In previous blog posts (here, here, and here), I detailed Overstock.com’s SEC Regulation G violations and resulting overstatements of EBITDA in its second, third, and fourth quarter fiscal year 2007 financial reports. In this blog post, I will analyze the SEC Division of Corporation Finance’s review of noncompliant EBITDA calculations for two another companies: CGG Veritas (NYSE: CGV) and CKX Inc. (NASDAQ: CKXE). Afterwards, I will compare their similar noncompliant EBITDA disclosures to Overstock.com’s noncompliant EBITDA disclosures.
Before we begin, please note that Audit Committee member Joseph J. Tabacco Jr. was notified via email, Cc’d to the SEC, several times last year about Overstock.com’s SEC Regulation G violations and he acknowledged reading such emails by returning read receipts to me. Therefore, Overstock.com cannot claim ignorance as an excuse for violating SEC Regulation G and materially overstating EBITDA. In addition, in Overstock.com's response to certain inquiries from the SEC Division of Corporation Finance noted the importance of EBITDA in helping investors evaluate the company’s financial performance by disclosing, “A multiple of EBITDA is currently the most standard measure of valuation in the industry.”
Why did Overstock.com continue to violate SEC Regulation G and as a result overstate EBITDA in Q1 2008? As detailed in previous blog items (here, here, here, and here), on Friday, April 18, 2008, Overstock.com issued a blatantly misleading surprise earnings release intentionally timed with the expiration of options to manipulate the market (i.e., as a "short squeeze"). Apparently, Overstock.com’s callous disregard of SEC Regulation G and resulting overstatement of EBITDA is yet another act by the company in furtherance of CEO Patrick Byrne’s manipulative and vindictive self-described campaign to “knee the shorts in the groin….for fun and amusement.”
Patrick Byrne once said, "...I think 'EBITDA' is the stupidest thing I ever heard emanate from Wall Street (no small feat)...." Now, in contrast to Patrick Byrne's previous comments about EBITDA, Overstock.com misuses EBITDA in violation of SEC Regulation G to materially overstate the company's financial performance. Patrick Byrne's so-called "gold standard" in communicating "with candor" Overstock.com's financial performance to investors is nothing more than a ruse or a wall of false integrity built to fool gullible investors and Wall Street analysts into trusting the representations of the company's unprincipled management team.
Worst yet, two key company officers have dumped stock as the price Overstock.com’s shares have continued to rise after its materially misleading Q1 2008 earnings release. On April 23 and 24, 2008 Jonathan E. Johnson, Senior Vice President – Corporate Affairs and Legal unloaded 55,922 shares of Overstock.com common shares and pocketed gross proceeds totaling about $957,000 after lying to Wired.com magazine about the comparability of the company’s revenues in its Q1 2008 earnings report. In that recent earnings release, Overstock.com compared Q1 2008 GAAP revenues to Q1 2007 non-GAAP revenues without making an appropriate disclosure. Johnson claimed to Wired.com that Q1 2007 revenues were reported in compliance with GAAP when in fact they were not restated to conform to GAAP. On May 13, David K. Chidester, Senior Vice President – Finance sold 2,766 shares and pocketed gross proceeds totaling about $77,000.
The SEC Division of Corporation Finance has required CGG Veritas to properly report EBITDA in compliance with SEC Regulation G
Let’s examine the SEC Division of Corporation Finance’s review of EBITDA disclosures by CGG Veritas, and afterwards compare that company’s noncompliant EBITDA disclosures with Overstock.com’s noncompliant EBITDA disclosures. CGG Veritas, like Overstock.com, had improperly removed certain stock-based compensation expenses from EBITDA causing its EBITDA computation to be overstated. The SEC notified CGG Veritas that its EBITDA calculation in the company's fiscal year 2006 annual report was not in compliance with SEC Regulation G guidance:
Form 20-F for the year ended December 31, 2006 Operating and Financial Review and Prospects, page 37 EBITDA, page 55
1. With regard to your disclosure of a non-GAAP measure labeled EBITDA:
The acronym EBITDA refers specifically to earning before interest, tax, depreciation and amortization. However, your measure also adjusts earnings for stock option expense. We will not object to your using such a measure as a liquidity measure but request that you rename it to avoid investor confusion.
