Why EBITDA can be hazardous to your health (Part Deux): Application to Valeant

In my previous blog I discussed EBITDA and how different it from operating cash flows.  Some of the comments that I got were that this is a made-up example. In all fairness, it is a somewhat synthetic example (though the idea was based on a real company, General Motors, circa late eighties).  So the question is what would happen had we looked at the company that starred in my first post, Valeant.

These are the numbers reported by Valeant:

Charting this over time yields the following graph:

As we can see, the two series are not the same.  Moreover, EBITDA is always larger than operating cash flows.  Finally, the two series become more and more divergent over time. 

The implication of this is that if we valued (foolishly) companies based on some EBITDA multiples (say, EV/EBITDA) then what we would get is a valuation that has nothing to do with discounted free cash flows or residual income valuations.

A possible criticism of this exercise is to say that one observations is not a representative statistical sample.  This is true of course.  So let's take a look at another company, Microsoft.

What this graph shows that for Microsoft the two series, like Valeant, are different and diverging over time.  The big difference is that in Microsoft operating cash flows are larger than EBITDA while for Valeant it is the other way around.

If you still do not accept my conclusion, based on the premise that also two companies is not a large enough sample,  I would challenge you to find a large sample of companies where EBITDA and operating cash flows are the same. I am willing to bet that this will not happen.

Will the New York State Attorney General ban stock trading next?

This week the New York State Attorney General, Eric Schneiderman , has ordered DraftKings and FanDuel to cease and desist their operations in New York .  The reason given was that daily fantasy sports (DFS) are in essence illegal gambling under state law.

Is it really gambling?  According to Joe Asher, the US CEO of William Hill, one of the largest betting and gambling companies it is gambling as players are “risking money on something of an uncertain outcome” http://www.usatoday.com/story/sports/fantasy/2015/01/11/fantasy-sports-gambling-debate-fan-duel/21612771.

Based on this criterion, investing in stocks  is gambling too and thus should face a similar sanction by Schneiderman. Let us see: Risking money, Check! Uncertain outcome, Check! Thus, all of the people who read this blog should face legal action soon. As matter of fact, as I argue below, there is more in common between DFS and  securities market than between DFS and the gambling industry.

There is no question that the growth of DFS has threatened the gambling industry.  Eilers Research estimated that “fans will wager over a quarter of a billion dollars on the outcome of eSports events in 2015 - a number that we project will exceed $23bn by 2020”(http://eilersresearch.com/wp-content/uploads/2015/08/eSports-Press-Release.pdf

An article in the Business Insider has estimated that”… the  number of entries at DraftKings this week increased from 3.75 million to 4.14 million, a 10.4% increase, while FanDuel's entries jumped 6.3%, from 3.18 million to 3.38 million”  This growth came after the insider trading scandal where employees of DraftKings were using their information to make millions on FanDuel.  http://www.businessinsider.com/draftkings-revenue-daily-fantasy-sports-2015-10.  The growth in this industry is evident when we look at the prize pools of the two largest companies. 

Source:https://rotogrinders.com/pages/growth-of-daily-fantasy-sports-719070

 Source: https://rotogrinders.com/pages/growth-of-daily-fantasy-sports-719070

At the same time, the casino industry is declining.  For example, gaming revenues in Nevada fell for the third straight month in August this year (http://www.reviewjournal.com/business/casinos-gaming/gaming-revenue-tumbles-nevada-strip-third-straight-month).  The only casinos that have done well recently did so due to their presence in Macau (e.g., LVS and Wynn).  Unfortunately, it seems that even this tide has turned.   In September this year, analysts estimated that Macau casino revenues fell 19% per day that week (http://www.bloomberg.com/news/articles/2015-09-23/macau-casinos-decline-as-analyst-says-gaming-fell-19-last-week)

Furthermore, at the same month the same market suffered 15th straight monthly decline (http://www.reviewjournal.com/business/casinos-gaming/macau-casino-market-suffers-15th-straight-monthly-decline)

The tremendous growth in DFS, coupled with the decline in the casinos and gambling industry, has undoubtedly led the latter to fight DFS. To large extent, this campaign is the result of the successful campaign that the industry led to ban internet gambling. On the other hand, DFS has some serious backers who undoubtedly will fight for keeping DFS legal.  The NHL, for example, is an investor in DraftKings, as is MLB, while the NBA has an equity stake in FanDuel, as are NBC and Turner Sports. 

