In the alphabet soup of investment metrics, a new variant on EBITDA has appeared in some IFRS based company presentations – EBITDA-AL, with the ‘AL’ meaning ‘after leases’. But does the new measure make any sense? And why use EBITDA-AL rather than the established EBITDA or EBITDAR?
All ‘earnings-before’ measures create comparability issues, omit key components of operating performance, and should be interpreted with caution. We think EBITDA-AL is worse than EBITDA, which never was that useful in the first place. Better to use EBIT, EBITA or EBITDA-AMCE, where maintenance capital expenditure replaces D&A.
Many companies in the European Telecommunications sector use an EBITDA-AL metric to communicate with investors. The EBITDA portion is the usual earnings before interest, tax, depreciation and amortisation. The additional ‘AL’ means ‘after leases’, with the IFRS expenses related to capitalised leases deducted from EBITDA, even though, under IFRS accounting, these are classified as depreciation and interest.
EBITDA-AL may additionally include other adjustments for one-off items or non-operating components of performance. Terms such as ‘adjusted EBITDA-AL’ or ‘adjusted core EBITDA-AL’ may be used if further adjustment is included. However, some companies already define EBITDA-AL after further adjustment, but don’t use the terms ‘adjusted’ or ‘core’ to make this clear. As usual, with non-GAAP (non-IFRS) metrics, definitions and terminology vary and you should never assume these measures are comparable across companies.
The extract from the Deutsche Telecom 2021 results announcement below shows ‘adjusted EBITDA-AL’ as one of four performance metrics highlighted in the initial summary, the others being revenue, free cash flow and adjusted earnings. EBITDA-AL is preferred to other operating measures such as operating profit (EBIT), EBITDA or EBITA.
Deutsche Telecom 2021 results highlights
Deutsch Telecom 2021 results announcement
But why are companies using EBITDA-AL instead of the more common EBITDA, and why is EBITDA-AL less common in other sectors? For example, in the case of European airlines we could fine little evidence of if its use, even though there is significant leasing activity.
To understand EBITDA-AL we first need to consider the use of EBITDA metrics, how before IFRS 16 these were previously adjusted due to comparability issues arising from leasing, and now adjusted for the effect of lease capitalisation after IFRS 16.
EBITDA has been a common analytical metric for many years. It is used as a measure of performance, including in the form of an EBITDA margin and EBITDA growth, and in assessing leverage where debt or net debt is expressed as a multiple of EBITDA. The measure is also combined with enterprise value to produce the EV/EBITDA multiple. But why use such an incomplete profit measure (particularly when describing value) given that enterprise and equity values must reflect all expenses?
The easiest EBITDA adjustment to rationalise is interest. Profit before interest reflects operating performance attributable to all providers of capital and is unaffected by the capital structure of a business. This improves comparability, particularly when combined with invested capital in ROIC measures and enterprise value for EV multiples. Indeed, we have previously explained how this operating view, when applied in an enterprise value based analysis, is the best way to think about equity valuation.1See for example our article ‘Enterprise value: Our preference for valuation multiples’.
Generally, the reference to interest encompasses all financing and investing related gains and losses and not merely interest income or expense. The important thing to remember regarding financing and investing is consistency. What is regarded as non-operating, and therefore excluded from EBITDA, must be consistent with how invested capital and enterprise value are defined.2For more about enterprise value calculations and how to ensure EV is comparable with EBITDA see our articles ‘Enterprise value – Calculation and mis-calculation’ and ‘EV to EBITDA multiples must be consistent’.
Corporate taxes are a significant expense for almost all companies. Taxation can also vary over time and between companies, particularly across jurisdictions, which impairs the relevance and comparability of pre-tax profit measures. Ideally, to capture these effects, operating performance is best measured post-tax.
The difficulty for investors is that there is no analysis of taxation between that attributable to the operating and non-operating components of pre-tax profit. In our view, it is better for investors to approximate this disaggregation themselves and work with post-tax operating profit (NOPAT) rather than use EBIT and its derivatives. However, given that tax rates often do not vary significantly between companies, using pre-tax operating results in assessing performance, returns and value is usually not a great problem.
Before depreciation and amortisation
This is the part of the EBITDA calculation that is perplexing. The cost of purchasing and replacing fixed assets used in operating activities cannot be avoided, and measuring performance without deducting anything related to this activity is clearly incomplete. Different companies use fixed assets to a different extent (we use the phrase fixed asset intensity to describe this) such that EBITDA is not comparable across companies. This issue with comparability applies even within sectors where there may be differing use of assets. Some companies may outsource certain elements of their activities, with suppliers investing in the necessary infrastructure, whereas others perform these activities in-house and have the related assets on their own books. The same is true for leasing, which we address below.
