In this blog post, I examine Overstock.com's (NASDAQ: OSTK) presentation of another non-GAAP financial measure, known as "earnings before interest, taxes, depreciation, and amortization" or EBITDA. Based on my analysis below, it appears that Overstock.com violated Regulation G by reconciling its non-GAAP financial measure, EBITDA, to "Operating loss" rather than "Net loss," contrary to the SEC's guidance on Regulation G. The result of Overstock.com reconciling EBITDA to "Operating loss" rather than "Net loss," contrary to the SEC's guidance on Regulation G, caused Overstock.com to overstate EBITDA by the at least the amount of "Loss from discontinued operations" for certain accounting periods presented in the second and third quarter 10-Qs for fiscal year 2007. In addition, certain stock-based compensation measures and "treasury stock issued to employees for compensation" were removed from Overstock.com's EBITDA calculation causing added overstatements of EBITDA for certain accounting periods presented in the second and third quarter 10-Qs for fiscal year 2007.
A serious question can be asked: Was Overstock trying to overstate its purported turnaround by violating Regulation G?
Regulation G
In accordance with Section 401 (b) of the Sarbanes-Oxley Act of 2002, the Securities and Exchange has established regulations defining the proper and improper use of non-GAAP financial disclosures by public companies.
Regulation G: EBITDA is a non-GAAP financial measure
In particular, Regulation G defines the EBITDA as a non-GAAP financial measure:
Another example would be EBITDA, which could be calculated using elements derived from GAAP financial presentations but, in any event, is not presented in accordance with GAAP. [Emphasis added.]
The “E” in EBITDA Refers to Earnings, and Earnings = Net Income
The Securities and Exchange Commission has provided specific guidance regarding the computation of EBITDA under Regulation G. According to the SEC’s "Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures" prepared by Staff Members in the Division of Corporation Finance, the following guidance is provided:
Question 14: Section I of the adopting release describes EBIT as "earnings before interest and taxes" and EBITDA as "earnings before interest, taxes, depreciation and amortization." What GAAP measure is intended by the term "earnings"? May measures other than those intended by the description in the release be characterized as "EBIT" or "EBITDA"? Does the exception for EBIT and EBITDA from the prohibition in Item 10(e)(1)(ii)(A) of Regulation S-K apply to these other measures?
Answer 14: "Earnings" is intended to mean net income as presented in the statement of operations under GAAP. Measures that are calculated differently than those described as EBIT and EBITDA in the adopting release should not be characterized as "EBIT" or "EBIDTA." Instead, the titles of these measures should clearly identify the earnings measure being used and all adjustments. These measures are not exempt from the prohibition in Item 10(e)(1)(ii)(A) of Regulation S-K. [Emphasis added.]
Therefore, the intended meaning of “earnings” for EBITDA under Regulation G is “net income as presented in the statement of operations under GAAP.” That is, Overstock should have based its computation of EBITDA on net income, adding back only interest, depreciation, and amortization (there were no taxes to add back). In direct violation of this requirement, however, Overstock.com instead based its computation of EBITDA on “operating loss” rather than “net income” as the starting point. This had the effect of materially overstating EBITDA for the second and third quarters of 2007, as well as the six months ended June 30, 2007 and the nine months ended September 30, 2007. Later, I will show you just how material the misstatement was. Hint: It’s much, much larger than the standard benchmark used by auditors and regulators to establish whether an item is “material.
Reconciliation requirement
In addition to violating Regulation G’s definition of EBITDA, Overstock.com also violated the SEC’s reconciliation requirement with respect to EBITDA. According to Regulation G, a company must reconcile its non-GAAP financial measure with the "most directly comparable financial measure or measures calculated and presented in accordance with GAAP." Read below:
Regulation G contains a general disclosure requirement and a specific requirement of a reconciliation of the non-GAAP financial measure to the most directly comparable GAAP financial measure. [Emphasis added.]
The SEC goes on to state that:
Whenever a company that is subject to Regulation G, or a person acting on its behalf, publicly discloses any material information that includes a non-GAAP financial measure, Regulation G requires the registrant to provide the following information as part of the disclosure or release of the non-GAAP financial measure:
- a presentation of the most directly comparable financial measure calculated and presented in accordance with GAAP; and
- a reconciliation (by schedule or other clearly understandable method), which shall be quantitative for historic measures and quantitative, to the extent available without unreasonable efforts, for prospective measures, of the differences between the non-GAAP financial measure presented and the most directly comparable financial measure or measures calculated and presented in accordance with GAAP. [Emphasis added.]
