's not illegal to trumpet EBITDA. Hundreds of companies report it, and most investment banks still consider it useful in assessing creditworthiness. "It comes down to a company's right to free speech," says professor Previts. As long as companies disclose all the financial information in the public filings that the SEC requires, they can describe the numbers in press releases and earnings calls any way they choose.
The problem with doing so in AOL Time Warner's case, argues Peter Cohan, an independent financial adviser in Marlborough, Mass., is that EBITDA doesn't reflect what's really happening. "EBITDA is conventional wisdom in the media industry that makes even less sense now than ever," he asserts. AOL declined to comment, though it defends EBITDA in its earnings releases as a valid measure of performance.
That's a position it's free to take -- though as criticism of EBITDA mounts, AOL Time Warner's use of it could have the unintended effect of shining an even brighter light into the dark corners of its financial reports.
Copyright 2003, by The McGraw-Hill Companies Inc. All rights reserved.
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