You would expect differences in fixed asset intensity to affect the EV/EBITDA multiple. Because market prices (and hence enterprise value) should consider the ongoing cost of replacing fixed assets, comparing EV with a measure that is stated before this cost will lead to the multiple being affected by fixed asset intensity – higher fixed assets leads to a lower multiple.
Below we show a typical sector chart depicting EV/EBITDA relative to fixed asset intensity. While there is obviously more going on that explains the differences in EV/EBITDA, we think the influence of fixed asset intensity is clear.
Influence of fixed asset intensity on observed EV/EBITDA multiples
The data in this chart is taken from some old analysis we did on European retail stocks. We use it merely to illustrate the relationship between EV/EBITDA and fixed asset intensity that is commonly found in practice.
The effect of fixed asset intensity on EV/EBITDA can also be seen when deriving target multiples from underlying value drivers. In our target EV multiple model, we also apply a measure of fixed asset intensity equal to D&A/EBITDA to derive a target EV/EBITDA from EV/NOPAT (which itself is derived from an underlying DCF framework). Unlike the real sector data above, the theoretical relationship in this model is exactly linear because we separately control for other value factors.
EV/EBITDA multiples must always be interpreted considering the differences in fixed asset intensity between companies. However, we think this is far more challenging than calculating and using metrics that explicitly allow for differences in the use of fixed assets, which is why we have never favoured EV/EBITDA as a measure of relative value.
So why is EBITDA and EV/EBITDA so widely used despite the D&A issue? We think there are three reasons, none of which we think are particularly persuasive.
- Non-cash expense: A common argument for excluding depreciation and amortisation is that they are ‘non-cash’ and somehow less relevant as a result. While it is true that the expenses themselves are non-cash in the period they appear, they are not non-cash at all when viewed in the context of the full accounting cycle. Depreciation and amortisation are a recognition of the cash cost of fixed assets but which are just recognised in profit in the year the assets are consumed rather than when purchased. Focusing on the cash capital expenditure instead of depreciation and amortisation is understandable but ignoring both is not.
- An allocation of a sunk cost: Because depreciation and amortisation relate to past investment in fixed assets they can be regarded as sunk costs and not relevant in measuring current performance. It is true that, in some cases, depreciation and amortisation can be less relevant because they are backward looking. However, this is best corrected by adjusting D&A rather than ignoring the cost of fixed assets entirely.
- Accounting differences: Depreciation and amortisation charges are based on judgement and, to an extent, are affected by accounting policy choices. Some argue that this makes performance measured before these items more useful. However, many items in financial statements are subjective and affected by accounting policy choices. If all of these were excluded from profit, there would be little left.
We do not think any of these arguments are a valid reason to ignore depreciation and amortisation, even though in some cases adjustments to D&A may be warranted.
From EBITDA to EBITDAR
Leasing is an alternative to ownership as a way for companies to access fixed assets. Prior to the implementation of IFRS 16, most fixed asset leases had a very different effect on performance measures and EBITDA, compared with fixed asset ownership.
Pre-IFRS 16 there was no problem if leases were classified as finance leases (essentially those where the lease term was a substantial part of the asset total life) because these were accounted for in the same way as owned assets acquired through the issue of debt. This resulted in a capitalised lease asset and related depreciation charge, and a lease liability on which interest accrued. Whether an asset was acquired by purchase or alternatively, through a finance lease, EBITDA would be the same. However, this did not apply to operating leases.
Most leases pre-IFRS 16 were classified as operating leases with no lease capitalisation and the lease payment reported as an operating expense.3The expense was not always equal to the lease payments due for the period. The total lease payments were allocated, generally on a straight-line basis, over the lease term. This operating lease expense would not be added back in the EBITDA calculation, which resulted in comparability problems – companies that used more operating leases had lower EBITDA (all other things being equal). Because value is similarly affected by both asset ownership and leasing, excluding the cost of one and not the other distorted EV/EBITDA multiples. Higher use of leasing resulted in a higher multiple.
To resolve this comparability issue companies and investors turned to EBITDAR, with the ‘R’ referring to rents or the lease expense for operating leases. By adding back this component of operating expenses, EBITDAR excluded all costs related to fixed assets, whether owned, acquired through finance leases or acquired through operating leases.