Your disclosure states that you provide this non-GAAP measure because investors use it to determine your operating cash flow and historical ability to meet debt service and capital expenditure requirements. As a measure of liquidity, therefore, your measure should be compared to the most directly comparable liquidity measure, which we believe would be net cash provided by operating activities as presented on your consolidated statements of cash flows.
Please comply in future filings. Refer to the requirements of Regulation S-K, Item 10(c). [Emphasis added.]
CGG Veritas responded to the SEC:
In response to the Staff’s comment, we will in future filings refer to the non-GAAP measure in question as “EBITDAS”, which we will define as “earnings before interest, tax, depreciation, amortization and share-based compensation cost”, and will reconcile to net cash provided by operating activities as presented on the Company’s consolidated statements of cash flows. [Emphasis added.]
Therefore, the SEC instructed CGG Veritas that EBITDA can only mean earnings (meaning net income or loss) before interest, taxes, depreciation, and amortization. No other items can be removed from earnings to compute EBITDA. If a company such as CGG Veritas and Overstock.com wants to remove stock-based compensation expense from its EBITDA calculation, such a non-GAAP measure cannot be called EBITDA.
The SEC Division of Corporation Finance was referring to Regulation G guidance provided by their "Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures" when they informed CGG Veritas that "EBITDA refers specifically to earning before interest, tax, depreciation and amortization." According to the SEC's Regulation G guidance:
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.” EBITDA can only be computed as earnings (meaning net income or loss) before interest, taxes, depreciation, and amortization and the SEC requires that “measures that are calculated differently than those described as…EBITDA in the adopting release should not be characterized as EBITDA.” That is, both CGG Veritas and Overstock should compute EBITDA starting from net income or loss and adding back only interest, taxes, depreciation, and amortization (there were no taxes for Overstock.com to add back).
However, in a direct violation of this requirement, CGG Veritas improperly used operating income rather than net income as the starting point in calculating its noncompliant EBITDA and furthermore improperly removed stock-based compensation from its noncompliant EBITDA calculation. Similarly, Overstock.com improperly used operating loss rather than net loss as the starting point in calculating its noncompliant EBITDA and furthermore improperly removed stock-based compensation from its noncompliant EBITDA calculation.
In the case of CGG Veritas, the company responded to the SEC by calculating EBITDA starting from net income rather than operating income and renaming their non-GAAP financial measure as EBITDAS or “earnings before interest, taxes, depreciation, amortization and share-based compensation cost.” In addition, since CGG Veritas considered its EBITDAS disclosure as a “measure of liquidity,” the company was required to reconcile it to net cash provided by operating activities as presented on the Company’s consolidated statements of cash flows.
Overstock.com continues to violate SEC Regulation G and overstate EBITDA
Meanwhile, Overstock.com continues to make two crucial errors in its EBITDA computations despite my email notifications to Audit Committee member Joseph J. Tabacco Jr. First, Overstock.com improperly reconciled EBITDA to operating loss rather than net loss, causing its EBITDA computation to be overstated by the amount of losses from discontinued operations. Second, Overstock.com improperly removed stock-based compensation expense from EBITDA causing its EBITDA computation to be overstated by the amount of stock-based compensation expense. See Overstock.com’s Q1 2007 and Q1 2008 EBITDA computations below from the company’s recent earnings release and 10-Q (Click on image to enlarge):
In Q1 2007, Overstock.com reported a $3.624 million loss from discontinued operations. However, since Overstock.com improperly reconciled EBITDA to operating loss rather than net loss, the company’s Q1 2007 EBITDA computation was materially overstated by at least the amount of its loss from discontinued operations or $3.624 million. In addition, Overstock.com improperly removed stock-based compensation expenses from EBITDA totaling $1.68 million in Q1 2007 and $1.339 million on Q1 2008 causing further material overstatements of EBITDA, too. Therefore, Overstock.com’s EBITDA was materially overstated in Q1 2007 by $5.304 million or 64.14% and in Q1 2008 by $1.339 million or 61.28%. See the charts below Click on images to enlarge):
Let’s examine the SEC Division of Corporation Finance’s actions regarding CKX Inc. and how that company complied with Regulation G in response to the SEC’s inquiry
