Debunking EBITDA

Posted: 01/1999

Debunking EBITDA
How Meaningful Is This Popular Measure of Success?
By Ken Branson

Spelling out the acronym is simple. EBITDA: earnings before interest, taxes, depreciation and amortization. EBITDA represents how much money a competitive local exchange carrier (CLEC) has before it begins to pay all the bills it incurs to climb over the barriers to market entry. It is the metric Wall Street analysts watch, CLEC managers target and CEOs lean on when asked what, in other businesses, might be a simple, yes-or-no question: Are you profitable?

Because getting started in the telecommunications business is very expensive, new entrants tend to pile up serious debt while they buy equipment, hire people and build out networks. That is, they have a lot of interest, taxes, depreciation and amortization to justify. Real profitability--more money coming in than going out--is far away. It's so far away, in fact, that investors and those who advise them focus on EBITDA rather than real earnings. They believe EBITDA has meaning for a company's future as they try to guess what that future holds.

"I would take the position that EBITDA is a far more valuable metric than earnings per share, and the bottom-line reason is that it's a far more accurate measure of a company's ability to earn money on assets invested," says Ian Link, vice president and portfolio manager at the Franklin Templeton Fund in San Mateo, Calif. "In telecommunications, so many companies are in different stages of development that I find earnings per share to be virtually useless."

EBITDA also tells financial analysts, and hence investors, whether a company's basic assumptions about itself and its place in the market are sound.

"For a business that is capital-intensive, real live net income can take a long time," says James Henry, telecommunications analyst at Bear Stearns & Co. Inc. "What you get first is cash flow, which is evidence of the viability of the economic model, and evidence that your cost structure is starting to come into line."

For initial investors in a telecommunications carrier, and for CLEC managers who have a financial stake in their company, positive EBITDA is a square checked on the way to a payday. A potential buyer will be more interested in a company that is EBITDA-positive, and will be much less interested in one whose management can't make a convincing case that the company will be EBITDA-positive in the relatively near future.

Because market analysts, investors and potential buyers look at EBITDA, the chief financial officers of CLECs take it very seriously. Dan Trampush, the chief financial officer of GST Telecommunications Inc., of Vancouver, Wash., says he and his colleagues use EBITDA internally, to measure the company's performance.

"We look at EBITDA monthly, and by market," Trampush says. "It shows the cash-consuming and cash-generating activities of an entity."

Trampush uses EBITDA to discipline as well as to measure the company's finances. GST managers may have an idea that will cost some cash up front and affect EBITDA. They have to convince Trampush that it's a really good idea and that it will have some near-term benefit. Otherwise, he is likely to recommend that the company not spend the money that particular quarter. Trampush says that the company might have to make a move that would hurt EBITDA in the short term, but is necessary to position the business for the long term. He just wants to see the business case first.

"What is the business case?" Trampush asks. "Some people who come to you will know; others won't. Some will say, 'What's a business case?' They don't know. Why should they? They're operations people, not financial people. So I go through it with them. Over time, they adapt their behavior to a format that you can work with."

The pressure to become EBITDA-positive quickly can, on occasion, lead to poor decision-making by CLEC managers, however.

"You may do something that positively affects EBITDA in the short term, while ignoring something you should be doing to position the company long-term," Trampush says. "In that case, managing for EBITDA would be imprudent."

While EBITDA may say a lot about how a CLEC is doing, it doesn't say it all.

"It's not a metric to be used in isolation, and clearly not the only one you need to look at," Link says. "You need to look at a company's raw ability to spin cash off assets in the ground." And the fact that a certain amount of money is in the till before bankers and the government are paid their due may be less significant than where the money came from.

"If they're EBITDA-positive, that's a positive sign, an indicator of how far along they are on the maturity cycle," says Peter Kennedy, a telecommunications analyst at Morgan Stanley Dean Witter & Co. "But how are they getting there? If [revenue] is all reciprocal compensation, and that gets restructured, it could all go away tomorrow."