What is the most directly comparable financial measure calculated and presented in accordance with GAAP?
The SEC did not mandate or define "the most directly comparable financial measure." However, the SEC provides certain guidance depending on whether or not the non-GAAP financial measure is intended to be considered a performance measure or a liquidity measure. According to Regulation G:
We do intend that the definition of non-GAAP financial measure capture all measures that have the effect of depicting either:
- a measure of performance that is different from that presented in the financial statements, such as income or loss before taxes or net income or loss, as calculated in accordance with GAAP; or
- a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP. [Emphasis added.]
Therefore, a non-GAAP performance measure must be reconciled to items such as "income or loss before taxes or net income or loss" or a measure of liquidity such as “cash flow from operations.”
Furthermore, the SEC guidance states that, if the non-GAAP EBIT or EBITDA financial measure is a performance measure, the registrant should make the following reconciliation:
Question 15: If EBIT or EBITDA is presented as a performance measure, to which GAAP financial measure should it be reconciled?
Answer 15: Because EBIT and EBITDA exclude recurring charges, companies should consider the answer to Question 8 if they intend to use EBIT or EBITDA as a performance measure. If a company is able to justify such use, EBIT or EBITDA should be reconciled to net income as presented in the statement of operations under GAAP. Operating income would not be considered the most directly comparable GAAP financial measure because EBIT and EBITDA make adjustments for items that are not included in operating income. [Emphasis added.]
Alternatively, if the non-GAAP measure is intended to be a liquidity measure, the SEC provides the following guidance:
Question 12: Are the requirements in Item 10(e)(1)(i) of Regulation S-K for the prominent presentation of, and reconciliation to, the most directly comparable GAAP financial measure or measures intended to change the staff's historical practice of requiring the prominent presentation of amounts for the three major categories of the statement of cash flows when a non-GAAP liquidity measure is presented?
Answer 12: No. The requirements in Item 10(e)(1)(i) are consistent with the staff's historical practice. The three major categories of the statement of cash flows should be presented when a non-GAAP liquidity measure is presented. [Emphasis added.]
Therefore a non-GAAP liquidity measure should be reconciled to, "The three major categories of the statement of cash flows should be presented when a non-GAAP liquidity measure is presented."
As I show below, Overstock.com did not reconcile EBITDA to any of the allowable GAAP numbers. Instead, Overstock.com reconciled EBITDA to "Operating Loss."
Was it a Performance Measure or a Liquidity Measure?
Based on Overstock.com’s disclosures in the second quarter fiscal 2007 10-Q, it appears as though management intends to use EBITDA as a liquidity measure. Specifically, Overstock.com disclosed:
However, we expect to spend less than $5 million in new capital expenditures during 2007, and therefore we use EBITDA as a reasonable measure of actual cash used or cash generated by the operations of the business. [Emphasis added.]
Similarly, in the third quarter fiscal 2007 10-Q, Overstock.com disclosed:
However, we expect to spend less than $5 million in new capital expenditures during 2007, and therefore we use EBITDA as a reasonable measure of actual cash used or cash generated by the operations of the business. [Emphasis added.]
If Overstock.com was in fact using EBITDA as a liquidity measure, the company should have reconciled it to any of, "the three major categories of the statement of cash flows should be presented when a non-GAAP liquidity measure is presented," rather than “Operating loss."
Why didn’t Overstock make the required reconciliation? Was it ignorance of the standard? Or was it trying to hide the fact that, in the case of Overstock.com, EBITDA is not a “reasonable measure of actual cash used or generated by the operations of the business”?