However, while EBITDAR solved the problem of different companies having a different ownership / lease split, the fact that all costs related to fixed assets are excluded meant that the metric was even more incomplete. Different degrees of fixed asset intensity would still affect EV/EBITDA and make it difficult to use in equity valuation.
From EBITDA to EBITDA-AL
Under the IFRS 16 lease capitalisation model, IFRS reporters now show depreciation and interest accretion for operating leases instead of the previous lease expense that reflects the lease payments. Because both depreciation and interest are excluded from EBITDA, the introduction of IFRS 16 has, in some cases, significantly increased this metric and therefore resulted in a lack of comparability pre and post IFRS 16.4When IFRS 16 was first issued we explained the impact on key metrics, including EBITDA, and provided a simple model to illustrate the effects. See our article ‘Leasing: Are you prepared for IFRS 16?’.
However, considering that now EBITDA excludes the costs related to both asset ownership and asset leasing, the result is, in one sense, more comparable and it largely removes the need for the EBITDAR metric. We have seen EBITDAR still applied by some airlines, but the ‘R’ adjustment is now very small because it only relates to the rent for short-term leases and possibly some variable lease payments.
EBITDA-AL is an attempt to recreate the pre-IFRS 16 EBITDA metric.5Deducting the leased asset depreciation and amortisation does not correctly recreate the prior operating lease expense or replicate the prior EBITDA calculation. This is because depreciation plus interest does not equal the old operating lease expense – it does over the full life of the lease, but the timing differs, with the new total expense front-loaded relative to previously. Of course, companies could have used the old operating lease expense in their non-GAAP EBITDA-AL, but this would have meant maintaining two accounting systems, including continuing to classify leases as operating and financing. The depreciation and interest costs related to capitalised leases are an approximation of the prior operating lease expense. By deducting these in the ‘AL’ adjustment the resulting EBITDA-AL is like the prior EBITDA. The result still suffers from the lack of comparability due to different use of leasing relative to ownership of fixed assets, but at least this degree of incomparability is more consistent.
We dislike the post IFRS 16 EBITDA and EBITDA-AL for the same reasons we previously disliked the pre-IFRS 16 EBITDA and EBITDAR. To varying degrees, all these metrics ignore the cost of fixed assets and create comparability issues where there is a difference in fixed asset intensity or in the relative importance of leasing versus asset ownership.
We support IFRS 16 and believe this provides more relevant financial statements. It makes no sense to us to (partially) recreate ’old’ accounting.
A better approach
We think that the costs of fixed assets should be included in all metrics used in analysis and valuation. In a pre-financing or enterprise value context we would use EBIT, or preferably the post-tax version NOPAT. The metrics may be adjusted for the effects of one-off or unusual items but remember never to ignore these items of performance entirely.
However, we think that there are three ways in which EBIT and NOPAT can be improved:
1. Intangible amortisation
We have explained in other articles why some intangible amortisation is best excluded from performance metrics. The recognition of intangibles that are acquired in business combinations differs from those that are internally generated – acquired intangibles are capitalised but those internally generated are usually not. This results in double counting where profit is reduced by both the amortisation of acquired intangibles and the expenses related to their replacement.
Accordingly, we recommend that investors exclude the amortisation of ‘replacement-expensed’ intangibles. Sometimes this adjusted metric is called EBITA, although strictly the ‘A’ should only apply to part of the overall amortisation expense.6See our article ‘Should you ignore intangible amortisation?’.
2. Maintenance capital expenditure
We think that an even better approach to dealing with fixed asset intensity in performance metrics and valuation multiples is to use current capital expenditure rather than the potentially out of date depreciation and amortisation. The relevance of D&A in valuation is that it is a proxy for the cost of replacing fixed assets (maintenance capex). However, current D&A may not always be a good proxy. This is partly due to the intangible amortisation problem we identify above, but there can be other factors that may mean that the future cost of replacing assets differs from the D&A expense, including the effects of inflation.
Few companies disclose maintenance capex, even though this is a suggested (non-mandatory) disclosure under IFRS accounting. Estimating it can be challenging and often using the D&A amount (adjusted to remove replacement expensed intangible amortisation) is the best approximation.7 It was this approach that we used in estimating the maintenance capital expenditure of Amazon in our article ‘Amazon free cash flow: An update’. Nevertheless, we think that EBITDA after maintenance capital expenditure (EBITDA-AMCE) is the ideal approach to measuring performance and the best metric to combine with enterprise value in a valuation multiple (EV/EBITDA-AMCE)
In the case of leasing, capital expenditure is a non-cash item because new leased assets exactly match the new lease liability, with both items netted to zero for cash flow purposes. Nevertheless, lease capex is very real and must be included in any maintenance capex figure in the same way that lease capex should be included in free cash flow and DCF models.8For more about ‘effective’ lease flows and how lease capital expenditure should be dealt with in DCF analysis see our article ‘DCF valuation models: Have you updated for IFRS 16?’.
