It might seem odd to see a piece about cash flow in a technical blog, but looking at EBITDA and cash flow got me thinking about whether the new wave of service provision (NFV, SDN, SDO, SD-WAN etc.) has any impact on the traditional ways of reporting for Service Providers currently based on high up-front costs for future service and revenue.
For many years EBITDA has been a preferred reporting indicator of Telecommunications Providers, and in turn, Service Providers. Execs knew the score – grow revenue, sort out your EBITDA, and get good Enterprise Value Multiples. Enterprise Value is how much it would cost to buy a company’s business free of its debts and liabilities. Enterprise Value Multiple is your Enterprise Value (EV) divided by your EBITDA earnings number.
But with automatic rapid growth for telecoms providers on hold for now, and the fact that even though companies may be hitting market expectations, they are not always seeing the Enterprise Value they would like in the market, the EV multiples are simply not there.
Based on that, I thought it might be interesting to look at what EBITDA is? Why the preference exists? And do changing cycles of investment with SDO/SDN/NFV/Agile change anything at all?
First up – What is EBITDA?
EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortisation.
The way to calculate this is:
EBITDA = Income before taxes + Interest Expense + Depreciation + Amortisation
So basically you add the deductions (Interest Expense, Taxes, Depreciation and Amortisation) to your net income.
Let’s break this down a little. Before the 1980s EBIT was a key indicator of a company’s ability to service its debt (Earnings before Interest and Tax). With the advent of Leveraged Buyouts (LBO) EBITDA was now used as a tool to measure a company’s cash. LBO is essentially a way of acquiring another company with a large amount of borrowed money. The assets from the acquiring company as well as the assets of the company being acquired are used as collateral for the loans. This enables acquisitions without committing lots of capital..
Some conflate operating income (or operating cash flow) with EBIT but these are not the same, as EBIT makes adjustments for items not accounted for in operating income and thus are non-GAAP (Generally Accepted Accounting Principles). Briefly, operating income is gross income minus operating expenses, depreciation and amortization but does not include taxes and interest expenses as in EBIT.
Let’s build this up from Cash Flow and Net Income.
Net income and Operating Cash Flow may seem very similar but they are not really the same. Operating cash flow, or raw cash flow in general might need converting through accrual accounting to get a more realistic measure of income, namely net income. Accrual accounting? Very briefly this recognises when an expense is incurred not when that expense is paid (think of buying something one month but then having 60 days before you need to pay it off, well the expense was incurred the moment you bought it really). As a result businesses can list credit and cash sales in the same reporting period that sales were made.
Cash flow or Operating Cash Flow (OCF) = Revenue minus Operating Expenses
Ideally you want your Operating Cash Flow to be higher than your operating expenses or you might not be in business for too long. Certainly an important measure.
Net income = Gross Revenue minus Expense.
Net income reflects the profit that is left after accounting for ALL expenditures, every pound/dollar the company earns minus every pound/dollar the company spends.
As I mentioned Cash Flow and Net Income are not the same, with Cash Flow showing not only how much a company earned and how much it spent, but when the cash actually changed hands. This difference is significant and an illustrative example is below:
Say you sign $20million worth of contracts in a year, complete work on $10million of them, and collect $8million of that work in cash in the year. But say you have also paid out $6million dollars in equipment, your raw cash flow would be $2million. Net income however might look significantly different.
So if you have provided economic value to your customers (revenue) of say $15m of the contracts (i.e. you have completed $10m of the contracts, are 50% of the way through the remaining $10m, so $5m of economic value to customers), and of the $6million of equipment purchased you consume only a third of this, and they are estimated to last 3 years, then $6million divided over 3 years is $2million, so your net income for the year would be $15million minus $2 million in expenses, so $13million.
$13 million is a very different number than the raw cash flow value of $2million, and perhaps a better indication of the operating income of the company.
Earnings and cash therefore are not the same thing but that is not to say that operating cash flow is not important. Companies must still pay interest, and they must pay taxes, and that cash has to come from somewhere, so using this to look at Free Cash Flow (Cash Flow after all capital expenditure), and looking at working capital to see whether a company can service its short term debts is useful.. A negative working capital might suggest a company will struggle with its short term debts.
Working Capital = Current Assets – Current Liabilities
Current Assets – assets that can be converted to cash in less than a year.
Current liabilities – liabilities that must be paid this year.
Now we have had a quick look at why Net Income might be a preferable way to get a read of a company’s operating income over and above raw cash flow, is there a way to calculate this to give us a better standard view of Net Income without all the financing decisions and conditions that are peculiar to each company? i.e. provide a better method of comparison?
Well EBITDA adds back (or deducts from the calculation the expenses associated with) interest, taxes, depreciation and amortization. This therefore removes the effects of financing and accounting decisions.
The idea being that by ignoring expenses like interest, taxes, depreciation and amortization you strip away the costs that aren’t directly related to the core operations of a company. The proposition is that what you are left with (EBITDA), is a purer measure of a company’s ability to make money.