Overstock.com’s second quarter fiscal year 2007 10-Q EBITDA disclosure
As discussed above, Overstock.com, contrary to the SEC’s guidance, computed EBITDA starting with “operating loss” rather than “net income.” As we will see in a moment, this had the effect of materially overstating EBITDA. Below, is Overstock.com’s full second quarter fiscal year 2007 EBITDA 10-Q disclosure:
Commentary—EBITDA (non-GAAP). EBITDA for the second quarter of 2007 was $(4.2 million), an improvement from $(7.5 million) in Q2 2006. For the first six months of the year, EBITDA was $(12.4 million), $1.6 million better than the $(14.0 million) in the previous year. We believe that discussing EBITDA at this stage of our business is useful to us and investors, because our current capital expenditures are significantly lower than our depreciation levels. During 2005 and 2006, we made significant investments in our systems and overall infrastructure, and as a result will have approximately $30 million of related depreciation expense in 2007. However, we expect to spend less than $5 million in new capital expenditures during 2007, and therefore we use EBITDA as a reasonable measure of actual cash used or cash generated by the operations of the business.
Although EBITDA was negative $4.2 million in the second quarter, EBITDA excluding restructuring costs (“adjusted EBITDA”, a non-GAAP measure) was a positive $2.0 million in the second quarter, and $(146,000) year-to-date. We believe that discussing adjusted EBITDA also provides useful information to us and investors, as we use this measure as a representation of cash used or cash generated from the operations of the business if we had not originally incurred these costs. For further details on EBITDA and adjusted EBITDA, see the reconciliation of these non-GAAP measures to GAAP operating loss as follows (in thousands): [Emphasis added]
An excerpt from Overstock.com’s “Consolidated Statement of Operations” which highlights the company's differences between “Operating loss” and “Net loss” is below (in thousands):
Since Overstock.com based its non-GAAP EBITDA financial measure on “Operating Loss” rather than “Net loss,” the company’s EBITDA was overstated by at least the amount of “Loss from discontinued operations” for each accounting period. That amount was:
- Second quarter fiscal year 2006: $1.128 million
- Second quarter fiscal year 2007: $0.3 million
- Six months ended June 30, 2006: $1.907 million
- Six months ended June 30, 2006: $3.924 million
Since Overstock.com based its non-GAAP EBITDA financial measure on “Operating Loss” rather than “Net loss,” the company’s EBITDA was overstated by at least the amount of “Loss from discontinued operations” for each accounting period. That amount was:
- Second quarter fiscal year 2006: $1.128 million
- Second quarter fiscal year 2007: $0.3 million
- Six months ended June 30, 2006: $1.907 million
- Six months ended June 30, 2006: $3.924 million
Other Overstock.com EBITDA overstatements for accounting periods presented in second quarter fiscal year 2007 10-Q
In addition, Overstock.com improperly removed from EBITDA the following expenses for each accounting period presented in the second quarter 10-Q:
- Stock-based compensation
- Stock-based compensation to consultants for service, and
- Treasury stock issued to employees for compensation
See the chart below (in thousands):
Total EBITDA Overstatements by Overstock.com for accounting periods presented in second quarter fiscal year 2007 10-Q
The chart below illustrates the materiality of Overstock.com's EBITDA overstatements for each accounting period presented in the second quarter fiscal year 2007 10-Q (thousands):
This means that Overstock.com’s EBITDA figure was overstated by a material amount in each and every one of the comparable periods presented in the second quarter 2007 10-Q.
To add insult to injury, Overstock.com also failed to reconcile EBITDA to any of the allowable liquidity measures. Was it because cash from operations was horribly in the red during the six month periods ending June 30, 2006 and June 30, 2007? Cash used in operating activities in those periods was an astounding (-$79.006 million) and (-$43.301 million), respectively.
Overstock.com’s third quarter fiscal year 2007 10-Q EBITDA disclosure
As discussed above, Overstock.com, contrary to the SEC’s guidance, based its EBITDA computation on “operating loss” rather than “net income.” That again led to a material overstatement of EBITDA in the third quarter. Below, is Overstock.com’s third quarter fiscal year 2007 EBITDA 10-Q disclosure:
Non-GAAP Financial Measure
Regulation G, Conditions for Use of Non-GAAP Financial Measures, and other SEC regulations regulate the disclosure of certain non-GAAP financial information. Our measure of “EBITDA” is a non-GAAP financial measure. EBITDA, which we reconcile to “Operating loss” in our income statement, is earnings before interest, taxes, depreciation, amortization and stock-based compensation. EBITDA is used in addition to and in conjunction with results presented in accordance with GAAP and should not be relied upon to the exclusion of GAAP financial measures. EBITDA reflects an additional way of viewing our results that, when viewed with our GAAP results, provides a more complete understanding of factors and trends affecting our results. You should review our financial statements and publicly-filed reports in their entirety and not rely on any single financial measure. Our discussion below (i) explains why management believes that presentation of EBITDA provides useful information to investors regarding our financial condition and results of operations, (ii) to the extent material, discloses the additional purposes, if any, for which management uses this non-GAAP measure, and (iii) provides a reconciliation of this measure to our operating losses. [Emphasis added.]