Is DFS gambling? I doubt that anybody would look at slot machines, card games, roulette and so on as anything even close to DFS.  The serious DFS players, just like serious stock investors, research the sport that they are in, looking at fundamental valuation and intrinsic value of players vs their pricing and, based on their analysis, make decision on picking players.  Just like the stock market DFS players can see the results of their decisions at the end of any trading day. In many respects they are a combination of value investors and day traders.    

This does not mean that DFS should not be regulated.  DFS now in my opinion should be viewed as a stock market in a pre-regulation state.  The Wall Street Crash of 1929, aka Black Tuesday, is widely viewed as the trigger to the establishment of the SEC. The insider trading scandal that rocked the DFS industry could similarly be the trigger for the regulation of DFS. What is sad about the DFS insider trading scandal is that it stems from the industry’s failure to regulate itself , followed by greed, which in turn,  led to DraftKings employees using inside information to reap huge payoffs at the expense of other players. This is am much insider trading as any stock market insider trading. The difference, however, is that, in the absence of  regulation, the DrafKings employees that traded on their private information, did not do  really any illegal thing, which is very bad for such an industry in formation.  As such, there is no question in my mind that DFS should be regulated.  At the same time, it should not be done using the same regulation that governs the gambling industry but more similar to securities regulation as there is much more in common with DFS and security regulation. The whole idea of security regulation is to make the capital market more equitable to investors, as should be the aim of any DFS regulation.

Note: I have never played DFS in my life but follow it with interest.

Why EBITDA can be hazardous to your health

Income is an opinion, cash flow is a fact!

Many people have approached me after my BNN interview to ask about why do I think that EBITDA is crap. To provide an explanation, I have decided to write this blog to illustrate this point.
In my first month as a Ph.D. student at Stern, I was asked by one of my mentors, George Sorter, to sit on an introductory accounting class .  Being a CPA and having an MBA, in my arrogance I thought that I am well beyond such materials.  I stood corrected, whatever I thought I knew about accounting was turned on its head.
One of the things that I thought that I knew well was the importance of income-based metrics such as EBITDA and that cash flow information is not as important.  It turned out that common garden variety metrics, such as EBITDA, could be hazardous to your health..
To illustrate this idea let's assume the following statements for the EIC Corp (any similarity between the name and and a real company is pure coincidence):

The statements above indicate that the company is doing very well
The income statement shows incredible growth of sales, gross margin, operating income, and net income.  The balance sheet also shows tremendous growth of working capital, total assets and equity, and the only liability that it has is accounts payable.
Using conventional wisdom, we can generate the following ratios (to make things simpler I used end of the year figures for ROA and ROE):

Our conclusion, based on such information, would be that EIC Corp. is a phenomenal company. Profitability analysis shows that the gross profit ratio went up from 60% to 65%, SGA/Sales went down by 5%, operating margin more than doubled, both ROA and ROE increased. Liquidity analysis reveals that the company is very liquid as the current ratio went from 7.30  to 22.75 and the quick ratio went from 6.30 to 19! Furthermore, solvency show ratios little vast decline in the leverage of the company, thus making it less risky.

And now let's calculate EBITDA for both years:
For 2013 it is 80+100=180 and for 2014 it is 800+100=900.  The only word that comes to mind here is wow! This is so great, the company EBITDA is now five times what it used to be last year.

So, what's the problem? It turns out that if we look at the cash flow statement, liquidity is not what we think.  The company is hemorrhaging cash from operations.

The picture looks even worse when we convert the indirect cash flow statement to the direct format. It actually failed to collect any cash from its customers and its operating cash flows before interest and taxes is  a negative 1,450, in other words the company is losing cash flows from its core business.

In consequence, EBITDA and some other common garden variety analyses would mislead us to think that the company here is highly profitable and very liquid while in fact it books revenues that it does not collect and inventory is moving very slowly. One way to improve the information would be to look at days receivable (405) and days inventory (434).

Now what will happen if we apply the Beneish Manipulation Index to the case here? It gives us a probability of earnings management of amost 100% and that sales are suspicious as evidenced by the Days Receivable Index and the Sales Growth Index.

In conclusion:

1. EBITDA is not a good surrogate to cash flow analysis because it assumes that all revenues are collected immediately and all expenses are paid immediately, leading, as I illustrated above, to a false sense of liquidity.
2. Superficial common garden variety accounting ratios will fail to detect signs of liquidity problems.
3. Direct cash flow statements provide a much deeper insight than the indirect cash flow statements as to what happened in operating cash flows. Note that the vast majority (well over 90%) of public companies use the indirect format.
4. EBITDA just like net income is very sensitive to accounting manipulations.