♪Do You Believe In Magic?♪
I am sure many remember The Lovin’ Spoonful’s 1965 hit fondly, Do You Believe In Magic? I apologize, but please do not include me in that cohort. We will leave that can of worms closed.
But if you are unwillingly subjected to anything for too long, you tend to develop a disdain for it.
I, personally, do not believe in magic. But I do believe in financial alchemy. And after being subjected to it for years, I do not like that either. We see it during every business cycle and bubble top in one form or another. Those who challenge the consensus are deemed bears and dismissed as too pessimistic. There is an accounting ‘joke’ that I enjoy, and it may just be accountants who do…so get ready to cringe.
Three accountants interview for a job.
The interviewer asks each one, ‘What is 1+1?’
The first interviewee says two.
The second interviewee says eleven.
The third interviewee responds, ‘What do you want it to be?’
That is not magic; that reflects the human desire to conform. Read Extraordinary Popular Delusions and the Madness of Crowds, and you will see historical recurring evidence of this trend. Investors talk about the career risk associated with fighting the markets. Well, this is an example from the corporate world.
There is career risk in the corporate setting too. As with investors, forced to allocate to popular sectors they prefer not to, employees are forced to comply with management or risk being fired. I am sure that we have all seen this in one form or another. Dissidents do not last long in either career setting. This was most recently visible with the AI tokenmaxxing push by management teams or risk being fired headlines just a few months ago. As the adage goes, ‘you go along to get along’. That pressure can force creative accounting and financial alchemy to reach KPIs (key performance indicators).
At the moment, a popular KPI (key performance indicator) is EBITDA (earnings before interest, taxes, depreciation, and amortization). The origin of EBITDA is attributed to John Malone and Tele-Communications Inc. (TCI) in the 1970s. As discussed in William Thorndike’s The Outsiders (2012):
“Related to this central idea was Malone’s realization that maximizing earnings per share (EPS), the holy grail for most public companies at that time, was inconsistent with the pursuit of scale in the nascent cable television industry. To Malone, higher net income meant higher taxes, and he believed that the best strategy for a cable company was to use all available tools to minimize reported earnings and taxes, and fund internal growth and acquisitions with pretax cash flow.
It’s hard to overstate the unconventionality of this approach. At the time, Wall Street evaluated companies on EPS. Period. For a long time, Malone was alone in this approach within the cable industry; other large cable companies initially ran their companies for EPS, only later switching over to a cash flow focus (Comcast finally switched in the mid-1980s) once they realized the difficulty showing EPS while growing a cable business. As longtime cable analyst Dennis Leibowitz told me, “Ignoring EPS gave TCI and important early competitive advantage versus other public companies.”
While this strategy now seems obvious and was eventually copied by Malone’s public peers, at the time, Wall Street did not know what to make of it. In lieu of EPS, Malone emphasized cash flow to lenders and investors, and in the process invented a new vocabulary, on that today’s managers and investors take for granted. Terms and concepts such as EBITDA (earnings before interest, taxes, depreciation, and amortization) were first introduced into the business lexicon by Malone. EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash-generating ability of a business before interest payments, taxes and depreciation or amortization charges. Today EBITDA is used throughout the business world, particularly in private equity and investment banking industries.”
Maybe in the 1970s-1980s EBITDA was an effective measurement tool; I am not sold myself, but it was a novel way to assess companies. I would posit it has become too popular a metric and is exposed to the follies of economic theory, Goodhart's Law.
The latest example of creative accounting/reporting is from Coreweave’s earnings report. If you listened to the earnings call, you would have left the call optimistic about their future. Management confidently told investors about the rosy business landscape, the lack of perceived financial risks, and the health of the AI markets. The press release told a very different story. To truly understand the business, you must analyze and compare the management commentary to financial reporting. Sometimes they align with each other. Other times they do not. For the three and six months ending this past quarter, the company was operating-income negative, once again. And Coreweave reported another net income and free cash flow loss.
But the non-GAAP earnings were more attractive. Although adjusted EBITDA margins were down quarter over quarter, they were quite healthy on a topical level: 59% and 57% quarter to date and year to date. And if you stopped there, stakeholders would assume this is a profitable, cash-accretive business. On closer look, the healthy EBITDA numbers are because Coreweave stripped out the equivalent of 86% of total operating expenses from adjusted EBITDA. Because there are no 'real' rules around non-GAAP numbers, this is allowed, but at what point is this number a bit misleading? Coreweave, whose total assets are comprised of 61% PP&E (Property Plant & Equipment) or 82% including operating leases, removed their depreciation and amortization, for a benefit of $1,393 and $2,540 quarter to date and year to date. Their adjusted EBITDA was only 1,510 and 2,667 quarter to date and year to date. They also removed stock compensation, income tax provision accruals, acquisition costs, and other income. The EBITDA adjustments were 83% and 87% of total revenue quarter to date and year to date. Coreweave is an asset-heavy business that leases its equipment and data centers to customers. Their business model requires an asset-heavy model, with PP&E that have finite useful lives. It is certainly aggressive to strip out the costs of using those assets from their adjusted EBITDA.
I want to note that Coreweave is not the only company pushing the bounds of non-GAAP adjustments. They are merely a recent example. Many other companies currently are doing the same and have done so in the past. The most ridiculous, in my opinion, was WeWork’s community-adjusted EBITDA.
But that is the problem with EBITDA: it allows companies additional discretion to adjust their numbers to appear more attractive. It removes from consideration their operating leverage reliance and associated costs (via interest expenses), the business asset heaviness or lightness (via depreciation expenses), and the business’ intangible asset values (via amortization expense). These are all important inputs to understand how companies operate. Stripping them out does normalize the numbers, but companies are not homogeneous entities. They are quite complex, dynamic, and heterogeneous by nature. It is like trying to compare apples to…lettuce. I am sure that some are not in agreement, but there is a reason why GAAP and IFRS accounting exist. It is to standardize accounting and reporting to ensure company financial statements are consistent and comparable. Charlie Munger was quoted as saying, “I think that, every time you see the word EBITDA, you should substitute the words ‘bulls@#t earnings.’"
The further you move away from GAAP and IFRS, the less reliable the numbers tend to be. Of course, there is value in non-GAAP reporting. And there are occasions where non-GAAP numbers are valuable. But to rely more heavily on them is a serious mistake, because just like the third interviewee from my cringeworthy accounting joke, the numbers can be whatever they want them to be with the help of some financial alchemy.
It is not magic what happens under the surface. Magic doesn’t exist.
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