Let’s examine the SEC Department of Corporation Finance’s review of CKX Inc.'s EBITDA calculations. Like Overstock.com, CKX reconciled EBITDA to “income or loss from operations” and similarly they both had losses from discontinued operations. As a result of using operating income or loss from operations rather than net income or loss as the starting point towards computing EBITDA, both CKX and Overstock.com overstated EBITDA by at least the amount of losses from discontinued operations. However, unlike Overstock.com, CKX Inc. did not improperly remove stock-based compensation expense from its noncompliant EBITDA calculations. The SEC notified CKX Inc.:
Reference is made to your presentation of the non-GAAP financial measure, EBITDA, in the table of your historical and pro forma financial information for the year ended December 31, 2004. We note that you define EBITDA as income or loss from continuing operations before interest expense, income tax expense (benefit), depreciation and amortization, and consider it to be an important supplemental measure of your operating performance which is used by management to evaluate the performance of the Company. However, it appears your definition of EBITDA does not comply with the guidance set forth in Question 14 of the “Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures.” Question 14 states that the term “earnings” is intended to mean net income as presented in the statement of operations under GAAP and further, measures that are calculated differently than those described as EBIT or EBITDA should not be characterized as “EBIT” or “EBITDA.” In this regard, please revise your calculation of EBITDA such that it is computed as net income (loss) (rather than income or loss from continuing operations) before interest expense, income tax expense (benefit), depreciation and amortization. Alternatively, if you believe your current presentation of your non-GAAP measure is appropriate, but has been characterized inappropriately as EBITDA, revise your presentation and supplementally tell us in detail how it complies with FR-65. [Emphasis added.]
Once again, the SEC reiterates how EBITDA must be computed by telling CKX to revise their "calculation of EBITDA such that it is computed as net income (loss) (rather than income or loss from continuing operations) before interest expense, income tax expense (benefit), depreciation and amortization." Any other calculation cannot be called EBITDA.
CKX responded to the SEC:
The Registrant has revised its presentation in the Summary Historical and Pro Forma Financial Data to include operating income before depreciation and amortization ("OIBDA"). All references to EBITDA have been removed. The Registrant has revised its disclosures to reconcile OIBDA to operating income which is the most directly comparable financial measure calculated and presented in accordance with GAAP. [Emphasis added.]Therefore, CKX renamed its noncompliant EBITDA disclosure as OIBDA or operating income before depreciation and amortization and the company was able to remove losses from discontinued operations from its non-GAAP financial measure.
What is the appropriate term for Overstock.com’s noncompliant EBITDA financial measure? Overstock.com, like CKX, improperly used operating loss as the starting point to compute its noncompliant EBITDA calculation. In addition, Overstock.com, like CGG Veritas improperly removed stock-based compensation expenses from its noncompliant EBITDA calculation. Perhaps Overstock.com's noncompliant EBITDA can be renamed OIBDAS or operating income or loss before depreciation, amortization, and stock-based compensation expense.
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. As detailed above, the SEC required CGG Veritas to reconcile EBITDA to net cash provided by operating activities, since CGG Veritas considered its EBITDA measure as a liquidity measure. Apparently, Overstock.com, like CGG Veritas, considered its noncompliant EBITDA as a liquidity measure and the company should have reconciled EBITDA to net cash provided by operating activities, too. Specifically, Overstock.com disclosed in its Q1 2008 10-Q:
…we believe that EBITDA is an additional measure of actual cash used or cash generated by the operations of the business. [Emphasis added.]
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." The SEC provides certain guidance depending on whether or not the non-GAAP EBITDA financial measure is intended to be considered a performance measure or a liquidity measure. If the non-GAAP 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.]
Therefore, if EBITDA is used as a performance measure, it should be reconciled to net income or loss as presented in the statement of operations under GAAP. 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, according to SEC guidance, "The three major categories of the statement of cash flows should be presented when a non-GAAP liquidity measure is presented." Overstock.com did not reconcile its noncompliant EBITDA to any of the allowable GAAP numbers. Instead, Overstock.com reconciled its noncompliant EBITDA liquidity measure to “Operating Loss.”
To be continued....
Written by,
Sam E. Antar (former Crazy Eddie CFO and a convicted felon)
Disclosure: Not long or short Overstock.com, CGG Veritas, or CKX Inc.
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