It is rare to see companies use maintenance capital expenditure in place of D&A. However, we have seen companies deduct the total capital expenditure from EBITDA. This produces a metric that is partially a profit measure and partially cash flow. The problem is that including investment or expansion capex in a measure of performance results in an artificially lower figure if growth and investment is higher. It is for this reason we prefer to deduct only maintenance capex.
3. Opco-Propco analysis
Operating performance that incorporates the cost of fixed assets can also be measured using an Opco-Propco approach. This involves a business being split into an asset ownership component (Propco), and an operating component (Opco) that uses those assets. Opco pays a hypothetical charge to Propco to access the assets, with operating performance measured net of this rent expense – in effect EBITDA-ANR, where ‘ANR’ is ‘after notional rent’.
The Opco-Propco approach has the added advantage of promoting greater comparability where companies access assets using different structures, such as use of ownership, long-term leasing or short-term leasing. This difference is reflected in Propco, the risks and rewards of which can be analysed separately, whereas Opco becomes more comparable, with a clearer focus on operating performance.
The measure EBITDAR has previously been used to promote comparisons where asset ownership and leasing structures differ, notably in the Airlines sector. In our view, EBITDA-ANR would be a preferable approach, particularly after lease capitalisation.
We have previously discussed Opco-Propco analysis in the context of property assets, but the methodology can equally be applied to other ‘strategic’ assets, such as airplanes. For more about the approach and how it helps promote better operating comparisons and more meaningful valuation multiples see our article ‘Real-estate and equity valuation – Opco-Propco analysis’.
Adjusted EBITDA and adjusted EBITDA-AL
When companies give EBITDA or EBITDA-AL, it will generally be an adjusted figure from which various non-recurring, or unusual items are excluded. This often applies even if the metric is not actually described as ‘adjusted’.
Here is how French telco company Orange describes their version of EBITDA-AL:
“EBITDAaL (EBITDA after Leases) corresponds to operating income (i) before depreciation and amortization of fixed assets, effects resulting from business combinations, reclassification of translation adjustment from liquidated entities, impairment of goodwill and fixed assets, share of profits (losses) of associates and joint ventures, (ii) after interest on lease liabilities and on liabilities related to financed assets, and (iii) adjusted for significant litigation, specific labor expenses, fixed assets, investments and businesses portfolio review, restructuring programs costs, acquisition and integration costs and, where appropriate, other specific items.”
Orange 2021 non-GAAP measures
When companies use these metrics to describe performance in comparison with prior periods it is understandable that attempts are made to enhance comparability. Removing one-off items or otherwise volatile components of performance, that may not be indicative of the underlying trend, helps in this regard. However, the result is an even more incomplete measure that is likely to be less useful as a basis for valuation.
We have previously supported non-GAAP disclosures on the basis that the separate identification of adjusting items provides investors with additional disaggregation, and hence a better basis from which to forecast. But this only works if the adjustments are clearly identified and quantified. The problem with the version of EBITDA-AL provided by Orange is that the adjustments are opaque, even after allowing for the additional explanations that are provided by the company, including in the accounting policy section of the annual report. Adjusting for “specific labor costs” and “other specific items” does not help investors.
Insights for investors
- EBITDA and similar metrics are incomplete and may not be comparable between companies, nor are they a suitable basis for valuation.
- EV/EBITDA is particularly affected by fixed asset intensity – a greater importance of fixed assets automatically reduces the multiple.
- EBITDA is now more comparable where companies make differing use of leasing, largely removing the need for EBITDAR.
- EBITDA-AL effectively re-creates the pre-IFRS 16 EBITDA but also recreates the prior lack of comparability.
- It is better to allow for the cost of owned and leased fixed assets in metrics used to assess performance and value. We favour EBITA and EBITDA after deducting maintenance capital expenditure … EBITDA-AMCE.
- Be aware that most EBITDA type metrics are also adjusted for additional ‘unusual’ items. This may improve comparisons over time but the further lack of completeness, particularly where adjustments are opaque, may not help in valuation.
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