Note: As discussed in my previous blog item, the obligatory reference to Regulation G was absent from previous filings submitted to the Securities and Exchange Commission. Why didn't Overstock.com make this Regulation G disclosure earlier? Was Overstock.com attempting to play a game of catch up in its third quarter 10-Q? Why did the company finally consider Regulation G in its third quarter 10-Q. Apparently, Overstock.com did not even comply with Regulation G, anyway.
Whatever the motive, the company went on to falsely state that EBITDA is also a “reasonable measure of actual cash used or generated by the operations of the business.” The disclosure continues:
Commentary—EBITDA (non-GAAP). EBITDA for the third quarter of 2007 was $4.1 million, an improvement from $(14.4 million) in Q3 2006. For the first nine months of the year, EBITDA was $(8.3 million), $20.0 million better than the $(28.3 million) in the previous year. We believe that, because our current capital expenditures are significantly lower than our depreciation levels, discussing EBITDA at this stage of our business is useful to us and investors. During 2005 and 2006, we made significant investments in our systems and overall infrastructure, and as a result will have approximately $30 million of related depreciation expense in 2007. However, we expect to spend less than $5 million in new capital expenditures during 2007, and therefore we use EBITDA as a reasonable measure of actual cash used or cash generated by the operations of the business. [Emphasis added.]
But, as I noted in my last blog entry, EBITDA was a lousy measure of “actual cash used or generated by the operations of the business” during the third quarter. Third quarter cash from operating activities was negative $2.456 million, as it has been in the vast majority of quarters since inception.
The remainder of Overstock.com’s misleading EBITDA disclosure, from the MD&A section, is copied below (Click on image to enlarge):
Overstock.com’s difference between “Operating loss” and "Net loss" for accounting periods presented in the third quarter fiscal year 2007 10-Q
An excerpt from Overstock.com’s “Consolidated Statement of Operations” which highlights the company's differences between “Operating loss” and “Net loss” is below:
Since Overstock.com based its non-GAAP EBITDA financial measure on “Operating Loss” rather than “Net loss,” the company’s EBITDA was overstated by at least the amount of “Loss from discontinued operations” for each accounting period, which was already amply discussed, that amount was:
- Third quarter fiscal year 2006: $0.708 million
- Nine months ended September 30, 2006: $2.615 million
- Nine months ended September 30, 2007: $3.924 million
Other Overstock.com EBITDA overstatements for accounting periods presented in third quarter fiscal year 2007 10-Q
In addition, Overstock.com improperly removed from EBITDA the following expenses for each accounting period presented in the third quarter 10-Q:
- Stock-based compensation
- Stock-based compensation to consultants for service,
- Stock-based compensation relating to performance shares, and
- Treasury stock issued to employees for compensation
See the chart below (in thousands):
Total EBITDA Overstatements by Overstock.com for accounting periods presented in third quarter fiscal year 2007 10-Q
The chart below illustrates the materiality of Overstock.com's EBITDA overstatements for each accounting period presented in the third quarter fiscal year 2007 10-Q (thousands):
This means that Overstock.com’s EBITDA figure was overstated by a material amount in both the nine months ended September 30, 2006 and September 30, 2007, as presented in the third quarter 2007 10Q.
To add insult to injury, Overstock.com again failed to reconcile EBITDA to any of the allowable liquidity measures. And again, I have to ask, was it because cash from operations was so horribly in the red during the nine month periods ending September 30, 2006 (-$78.242 million) and September 30, 2007 (-$45.757 million)? Does Overstock.com management really expect us to believe that their EBITDA metric, as presented or as corrected, was really a “reasonable measure of actual cash used or cash generated by the operations of the business”? How stupid do they think we are?
