Thu, Oct 06, 2022 page9

• Conjuring company profits from thin air can make capital disappear

  The end of the free-money era should also mark the end of the adjusted profit free-for-all

  • By Chris Bryant / Bloomberg Opinion
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  What is a profit? A recent ill-tempered television appearance by the cofounder of home-flipper Opendoor Technologies, Keith Rabois, showed just how far the world has drifted from a common understanding of earnings.

  Rabois, a Miami venture capitalist, was irritated by his interlocutor’s (not unreasonable) suggestion that Opendoor is loss-making.

  Net losses total US$1.7 billion since inception, according to the latest accounts, and the quarter that just ended is likely to be ugly due to falling house prices.

  

  Illustration: Mountain People

  However, on a “per-home basis” — also known as a “contribution margin,” which excludes groupwide costs such as marketing and technology development — Opendoor has consistently made money for years, Rabois said.*

  The clash reflects the extraordinary proliferation of alternative financial performance measures during an era of “free money,” when investors were focused on top-line growth over bottom-line earnings.

  Opendoor is far from alone. Non-standard financial metrics are widespread in private equity buyouts and among start-ups that report losses under normal accounting, but they are also used by almost all S&P 500 companies.

  British annual reports include 16 such figures on average, the British Financial Reporting Council found.

  One of the favorites is adjusted earnings before interest, taxation, depreciation and amortization, also known as “eventually busted, interesting theory, deeply aspirational.”

  Which numbers should investors actually rely upon? It is increasingly hard to know. While these alternative figures can provide a more complete and meaningful picture than a regular profit and loss statement, they are not recognized by generally accepted accounting principles (GAAP) or the International Financial Reporting Standards used outside the US.

  Not surprisingly, they tend to make earnings appear higher than they otherwise would, and can even magically turn an accounting loss into an adjusted profit. Remember WeWork’s infamous community-adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), which stripped out swathes of the office provider’s expenses?

  The use of these metrics partly reflects how accounting standards have not kept pace with changes in the economy, especially the importance of intangible assets, but the danger is that investors place too much trust in flattering numbers. Alternative performance metrics are not audited as closely. In a recession, the worst offenders might discover that a large “total addressable market” and an adjusted profit soup do not pay the bills.

  “Both private and public companies are taking astonishing liberties by misrepresenting their profitability. Some definitions of adjusted EBITDA and adjusted earnings are simply farcical,” said Stephen Clapham, founder of research and training firm Behind the Balance Sheet.

  Some top managers appear to have recognized that the market mood-music has changed, and therefore so must they.

  Uber Technologies chief executive officer Dara Khosrowshahi told employees in May that free cash flow, not adjusted EBITDA, must be the priority.

  The ride-hailing company has lost US$32 billion since its inception, so a pivot was long overdue.

  There is no problem with companies that exclude genuinely one-off charges or neophyte companies drawing attention to their unit economics. Healthy contribution margins imply that the business should generate cash once it has scaled up and fixed costs weigh less heavily.

  Banning disclosure of non-GAAP information might even harm investors: Those overly focused on Amazon.com’s bottom line in its early days probably missed out on its astonishing rise.

  However, there is often too big a gulf between adjusted and bottom-line earnings.

  Sports betting firm DraftKings said that in all states where its platform has gone live, it would be “contribution profit positive” this year — defined as gross profit minus advertising expenses.

  Yet on an adjusted EBITDA basis, the company expects to lose about US$800 million, while the net loss is likely to be about US$1.4 billion, the Bloomberg-compiled analyst consensus said.

  One challenge for investors is that alternative financial indicators are not commonly defined, making companies harder to compare. Although it can be helpful to view the same numbers that inform management’s decisionmaking, flattering adjustments can lead them astray.

  Consider loss-making mobile games company Skillz, which last year claimed to be profitable on an adjusted EBITDA basis, when adjusted for the cost of acquiring new customers.

  Yet user acquisition marketing expenses were almost two-thirds revenue that year.

  When Skillz sought to reduce its marketing spend in recent months, its revenue plunged, and so has the stock. (Skillz has said the metric helps investors understand “the value of existing users on the system.”)

  Adjusted EBITDA is especially problematic because companies have huge discretion about what to include. Last week, Singapore-based Grab Holdings vowed to break even on an adjusted EBITDA basis by the latter half of 2024, but its definition includes more than half a dozen add-backs. This is not unusual.

  Removing stock-based compensation expenses from EBITDA calculations is widespread, because in theory, it is a non-cash charge.

  Rabois called stock compensation a “fake” expense.

  However, this employee pay is in reality a real cost to the business, because existing shareholders are diluted. Often the company repurchases equity to lower the share count, and if the stock price falls, the business either has to give more cash to employees to offset its lost earnings, or issue even more stock, as property listing platform Zillow Group recently said it would do.

  In the wake of Enron and the dotcom bust, regulators adopted stricter rules on non-standard financial measures. Such metrics must not now be given undue prominence compared with GAAP figures (bigger fonts are banned), and companies must at least show how they have been derived.

  It would be helpful, too, if regulators better defined non-standard financial measures to aid comparability.

  European financial regulators should follow the US Securities and Exchange Commission’s example by publishing the letters they write to companies querying accounting adjustments.

  With luck, the end of the free-money era will also mark the end of the adjusted profit free-for-all, but do not count on it.

  * Opendoor was profitable on a GAAP basis in the first quarter of this year.

  Chris Bryant is a Bloomberg Opinion columnist covering industrial companies in Europe. He was previously a reporter for the Financial Times.

  This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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