John Malone—The Cable Cowboy Who Rode EBITDA to Wealth and Fame

Introduction:? Origin of EBITDA

Oscar Wilde lamented: “When I was young I thought money was the most important thing in life, now that I’m old—I know it is.”? When I was younger, EBITDA was the cache for cash among corporate lenders and investment bankers despite some of us questioning its pretensions.? EBITDA is the acronym from Hell for those of us who cringe every time we hear some analyst or CEO brag about a company’s EBITDA.? Warren Buffett’s long-time partner Charlie Munger hated it: “I think that every time you see the word EBITDA, you should substitute the words "bullshit earnings.”[i]

For those of you unfamiliar with the term, EBITDA stands for the sum of earnings before taxes plus interest expense plus taxes plus depreciation and amortization.? So, why add back all that stuff to pre-tax profits?? That’s why you need to know about John Malone, the ‘cable cowboy” who invented it.

John Malone—He Did It His Way[ii]

As Liberty Media’s chairman and largest stakeholder, John Malone is one of the world’s most influential media magnates. He also possesses 28% of Discover Communications which recently snapped up fellow cable TV stalwart Scripps Network for $14.6bn, has a 25% share in Liberty Global, the largest international cable company that claims it has nearly 30 million subscribers, and owns 8% of professional baseball team Atlanta Braves.? He currently owns 2.2 million acres and is the biggest landowner in America.? As a result, Malone has a $9.2 billion net worth, and thanks to his media deals and land ownership, he’s been nicknamed the ‘Cable Cowboy’.

Malone was born on 7 March 1941 in Milford, Connecticut, a suburb north of New York City. Following an education at Yale University and John Hopkins University, Malone enrolled in New York University’s electrical-engineering program at Bell Labs, an institute renowned for developing several major telecom innovations, namely the laser beam and radio transmission. It was at Bell Labs that he first got a taste of the telecoms industry.

After returning to John Hopkins in 1967 to earn his PhD in operations research, Malone joined the management consulting firm McKinsey & Company in 1968. However, tired of the constant travelling his job required, he left five years later to join General Instruments while at GI, he ran the Jerrold subsidiary which produced minicomputers for the cable TV industry and at age 29, he was eventually offered the role of CEO of Tele-Communications Inc.? TCI was a fledgling cable company with only 400,000 subscribers and owed its creditors $132 million.

Within 17 years of snapping up smaller operators and acquiring minority stakes in other channels, TCI, under the management of Malone, had accumulated 8.5 million subscribers and had grown into the second largest cable company after Time Warner.? After a failed merger between TCI and multinational telecommunications conglomerate Bell Atlantic Malone sold TCI to AT&T for $50 billion in 1999. TCI subsidiary Liberty Media remained a separate organization, with Malone heading the operation.? He expanded LM beyond cable services into actually owning the networks broadcast on its infrastructure, including the Discovery Channel, QVC and Virgin Media.? In 2007, LM bought the Atlantic Braves baseball team the Atlanta Braves.?

So how did the Cable Cowboy grow his herd of cable companies?

Scale Model Cable[iii]

Early in his career, as he began to consolidate cable systems in the 70s, Malone realized that scale provided a tremendous advantage in cable television. The larger the company, the more leverage that company had to negotiate lower programming costs per subscriber. Since programming costs were the largest single operating expense, the largest cable operator would always have a significant advantage over the rest of the market.

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.

Instead of EPS, Malone emphasized cash flow to lenders and investors, and in the process invented EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).? Going further up the income statement than anyone had gone before to determine the cash-generating ability of a business before interest payments, taxes, and depreciation or amortization charges. Before his competitors adopted its use, Malone gained an advantage over his competitors by getting investors and lenders to focus on this figure over net income.

