Kim Kardashian, The Modern Day John Malone?

Is Kim Kardashian the modern day John Malone?

Is the depreciation of assets (based on physics and market information) real or should we ignore this recurring expense when assessing performance determining value?

What can we learn from the past via John Malone and the present via Kardashian’s sale of her smashed Range Rover?

As noted in the exceptionally favorable coverage of Thorndike’s The Outsiders and Roubichaux’s The Cable Cowboy [1], John Malone led the cable company TCI on an exciting ride from 1973 until TCI was sold to AT&T in 1999 for ~$50B. Interestingly, AT&T lost roughly 30% of its value in the year that followed the TCI acquisition (while the market was up over 8%).[2]

Malone was certainly an interesting person and clearly one of the most fascinating financial alchemists of the past few decades, if not all time. As one particularly lasting form of his financial alchemy, given the unique and intentionally complicated nature of TCI’s business, he created the now common financial metric, our good friend EBITDA (earnings ignoring the recurring expenses of interest, taxes, depreciation and amortization).

EBITDAs (this is not a standardized metric, so many forms and interpretations exist) [3] are widely accepted by many academics and practitioners as a metric to represent profitability, cash flows or, really whatever we want and is commonly used in valuation. [4,8] As we can see from Plato's Allegory of the Cave or the pervasive impact of social media influencers, EBITDAs are naturally popular with humans as EBITDAs help embellish performance (by ignoring expenses), embellish valuation (by ignoring recurring cash outflows) and allows the user to control the story being offered. As humans we prefer to be assessed independent of the flaws that we do not like or those that make us look worse.

Stated differently:

The most succinct summary of the use of this metric for embellishment comes from excellent analysis offered by finance thought leader, Michael Mauboussin, What Does an EV/EBITDA Multiple Mean?

“Companies that emphasize EBITDA are on average smaller, more leveraged, more capital intensive, and less profitable than their peers.”

While these distortions and the ways in which EBITDA impairs comparability[4,6,8] can be undone, this might not always be the case. For example, the introduction of Mauboussin’s work also notes:

"… a na?ve use of EV/EBITDA leads to valuation mistakes. We find that investors commonly employ EV/EBITDA without being fully aware of the underlying economic assumptions the multiple implies."???

Back to Malone and Kardashian:

In some ways, Malone’s use of EBITDA was less of an artificially embellished metric than we see in use today with various EBITDAs. Setting aside interest expense (TCI had massive amounts of debt), given the way TCI structured various deals and its business, it had paid little to no taxes on little to no taxable income (TCI had meaningful Net Operating Losses). That is, ignoring tax expense when tax expense is ~0 (and others are paying ~50%) is different from ignoring it when it is 15-25% of taxable income.[5]

In addition, and what brings us to Kim Kardashian, is that TCI was a unique example of a company where depreciated assets were not replaced. Stated differently, TCI drastically cut and even avoided maintenance capex. Maintenance capex represents the recurring capital expenditures required to maintain levels of revenue or business performance… for an individual outside of a company, Depreciation Expense can be a useful proxy for determining Maintenance capex.[6]

In some ways, TCI appears to be a case where a brilliant financial alchemist had his cake and ate it too (to be clear, Malone and TCI shareholders ate the cake), but could this also be a cautionary tale?

What is the straightforward and accessible story that Kim Kardashian has provided?

Is it: A smashed car is not, in fact, valued like a smashed car, but valued like a brand new one.

Focusing on its desire to ignore Depreciation Expense, EBITDA is telling us the same story as Kardashian conveniently offers:

Smashed cars, depreciated assets, etc. are not smashed cars or depreciated assets, nor should they be valued that way. Rather, we should value smashed cars or depreciated assets as brand new.

Stated differently, our choice to ignore depreciation expense is an argument that depreciation is not a real or recurring expense related to the business we are examining. A similar choice would be to ignore that Kardashian’s car was smashed. ?

Here is how it worked for Malone: [7]

• TCI was the largest company in the cable industry with the least maintained facilities. (p. 107). ?Malone steadfastly refused to upgrade his rural systems (p. 103).
• Malone saw a combination of factors clouding TCI’s future... [including] the enormous cost of upgrading the company’s rural systems [so he sold TCI] (p. 98)
• The financial terms, [TCI was sold for] twelve times EBITDA… remarkably the company received no discount for its patchwork quilt of decrepit rural systems (p. 98).
• Because of these polyglot joint ventures, TCI was notoriously hard to analyze… To understand the company you had to review all of their footnotes and very few did. (p. 106)

That is, Malone, an influencer in his own right, sold AT&T a smashed car as if it was brand new… and AT&T bought the smashed car as if it was brand new. Curious if this had anything to do with AT&T’s stock dropping ~30% in the year that followed the purchased of TCI and “its patchwork quilt of decrepit rural systems.”

Will it work for Kim Kardashian as it did for Malone?

In her defense, it appears as Kardashian's smashed car is, in fact, marketed as a smashed car in a manner that is accessible to even those catering to the superficial:

Setting aside that a Google search is easier than navigating a 10-K, is this the same as when we see or use EBITDA? Is it possible that we know that in most cases depreciation is a real, recurring operating expense related to recurring cash outflows? Moreover, similar to the lessons from the Emperor’s New Clothes, we can all see depreciation expense in the GAAP financial statements. We’re not required to ignore this recurring expense... Does it get harder to point out the naked emperor when everyone else is fawning over his amazing clothes?