Trampush, whose company does not include reciprocal compensation when calculating its revenues, agrees that not all revenue is equal. "Good revenue, for us, would be excellent growth, month over month, for data services," Trampush says. "Another would be local service revenue. A third would be long-haul capacity leases. They're good because they have high margins, high growth potential, and the infrastructure is already in place."

Link says he inquires into which costs a company lists as expenses, and which ones it lists as capital expenses. The former are accounted for year by year; the latter can be accounted for a little at a time over several years. Of particular interest to CLEC followers, he says, is the expense associated with acquiring customers.

"Let's say we're a CLEC, and we've spent $500 to acquire a customer," Link says. "We might say, 'Okay, it cost us $500 to get this guy, so we'll count that $500 under cost of goods sold,'" Link says. "Or we might capitalize it. In that case, we say, 'Look, this guy cost us $500, but he'll be with us at least five years, so let's put him under capital, and we'll expense $100 a year for five years, instead of expensing the whole thing in one year.'"

Michael Viren says the expense-capitalization argument is susceptible to considerable hair-splitting.

"Take the development of operations support systems (OSSs)," says Viren, the president and CEO of 2nd Century Communications Inc., a Tampa, Fla.-based CLEC startup. "You could argue that it's a cost of construction, and most auditors will let you capitalize it. But it's really research and development, and should be expensed. Now, if I'm installing an OSS I bought from somebody else complete, that's a capital expense. But if I'm starting from scratch and building my own, well, that's a debatable question."

This is an accounting--not a morality --issue. Still, Link thinks it provides some insight into the mentality of a carrier's managers. "If they want to do this over two years, I don't think it's that big a deal," he says. "But five years? That makes me nervous."

A company that engages in "capitalizing" things that a reasonable person might be inclined to "expense" is not necessarily a bad company, just an aggressive one, in Link's view.

Viren says a more realistic measurement of a company's performance than EBITDA is free cash flow. 2nd Century will be free-cash-flow positive by the beginning of 2003, "at the latest," Viren says.

Free cash flow, he says, is EBITDA before interest and taxes. Interest and taxes, he says, are real expenses. Depreciation and amortization, however, are "accounting anomalies." Viren believes EBITDA, by taking into account depreciation and amortization, tells more about a company's past than about its future.

"When analysts look forward, they should be looking at real things," Viren says.

USN Struggle Continues
By Ken Branson

Things continue to get hairier at USN Communications Inc.

Attorneys in New York and Chicago have filed class action lawsuits against the company alleging that USN management and the underwriters of its February 1998 initial public offering (IPO) misled potential investors about the company's financial status and business prospects.

The stock opened at $15, went as high as $23 last spring and now trades at around 50 cents per share. USN did not return calls from X-CHANGE seeking comment.

A $10 million, 60-day loan at 17 percent is due to Merrill Lynch Global Allocation Fund Inc. on Jan. 15. The lender's parent firm, Merrill Lynch & Co., was one of the underwriters of USN's IPO and a defendant in the lawsuit filed in New York.

USN released its third-quarter earnings report a week late, and the report carried mainly bad news. While its revenues rose to $51.9 million, compared to $15.3 million in the third quarter of 1997, its net loss more than doubled to $68 million. Its negative earnings before interest, taxes, depreciation and amortization (EBITDA) also more than doubled to $56.1 million.

According to its quarterly earnings report, USN must obtain still more financing if it is to meet its financial obligations. Otherwise, the company may not be able to continue doing business, according to the report. USN announced in November that BT Alex. Brown & Co. had been retained as a financial adviser.

Meanwhile, USN last month announced plans to lay off 650--or 46 percent--of its employees, eliminating nearly all of its direct sales staff.

Citizens Utilities Continues to Spin Off Telecom Business
By Ken Branson

Citizens Utilities Inc., which owns energy and communications companies in 21 states, continues its corporate mitosis. The company, which announced in May 1998 that it would spin off its telecommunications businesses, has applied for permission to do just that in 11 of those.

Citizens, headquartered in Stamford, Conn., has filed for separation in Arizona, California, Idaho, Louisiana, Montana, New Mexico, Oregon, Tennessee, Utah, Washington and West Virginia.