The Art of the Deal—A Lot of Bull[iv]

Let’s go back in time again.? In 1972, John Malone was offered the top job at Tele-Communications Inc (TCI), a cable company. He took charge on April Fool’s Day, 1973.? At the time of his hiring, Malone was president of Jerrold Electronics, a division of General Instrument that supplied cable boxes and credit to the cable systems companies. He had been offered the Jerrold Electronics job when he was 29 years old, just two years earlier.? Before JE, he was at McKinsey Consulting. And before McKinsey, he had a job at AT&T’s famed Bell Labs, where he applied operations research to find optimal company strategies in monopoly markets.? Malone had recommended that AT&T should increase its debt load and aggressively reduce its equity base through share repurchases, a highly unorthodox recommendation at the time, and it was ignored by AT&T’s board.

But Malone had been thinking about the interplay between debt, profit, cash flow, and corporate taxes for some time.? Even when he was first offered the TCI job in 1972, he had already noticed several structural properties in the cable industry that piqued his interest:

1-The cable industry had highly predictable subscription revenues.? Cable television customers in the 60s — especially those in rural communities — were eager to upgrade to cable for better TV reception. These subscribers paid monthly fees and rarely cancelled.

2-Cable franchises were essentially a legal right to a local monopoly, which meant that cable system operators had limited competition once it established itself in a given locale.

3-The industry itself had very favorable tax characteristics — smart cable operators could shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction. Once the depreciation ran out on particular systems, they could then sell them to another operator, where the depreciation clock would start anew.

4-Most importantly, the entire market was growing rapidly--over the course of the 60s and into the start of the 70s, subscriber counts had grown over twentyfold.

Of course, Malone didn’t have much time to reflect on these observations. He landed at TCI and found the company at the brink of bankruptcy. Bob Magness, the founder of TCI, had grown the company over the course of two decades by relying on debt — about 17 times revenues, at the time of Malone’s hiring.? Malone spent his first couple of years at TCI fighting to keep the company alive. He flew into New York every couple of weeks, hat in hand, renegotiating covenants and asking for extensions on debt repayments.

Malone and Magness also had to worry about hostile takeovers, given TCI’s low stock price in the early 70s. They executed a series of complicated financial maneuvers a year or so after Malone took over, placing a large block of stock in a holding company to grant them majority control.? Later, they created a separate class of voting stock. These moves gave them hard control of the company and allowed Malone to focus on restructuring its finances.

Malone understood a few things about the cable industry that many outsiders did not:

1-Cable was similar to real estate--high fixed costs up front as you built or bought the systems, and then highly predictable, monopoly cash flows for a long time afterwards.

2-If he used debt to finance acquisitions, he could keep growing the company, and use the depreciation on acquired systems plus the write-offs from the loans itself to delay paying taxes on that cash flow.

3-Untaxed cash flows from all of those cable subscribers could be used to

? a) service the debt,

? b) pay down some of those loans but only when necessary; Malone wanted to keep the debt-to-earnings ratio at a five-to-one level

? c) demonstrate to creditors that TCI was a worthy debtor.

? d) the larger TCI got, the lower the cost of acquiring programming, i.e. shows and programs, because it could amortize those costs across its entire subscriber base.

The problem was that Wall Street in the 70s and 80s didn’t understand any of these points. In 1986, brokerage firm E. F. Hutton refused to publish a report on TCI because “we don’t publish reports on companies or industries that don’t show a profit.”? And indeed, Malone’s strategy required TCI to show a loss for many years; for the next 25 years, it was never in the black.

Malone went on a charm offensive. He began talking to Wall Street analysts, explaining his logic.? To make his point, Malone created a new accounting metric, something he called ‘earnings before interest, depreciation, and taxes’, or EBITDA.? Through a combination of logic, jawboning, and sheer force of presence, Malone persuaded Wall Street to take a second look at the cable industry, long shunned because of its nonexistent earnings and heavy debt load.? Malone argued, successfully, that after-tax earnings simply didn’t count; what counted was cable’s large cash flow funding TCI’s continual expansion. Buying cable was like buying real estate. As the value of TCI’s franchises rose, so would the value of its stock. Because TCI had high interest payments and big write-offs on cable equipment, it produced losses, and because it produced losses it paid hardly any taxes to the government. As long as cable operators collected predictable, monopoly rent from customers, met interest payments, and grew from acquisitions, why worry?? Tax-sheltered cash flow could be leveraged to land more loans to create more tax-sheltered cash flow.

