Cannabis Musings - March 15, 2024
What's the deal with adjusted EBITDA?
Friends, it’s earnings season. Importantly, that means that it’s almost time for baseball, but until then, we spend our time looking at how public companies fared financially in 2023. I thought I’d take the opportunity to dive into the one financial metric that grinds my gears - adjusted EBITDA.
First, what’s EBITDA? In case you’re not a finance person, EBITDA stands for earnings before interest, taxes, depreciation, and amortization, all of which you find on a company’s financial statements. For many companies (including all public companies, because it’s the law), financial statements are prepared in accordance with GAAP (generally accepted accounting principles, a set of financial accounting standards developed by the aptly-named Financial Accounting Standards Board) and audited (scrutinized and signed off on) by an outside accounting firm. EBITDA itself is non-GAAP, meaning that it’s not kosher to put on GAAP financial statements, but because it’s derived from GAAP-compliant numbers, it’s got a basis in standardization.
EBITDA is used by finance folks to measure and portray a specific aspect of a company’s financial health. For example, it can help me understand how well my (illustratory) infused knish company’s operations generate cash profits before taking into account (i.e. by adding back to net income) certain non-cash (depreciation and amortization) and essential cash (tax and interest) items. In short, how profitable are my delicious knishes? (There’s also EBITDAX, which is used in the energy space to take into account exploration purposes, and which definitely sounds cooler.)
One problem with EBITDA is that it doesn’t do a great job of portraying my knish company’s actual cash position because it’s adding back non-cash items that are accounting/tax concepts (putting it generally), as well as significant cash expenditures. For that, we could also look at my company’s free cash flow, which generally takes earnings, adds back non-cash items, and then deducts working capital and capital expenditures. The two metrics measure slightly different things, but EBITDA is the metric preferred by investors and bankers.
The problem with using EBITDA to measure the financial performance of a cannabis company is that the taxes are too damn high. Cannabis has the unique honor of being subject to IRS Code Section 280E, which, if you’re new to this industry, is a significant reason why plant-touching companies are so hard to operate profitably – you get to pay your taxes, but don’t get to take most normal operating deductions. Thank the funniest Tax Court case in history for that gem.
Because an abnormal amount of my knish revenues goes to paying excessive federal taxes (due to 280E), then adding that amount back to EBITDA arguably makes that number less useful in portraying the actual financial health of my infused knish company. This is compounded by the fact my borrowing costs (interest rates) are much, much higher than those for pretty much everyone else that doesn’t work in cannabis. Adding back that abnormally high cash interest expense creates even more distance between my EBITDA and my net income. Chances are, I have positive EBITDA and I burn cash like it’s going out of style.
Okay, so then what is adjusted EBITDA? Well, you take EBITDA and add back more stuff. That stuff is at my discretion (again, EBITDA isn’t standardized), so my adjusted EBITDA formula will almost certainly differ from another company’s adjusted EBITDA formula. It’s like comparing live resin to live rosin – it’s mostly the same, but it’s not. Typical adjustments are for large, one-time cash expenditures like acquisition costs.
The adjustment that really annoys financial analysts is for stock-based compensation. Let’s say my company has a juicy employee equity incentive plan. My financial statements will add back the fair value of those equity grants during the reporting period. That value is recognized as a non-cash expense on my income statement, so, like depreciation and amortization (also major, non-cash expenses), I’ll also add that back to EBITDA. Many companies do this, but because it can be such a large expense (particularly if you’re an earlier-stage company that’s relying heavily on equity grants to retain employees), it can have a significant effect on adjusted EBITDA number.
Another one we see fairly often in the cannabis industry is impairment of goodwill and other intangible assets. An impairment is essentially a reduction of the value of an asset on the company’s financial statements, because its fair value drops below its value stated on the balance sheet. So, are you pondering what I’m pondering? Say my infused knish company bought a cannabis operating license back in the salad days of 2018 for $10 million. Today, let’s say that the fair value of that license is $500,000. I need to write down that intangible (non-physical) asset on my balance because its value been impaired, even though no cash has changed hands. But, when I then go to calculate my adjusted EBITDA, I’m going to increase that amount by the $9.5 million impairment, because I can.
Cannabis’ business cycle has amplified all of this. You may recall that there was a lot of cannabis investment and acquisition activity back in 2017-2020, at valuations that ran the gamut from oy vey to oy gevalt. I’m generalizing here, but for the most part, those assets are worth a lot less today than what was paid for them. That massive destruction of value resulted in investing/acquiring companies having to take write downs on their financial statements. It’s reflective of the fact that we’re still in a very high growth, early-stage industry (very similar to what happened the first dotcom boom-bust cycle).
So, that impairment addback to my adjusted EBITDA is indeed a real number, but it’s one that’s been made very large by the macro trends in the industry. As a result, it has an outsized effect when I turn my EBITDA into adjusted EBITDA.
Let’s be perfectly clear – all of this is appropriate, accepted, and (generally) standard practice. If my infused knish company were (a) real and (b) public, I’d do the same thing. I’m not being critical of public cannabis companies (many of which have Cannabis Musings readers, for which I’m very appreciative!). My point is that we all need to be careful when reading a headline number. Consider not only that EBITDA is not quite as useful in cannabis as it is in other industries, but also dig into what adjustments are being made and why. In other words, what’s going into that knish?
Be seeing you!
(Background research came from two articles in the American Bankruptcy Institute’s Journal by Carlyn Taylor and John Yozzo – EBITDA Addbacks Have Become Problematic from February 2022, and Adjusted EBITDA Is in the Eye of the Beholder from June 2023. Both articles research the real-world effects of EBITDA adjustments.)
© 2024 Marc Hauser and Hauser Advisory. None of the foregoing is legal, investment, or any other sort of advice, and it may not be relied upon in any manner, shape, or form.