Let’s take a brief look at what these costs are to reach EBITDA:
Interest expense – is the interest payable on any borrowings such as bonds, loans, convertible debt or lines of credit (interest rate X outstanding principle amount of debt). You hear this referred to as just the Principle sometimes.
Taxes – Generally refers to income i.e. by a state or country. Business taxes (property, payroll taxes etc. are considered operating expenses and therefore no factored into EBITDA.
Depreciation – In this sense the reduction of the value of an asset over time. Tangible assets – both fixed assets (land, buildings, machinery) and current assets (Inventory). Basically things that can be physically harmed. Depreciation is a way of giving a cost to a tangible asset over its useful life, or how much of an assets value has been used up over time.
You also have something called intangible assets, which are things you can’t really touch like copyrights, patents , brand recognition etc. (as opposed to equipment, machinery, stocks, bonds and cash for example). Goodwill is also a part of this, so solid customer base, reputation, employee relations, patents and proprietary technology – an amount you are willing to pay over the book value of the company (If the company was liquidated, the value of the assets the shareholders would theoretically receive)
Amortisation – Deals with these intangible assets. So the paying off of debts such as a loan or mortgage with a fixed regular repayment schedule over a time period. Also the spreading out of capital expenses of intangible assets over the assets’ useful life, i.e. a fixed period. Say you spend $10 million on a patent with a useful life of 10 years, then over these 10 years you can spread the cost as a $1million a year amortisation expense.
So EBITDA is not really a good measure of cash flow, but can be a reasonable measure of a company’s profitability or net income. However it does leave out the cash required to fund working capital and the replacement of old equipment, which can be significant.
This is particularly useful for new companies or those trying to attack a new large market where depreciation and amortisation spreads out the expenses of large capital investments, which can be considerable.
Conversely EBITDA has a bit of a bad rep as it has been used by a bunch of dangerously leveraged companies in boom times, but that is not to say it is all bad by any means.
There are many pros and cons to EBITDA but most are out of scope of what I am trying to convey, namely that telecoms providers tend to like it as a reporting method, have large initial infrastructure outlay to get return on investment over time through telecoms or service provision. They are also not seeing the Enterprise Value multiples they would like despite a focus on market expectations around EBITDA (which doesn’t penalise a company in the market for having to invest in longer term infrastructure providing earnings are going in the right direction).
As with all accounting it is useful to look under the covers when you get chance to get a better read. In Service Providers or Telecommunications companies where there is significant expense in building out the network, buying frequency, and installing physical towers or radios, it makes a deal of sense to judge them more fairly over a longer term as repeated income will come some time after the initial investment.
In the boom years however, rapid growth was a sure fire way of getting great EV multiples, but with growth in the industry now at GDP levels and below, fixed lines in decline, mobile revenues tailing off and there being no business case in the transport of bits, EBITDA focus does not automatically equate to investor or customer value.
In essence it gets harder and harder to hide behind growth. Knee jerk reactions from execs can zone in on cash and EBITDA while they under-invest in the very things that provide economic value to customers (your revenue as a provider) i.e. better products and services to facilitate ROI, and lead to better capital returns. Essentially the focus needs to be on creating value and not just controlling costs.
So my question is, with SDN, NFV, Software Defined Orchestration, Agile product development etc. can you facilitate some of the above? Are the providers who are simultaneously adopting flexible automation and orchestration to roll out new services faster (services chained to customers’ business logic), with greater visibility and with better quality, likely to be the ones who get the EV multiples they hope for?
“What is that huge fiery technology shift I see? Should we prepare?” . “Don’t worry it’s miles away….stop thinking, keep cutting costs and we’ll be fine!”
As customers start to play providers off against each other with shorter term contracts to drive down cost and improve service (as with SD-WAN), does flexibility to respond with new services and efficient operations become more important than high sunk costs, long contracts, eventual gain, and a relentless focus on internal cost cutting with traditional technology to justify business as usual?
Is this all doubly worrying with the reduction of some SPs to mere local cloud access providers (just give me a pipe to the nearest cloud provider thanks)? Is it coincidence that the big cloud providers are the ones physically laying fat cables to connect their services nowadays?
Reducing operating costs and quick iterative roll-outs with new techniques and technology certainly seems to appeal to the largest and more innovative SPs. Using the latest methods to hold vendors to account and change traditional network operating practices (e.g vCPE), while simultaneously recognizing they can provide new services to customers with more flexibility, seems primed for technology shifts like 5G. Will all of this lead to a renewed focus on ROI rather than EBITDA growth or Capex/Sales? At the moment EBITDA growth and Capex/Sales don’t appear to be moving the EV multiple needle.
Are those who are not adopting new ways destined for extinction?
Of course EBITDA isn’t going to be ditched by Telecoms providers anytime soon, but maybe a softening of the relentless internal focus on one reporting measure will only lead to better value for customers, and in return better results for those providers focusing on customer value. You never know, internal business cases might actually start to incorporate vision.