Is Overstock.com Using Non-GAAP Measures to Hype a Bogus Turnaround?
On March 7, 2006, in an interview with ZDNet News, Patrick Byrne said:
We have a plan this year that we should cross the billion-dollar mark. Put it this way: Amazon, at our stage, was losing $1.2 million a year in operations. It made up a phony accounting standard--pro forma. And when it reached pro forma breakeven, Wall Street set off fireworks. [Emphasis added,]
Overstock.com never came close to achieving the "billion-dollar mark" in annual sales as hyped by Byrne and the company has resorted to making up its own "phony accounting standard" governing the use of EBITDA, in apparent violation of SEC Regulation G, to overstate its financial performance.
Using non-GAAP financial measures to hype Overstock.com's performance is nothing new for double taking CEO, Patrick Byrne. He continues to use non-GAAP financial measurements as it suits him, depending on his agenda at the time. In a previous blog item, I detailed how Byrne interchangeably used both GAAP and non-GAAP sales figures prior to Overstock.com’s IPO. The trouble was, during that period he used these two sales measures interchangeably without ever telling the user which measure he was using, leading one to conclude that Overstock’s sales were much higher than they really were at the time.
In another blog item, I detailed how Patrick Byrne used non-GAAP financial measures, the reduction of inventory reserves, and the reversal of previously booked restructuring expenses to hype up Overstock.com financial performance for the second quarter of fiscal year 2007. Without, the use of what Patrick Byrne has defined as a "phony accounting standard--pro forma," Overstock.com's hyped up turn around would have all but disappeared. In addition, I detailed how the reduction in inventory reserves in the second quarter of fiscal year 2007, wiped away Overstock.com's entire improvement in operating income.
Playing a game of catch up on disclosures is nothing new for Overstock.com and its double talking CEO, Patrick Byrne, too. For example, on May 9, 2006, the Securities and Exchange Commission launched a formal investigation of Overstock.com. On May 17, 2006, Patrick Byrne received a personal subpoena from the SEC. However, Overstock.com delayed its disclosure of Patrick Byrne's subpoena for almost an entire year, belatedly disclosing Byrne's SEC subpoena in the company's first quarter fiscal year 2007 10-Q that was released on May 9, 2007.
On May 10, 2007, while attempting to deflect from the news of Overstock.com's belated disclosure of his personal SEC subpoena, Patrick Byrne offered more double-talk and suggested that Overstock.com and he was not the target of a Securities and Exchange Commission investigation.
Here is the punch-line: as a matter of law I must tread carefully here, but I can say that the heart of the investigation is not, I would suggest, Overstock-centric, but rather, concerns itself with a strange set of relationships among ..... Well, let me just say that the irony here is just delicious.
On May 12, 2007, in a post (message number 7271) on InvestorVillage, using his Hannibal alias, Patrick Byrne continued his double talk and claimed that:
The funny part is how it still has not dawnede on the miscreants that a fair bit of the material being requested by the SEC concerns THEM, not me or Overstock.
However, on August 10, 2007, Byrne finally admitted that he is in fact, "the target of their [SEC] investigation," in contrast to his previous denials.
Again, it appears that its just business as usual at Overstock.com, where the primary business activity is over-hyping its results. The tone at the top of this perennially money losing and capital hungry company has been set by a lying CEO who talks out of three sides of his mouth.
Patrick Byrne once said, "...I think 'EBITDA' is the stupidest thing I ever heard emanate from Wall Street (no small feat)...." Now, Overstock.com and Patrick Byrne conveniently misuse EBITDA in an apparent violation of Regulation G to mislead investors.
To be continued....
Written by,
Sam E. Antar (former Crazy Eddie CFO & convicted felon)
For additional information about Overstock.com's misleading financial disclosures, please read the blog posts below:
08/22/07: Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors? (Part 2)
08/24/07: Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors? (Part 3)
2 comments:
Sam,
Why were these problems not picked up by Overstocks auditors? Can we trust supposedly independent audits AT ALL?
Hector,
10-Qs are not audited. However, they are reviewed by the external auditors.
I have little faith in the ability of most independent auditors.
Respectfully,
Sam E. Antar (former Crazy Eddie CFO & convicted felon)
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