"We don't have any control over the hearing process, of course," says Brigid M. Smith, assistant vice president of corporate communications. "But we expect to be finished by the end of next year."

The telecommunications businesses include Citizens Communications Inc., an incumbent local exchange carrier (ILEC) with 900,000 access lines; Electric Lightwave Inc., a competitive LEC (CLEC) based in Vancouver, Wash., of which Citizens owns 83 percent; and now, Rhinelander Telecommunications Inc. of Rhinelander, Wisc.

Citizens closed the Rhinelander acquisition--an $83 million, cash-for-stock deal--in December. "We continue to see benefits in buying operations in rural areas," Smith says.

After the separation, the Electric Lightwave and Citizens Communi-cations will continue as separate, wholly owned subsidiaries of the new company. Rhinelander will continue as a brand name, company officials say. The new company also will own Citizens' minority shares in Centennial Cellular Corp. and D and P Telecommunications, an ILEC in Lancaster, Penn.

Jack Reich, president and CEO of e.spire Communications Inc., has resigned after the company turned in disappointing results for the third quarter of 1998. Anthony Pompliano, e.spire's founder and chairman, takes over as president.

Williams, the energy conglomerate from Tulsa, Okla., plans to issue an initial public offering (IPO) of a minority of Williams Communications Inc., its communications subsidiary. Williams hopes to raise between $500 million and $750 million from the offering, which will take place in the second quarter of this year.

First World Communications Inc., San Diego, has acquired Optec Inc., Portland, Ore., the network integration services subsidiary of Enron Communications Inc., also of Portland. The deal is worth $20 million.

Rocky Mountain Internet Inc. (RMI), Denver, has completed its acquisition of the Internet access and hosting business of Unicom Communications Inc., Overland Park, Kan. RMI made the acquisition in a stock transaction valued at $1.7 million.

MCI WorldCom Inc. has created an investment fund for companies "with technologies that influence the future development of the MCI WorldCom network." Susan Mayer, senior vice president at the Jackson, Miss., communications giant, has been named president of the fund.

In other MCI WorldCom news, the company and News Corp., New York, will obtain a 37 percent stake in EchoStar Communications Corp., Littleton, Colo., in exchange for a license to operate a direct broadcast satellite business. News Corp. gets 24.03 million new shares of common stock; MCI WorldCom gets 5.9 million new shares. EchoStar also gets two new satellites, an uplink center in Gilbert, Ariz., permission to rebroadcast the signals of News Corp.'s Fox Network, and a worldwide license agreement to build and manufacture set-top boxes.

Level 3 Communications Inc., Omaha, Neb., plans a private placement of $500 million. The debt, consisting of senior discount notes, will be offered to "qualified institutional buyers"--which usually means commercial and investment banks and insurance companies.

2nd Century Communications Inc., a startup competitive local exchange carrier (CLEC) in Tampa, Fla., has selected asynchronous transfer mode (ATM) switches from Siemens Information and Communications Networks Inc. for the backbone of its new network. Financial terms of the deal were not announced.

GST Telecommunications Inc., Vancouver, Wash., will provide the West Coast network backbone for the U.S. Defense Department's Next Generation Internet SuperNet program. GST will provide access points along its West Coast network for members of the National Transparent Optical Network Consortium (NTONC), including carriers, corporate and government users, and suppliers. Financial terms of the deal were not disclosed.

Internet Communications Inc., whose failed merger with Rocky Mountain Internet is the subject of litigation, has received $2 million in funding from the Anschutz Corp. of Denver. In exchange, the Greenwood Village, Colo., local area network (LAN) designer will issue enough preferred convertible stock to Anschutz to make that company a 57 percent stockholder in Internet Communications.

Cisco Systems Inc., San Jose, Calif., has completed its acquisition of Selsius Systems Inc., a Dallas-based subsidiary of Intercom Inc. Selsius makes Internet protocol (IP)/public branch exchanges (PBXs). Cisco spent $145 million in stock and cash on the deal, and expects to take a one-time charge against after-tax earnings of between 3 cents and 6 cents per share in the second quarter of 1999.