Does EBITDA matter? . before you take interest, Tax, Depreciation and Amortisation into account - European Line - earnings profits - Brief Article

Telecom Asia, June, 2002 by Ian Scales

The search for the villains behind the telecom crash continues apace, and EBITDA (not the lack of it, but the whole idea of it) is often mentioned as a prime suspect.

Companies', analysts' and investors' obsession with EBITDA as a performance measure (so this line of reasoning goes) blinded them to the fact that the investment made in, and the debts run up by, the telecoms sector was too high and could never be serviced by likely earnings. This applied to whatever it was that was being invested in: fiber networks, colocation space, service provision. And worse still, incentivizing senior executives against EBITDA improvements distorted their corporate stewardship. Result: mess and misery.

That EBITDA must be powerful juju to cause all that damage, so just what was it?

EBITDA is earnings (profits) before you take interest, Tax, Depreciation and Amortisation into account. Interest and tax we all understand; depreciation relates to writing down assets; and amortization is a mechanism which enables goodwill, or the premium over asset value (essentially the intangible value) you might have paid in an acquisition, to be written off over a period of years.

EBITDA therefore clocks the performance of the business model itself, cleared of the clutter of a company's financial manoeuvres. It simply measures the money coming in and it subtracts all the people costs and other overheads (everything from sales, marketing and operations costs to customer support, power, rent and coffee and biscuits in the meeting rooms) to arrive at its figure.

Only a measure

What that calculation measures is the fundamental business mechanism which generates the cash. At the early stages in a business's life (especially one kick-started by a huge capital investment, like a network) you need to measure the rate of growth in EBITDA to make sure enough cash is going to be generated in the long run to make the pay-back on the capital investment.

So if EBITDA is improving it's a very good thing indeed. If EBITDA is getting worse, it probably means you have to go back to the drawing board and re-think strategy and structure.

So EBITDA is a useful measure, but only a measure. And frankly, the idea that everyone forgot that a return on investment was required for broadband networks and other capital-intensive undertakings, is stretching things a little. It was a crazy time, but the late 1990s wasn't THAT crazy....

How about ROI?

EBITDA might be out of favour, but we might soon be hearing more about a new measure: return on investment (ROI). That's because a gap is currently opening up in the European telecoms market. On the one side are those entities which (or are about to) have lost most, if not all, of their debt burden (either by a financial restructuring, or through being bought up at a fraction of their cost after a collapse), and those who did well enough to avoid getting into financial trouble but still have heavy debt on their balance sheets.

"There has never been a better time to buy telecom assets," said Andrew Harrington, a veteran telecom financial analyst. "After all, this is a market which still has an underlying growth rate of l0%."

The irony is that it may become very difficult for the financial survivors, such as Level 3, Cable & Wireless, and Telia International Carrier, say, to compete with the "liberated" assets of former competitors such as Carrier 1, 360 Networks and Global Crossing. One way or another, "failed" network assets don't disappear, they get bought and come back to compete in the market. But the companies wielding them will be at a profound advantage, having bought them at a fraction of their original cost. That means they have to make comparatively less money from them to show an acceptable ROI to the new owners. That's one hell of an advantage.

Stability premium

"I think there is an undoubted problem there for all sorts of companies," says Stephen Young, senior consultant at Ovum. "What they [the financial survivors] will argue though, is that they benefit from a 'stability premium'," he claimed. In other words, precisely because they haven't got into difficulties they might be deemed more worthy partners by many users who will be prepared to pay extra to deal with them.

"The next question to ask, though," says Young, "is whether a so-called stability premium has more value than a re-engineered balance sheet. I rather think it may not."

Re-engineered balance sheets and (where survivors have bought failed companies) cheap assets may offer scope to re-think business models, agree both Harrington and Young.

Essentially, if you've paid less for the underlying assets you can try to plan a faster and surer route to profitability than those telcos who have survived but are stuck with expensive assets. That's because business models can be ambitious--taking a long time to reach "free cash flow" status, but aiming to build scale and scope on the journey. Or they can be "cut to the chase" models which look to being lean and simple enough to generate cash in the near term.