Six Letters That Should Spell Danger to Investors

Six Letters That Should Spell Danger to Investors

"Facts all come with points of view. Facts don't do what I want them to."
--Talking Heads, "Crosseyed and Painless"

Twitter, the world's best invention for learning about Kim Kardashian and the debt ceiling in the same screenshot, is getting ready to go public. Caught up in the hullabaloo about its future prospects are complaints that the microblogging site is using a familiar trick from the corporate playbook: presenting its results using earnings before interest, taxes, depreciation, and amortization, a.k.a. EBITDA, an alternative non-GAAP financial metric that some critics call "earnings before the bad stuff."

Dallas Mavericks owner and billionaire businessman Mark Cuban shed some light on the ruse recently when he called it "a term companies use when they want to make it seem like they're doing better than they are."

According to GAAP (that is, generally accepted accounting principles), a standard enforced by the SEC, Twitter had a net loss of $69.3 million in the first six months of the year, but its adjusted EBITDA, which removes stock-based compensation expenses as well as the others, totaled positive $21.2 million. Based on this redirection, Twitter appears to be a thriving profit engine.

Don't read the fine print
While the SEC requires publicly traded companies to report financial results according to GAAP, it also allows businesses to provide nontraditional metrics, so long as management adds a statement explaining why it "believes the presentation of the non-GAAP financial measure provides useful information to investors." Unfortunately, these statements don't have to be very convincing. Twitter says the unofficial measurements help "identify underlying trends" and "enhances the overall understanding of our past performance and future prospects," but the statements never goes into detail or moves past MBA-style boilerplate.

Twitter is far from the only company employing this tactic as it has become particularly popular with the Web 2.0 brand of companies. LinkedIn , for example, is an avid user of adjusted EBITDA, trumpeting that the line item grew more than 75% in its last quarter and now makes up 24% of its revenue. That sounds great until you look at the social network's GAAP earnings per share, which were just $0.03, compared to a $0.38 non-GAAP per-share profit. Among the expenses LinkedIn excludes in EBITDA and non-GAAP earnings are stock-based compensation and amortization of intangible assets. While those may be noncash expenses, the implication seems to be that there is no cost to diluting shareholders by paying employees with stock or by amortizing intangible assets it purchased with real cash. The premise of that argument is simply false.

Oh, but there's more bad stuff
Tech companies may be the most egregious offender when it comes to the invented metrics, but they're far from the only ones.

SiriusXM Radio is also incredibly fond of this figure. The company highlights EBITDA measures in its earnings releases and earnings calls, and it generally underplays the all-important bottom line. In its last quarter the company proudly announced a 19% jump in adjusted EBITDA and said that its adjusted EBITDA margin hit 30%.

Why the top billing for the custom metric? Well, the satellite radio company has (surprise, surprise) huge investments in satellites. In its last quarter, depreciation and amortization were more than half of net income. It's no wonder the company would want to hide an expense like that. With the upcoming launch of its FM-6 satellite, Sirius expects those depreciation expenses to grow, and by 2017 it will likely need to begin replacing its current crop of satellites, at which point those noncash depreciation expenses become very real.

Sirius' valuation seems to play into this deception, as it trades at a P/E of 52 even though its top line is growing at just about 12%. There are plenty of bull arguments for Sirius, including its operating leverage and a monopoly in satellite radio, but management's insistence on promoting EBITDA seems to undermine the progress the company has made. Considering adjusted EBITDA was more than double net income in its last quarter, management seems likely to continue to play up the adjusted earnings figure.

Rite Aid offers a similar example. In its most recent quarter, the turnaround drugstore chain posted net income of $32.4 million but an adjusted EBITDA of $341.6 million. Here, a major culprit appears to be interest expense, which totaled $106.7 million in its latest report. That expense is an actual cash outflow the company must pay each quarter. The only argument for omitting it seems to be that it is not a direct result of operations. Nonetheless, Rite Aid has nearly $6 billion in debt on its books -- a concern that investors should not overlook. That debt burden also ensures that interest expense will be a nagging line item for years to come unless the company can generate significant cash flow to pay it down.

Like the case with Sirius XM, focusing on EBITDA here seems to be a distraction. While Rite Aid's turnaround strategy, with a recent uptick in same-store sales, appears to be taking hold, it's foolish for investors to think EBITDA can be substituted for actual profits.

Hey, how many near-home-runs did A-Rod have this year?
While generally accepted accounting principles and the income statement may not be perfect tools to measure business performance, they're the choice of the SEC and the accounting profession because they generally provide the most accurate and honest representation of profitability. Without those rules, it's too easy for companies that are burdened with high depreciation (capital expenditures), interest, or stock-based compensation to simply whitewash those expenses away.

The concept of invented metrics like EBITDA seems even more ridiculous when viewed through the lens of another statistically significant arena such as sports. In baseball, there's no stat for "home runs plus balls hit to the warning track"; in basketball, a near-miss is recorded no differently from an air ball. An out is an out, and a miss is a miss. In business, it's important for investors to understand the different kind of expenses their companies are dealing with, but ultimately a cost is a cost. As Mark Cuban alluded to before, investors would be mindful to look past these distractions and focus on the actual bottom line.

Linkedin may not be a model of financial reporting...
Yet the professional social network has the stickiest business model of any of the up-and-coming Web 2.0 stocks and the competitive advantages to boot. Find out in this jaw-dropping investor alert video why our own chief technology officer is so confident in Linkedin that he's putting $117,238 of his own money on the table. Just click here to watch now!

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Fool contributor Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends LinkedIn. The Motley Fool owns shares of LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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