Problems with EBITDA—It Still Doesn’t Spell Cash Flow

EBITDA is often criticized as an imperfect measure of earnings to use broadly in comparing the profitability of companies across industries. But the concept wasn’t developed for this purpose. It was invented by billionaire investor John Malone to ?show debt servicing ability in his fast-growing cable company—lots of cable equipment expenses and depreciation & amortization generating losses and minimizing taxes.? His expectation of losses for many years also inferred that not much principal was to be repaid.

The problem for most bankers is that Malone’s cable model doesn’t track well with most bank borrowers, who are not enjoying monopoly revenues and not constantly acquiring substantive capital equipment.? EBITDA ignores the working capital and fixed asset investment needed to support revenue growth. It masks the financial burdens of debt – by adding back interest expense, EBITDA effectively ignores the cost of debt. Companies that carry large debts with high interest rates may look profitable under EBITDA, but interest expenses are still financial obligations of the company. EBITDA ignores the costs of assets because by adding back interest expenses and depreciation, EBITDA treats assets as if they are free. The assets held by a company do come at a cost as reflected by economic factors that may impact the salvage value, EBITDA is not accepted under GAAP or SEC for reporting purposes--EBITDA is a non-GAAP measure. As a result, there is no governing body that oversees how EBITDA is calculated and that leaves organizations able to determine if and how they want to report EBITDA. [v]

Summary and Closing: No End to EBITDA, Right or Wrong

Twenty years ago I criticized the use of EBITDA as a measure of cash flow repayment ability because of its obvious flaws—ignoring the needs for more working capital and fixed asset investment to support sales growth, assuming that creditors would be paid before government taxes, figuring that lenders would be content with just interest but no principal reduction, and drawing on depreciation and amortization as a repayment source instead of replenishing fixed assets.[vi]?

What few of us knew then was the man behind EBITDA, and now you know his name—John Malone.? When you consider the reasons why he invented EBITDA fifty years ago, substituting EBITDA for profits in order to show his lenders and creditors that his cable company did have some cash flow to service its massive debt load, then his ploy makes some sense—no taxable profits thanks to depreciation and amortization, minimal taxes, and no principal repayment.? He could continue buying out other cable companies, restarting the depreciation and amortization write-down clock, and expanding his cable monopoly revenues.? It has made him a rich man.

EBITDA is still with us but take this metric in context.? We have much more accurate ways to measure cash flow, especially the cash flow statement implemented in 1988 as FAS 95 and now classified as ASC 230.? Mark Twain once joked:? “The lack of money is the root of all evil,”? so maybe that is origin myth behind John Malone’s EBITDA.

[i] The Financial Review, “Charlie Munger: 'Every time you hear 'EBITDA' substitute it with 'bull**** earnings,’'' video of Warren Buffett and Charlie Munger speaking at the 2003 Berkshire Hathaway annual meeting, https://www.youtube.com/watch?v=l82kIjqBtqw

[ii] Joshua Lee, “ John Malone: everything you need to know about America’s single largest land owner--

Meet the most powerful man that you’ve never heard of,”? Gentlemen’s Journal, ????????https://www.thegentlemansjournal.com/article/john-malone-everything-need-know-americas-single-largest-land-owner/

[iii]Peter Lynch, “Who Invented EBITDA,” https://www.asimplemodel.com/insights/who-invented-ebitda

[iv] Eric Chunn, “John Malone and the Invention of EBITDA,” Capital Thinking, March 3, 2021, https://blog.capitalthinking.co/cash-flow-is-a-fact-profit-is-an-opinion/

[v] See my articles “EBITDA:? It Doesn’t Spell Cash Flow,”? The RMA Journal, November? 2001, and “Approach Adjusted EBITDA with Caution,” The RMA Journal, March 2020, pp. 20-27.

[vi] See endnote v’s “EBITDA:? it Doesn’t Spell Cash Flow.”