However, we can also choose to ignore depreciation or other aspects of reality, especially if the artificially embellished version, whether social media or financial metrics, is far more exciting.

Incentives matter, so while ignoring these aspects of reality certainly may be beneficial to those selling the company or car is following the financial alchemists or social media influencers this best choice for the rest of us?

As Edward Chancellor notes in Devil Take the Hindmost:

“Operations of financial alchemy, as Sir Isaac Newton discovered, were more likely to damage the mind of the alchemist than to achieve any lasting transmutation of base metals into gold.”

Someone may buy Kardashian’s car and if they do, I hope they get a massive amount of utility from owning a smashed Land Rover that Kim Kardashian drove, smashed, laid on the hood, etc. and not as they believe it is a brand new car. That is, Kardashian certainly may be able to sell it for a celebrity premium, not just the value of an anonymous used car.

ENDNOTES AND ADDITIONAL ELABORATIONS OR TECHNICAL POINTS

[1] I do recommend both of these books as well as David Senra 's cover of John Malone in his excellent podcasts, Founders: Episode #268. There is a lot more to learn about John Malone beyond the quick points noted here and an incredible amount to learn in the rest of The Outsiders and throughout the Founders podcast.

[2] Using the period from early January 1999 to mid February 2000 and comparing it to the S&P500 index over the same time. The dot com bubble hit its peak on March 10, 2000... so this is before the bubble burst.

[3] EBIT itself is non-standardized as covered here: Is Operating Income EBIT. In addition, as EBITDAs make additional adjustments, standardization decreases even further. For example, when taken literally, EBITDA actually includes all one-time and truly non-recurring items, but many adjust these out (there is a good argument for adjusting out one-time and truly non-recurring items when it comes to valuation as covered here: The Flaw of Net Income and here: Uber and the Persistence of Core Earnings ). As another example, versions of EBITDA exclude stock compensation, especially (and not surprisingly) with companies that are human capital intensive, not physical capital intensive. A near-countless amount of other company-specific adjustments exist.

[4] If the reason for ignoring depreciation expense is worries about how choices of useful life may impact the reported depreciation expense, this issue is greatly mitigated once the number of assets we have is greater than the useful life of these assets. For more on this and a discussion on the various ways that EBITDA impairs and does not enhance comparability of businesses, check out my post: Does EBITDA Enhance or Impair Comparability.

[5] More on the validity of adding back interest expense in certain cases here: The Flaw of Net Income and more on understanding some benefits of Operating Income here: Is Operating Income EBIT

[6] In valuation, all of the distortions and comparability impairments that EBITDA introduces can be undone. For example, the multiple used in valuation can be mathematically reduced given the expected outflow of cash via taxes and capital intensity (the excellent Mauboussin articles noted above covers this process in depth). Conceptually and practically, removing the distortions that EBITDA introduces is similar to not using EBITDA as a multiple in valuation, but using a more representative and comparable metric, such as Net Operating Profit After Taxes. For more on considering Maintenance capex in valuation and a clear-eyed focus on valuation in a world overrun by confusing adjustments to adjustments, check out this slide deck: Determining Company Value ).

[7] Excerpts taken from Thorndike's The Outsiders p. 98-107. As far as I can tell, Thorndike is offering this information in effusive praise of Malone, not as a cautionary tale.

[8] If the reason for ignoring depreciation expense is that it is labeled as a "non-cash" expense in a strictly bookkeeping sense, it’s worth considering a few things:

What does non-cash mean?

Non-cash is a bookkeeping term that means we do not immediately credit the cash account when this entry is recorded in the bookkeeping process. Non-cash does not mean that cash is not affected in an ongoing or valuation sense—as assets depreciate and can no longer be used, we replace them (using cash) as otherwise we would give up the associated revenue and other cash inflows from operations (that is, we lose the E in EBITDA if we don’t replace assets with the cash outflow related to the D). At the company level, the need to replace assets is a constantly recurring cash outflow.

Moreover, if classifying some expenses as non-cash is informative then there should be excellent examples of material and recurring direct cash expenses for large businesses. Are there?

• For example, for Cost of Goods Sold we debit Cost of Goods Sold expense and credit Inventory. Cash is not credited, so Cost of Goods Sold is also a non-cash expense.
• For Wage Expense we we debit Wage Expense and credit Wages Payable... For Utilities Expense we debit Utilities Expense and credit Utilities Payable... Again, Cash is not credited, so Wage Expense and Utilities Expense are also non-cash expenses.

In some ways, isn’t the term non-cash just a less-than-helpful way of saying regular expenses? If we use the bookkeeping label of non-cash as our guide for what to ignore, wouldn’t we ignore most expenses? With that in mind, another issue with EBITDA is that other expenses ignored via EBITDA, like Interest or Taxes are paid in cash.

Thoughts, comments, suggestions? What did I miss or overlook?

Thanks to Neha Tandon Sharma for the original article and coverage of Kim Kardashian.