TIL: Today I Learned Something Disquieting About EBITDA & Non-Controlling Interests
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On the weekend I posted on our subReddit a disconnect I found on Cresco Labs as it related to EBITDA versus Net Comprehensive Income that accrues to CL shareholders. Check out the comments. I got a few nasty grams from folks that do not read the financials or the MDA.
The gist of my comments was… The starting point for any EBITDA calculation is Net Income but shareholders actually own/accrue Comprehensive Net Income not Net Income. So why is EBITDA not calculated based on what the shareholders OWN versus the Net Income figure, which may be less (significantly less in the examples I will show you) than what shareholders actually earned?
And when I surfaced the potential for an issue at Cresco Labs, I also knew that Aphria had a similar issue with their Aphria Diamond JV.
My issue is a shareholder for either CL or APHA (and a number of more companies) should not give a rat’s ass about any EBITDA that doesn’t accrue to the shareholder and goes to their JV partner. So, why are you using Net Income and not Comprehensive Net Income as the starting point for EBITDA calculation?
Consolidation be damned, tell me what accrues to the shareholder not to everybody that is sitting around the table including JV partners. JV partners get their own Net Income. What does the shareholder get?
Let us get to learning…
As mentioned, Net Income is the starting point for EBITDA, it is the “E”. From there you add back Depreciation/Amortization, Interest and Taxes. Any calculation after this point (“Adjustments”) deviates from defined terms for EBITDA under IFRS or GAAP. Adjustments are at management discretion. (I wrote an article about EBITDA and OPEX Burn/Generation awhile back if the reader needs more of a primer.) As soon as ANY Adjustment is made, management is required to put a disclaimer on the fact that Adjusted EBITDA is not an IFRS or GAAP defined term.
On the Income statement after you get to Net Income you must THEN deduct (in a single line item) the Net Income the JV(s) generated, and that gets you to Comprehensive Net Income Attributable to the Shareholder. The deduction is referred to as Non-Controlling Interest (or NCI). So, if the JV was profitable the Net Income of the Company YOU are invested in gets a deduction from Net Income to get to YOUR Comprehensive Net Income.
Under accounting rules once you have a controlling interest (+50% ownership and/or control via other mechanisms like voting) you get to consolidate the entities Revenue, Expenses, Assets and Liabilities at 100% into your Income Statement and Balance Sheet. The revenue net of all expense gets you to Net Income, which is the starting off point of EBITDA, it is the “E”. Net Income is also the “E” in Earnings per Share.
It is very important to understand that Consolidation is about what is controlled not what is owned. As an example:
A JV, partially owned by a pubco, has $100 million in cash and $100 million in equity on its balance sheet. The JV is owned at 51% and is controlled by the pubco. Shareholders to the pubco “owns” $51 million of the cash. When you look at the pubco consolidated balance sheet they will have $100 million in cash, $51 million in equity plus $49 million in Non-Controlling Interest.
But that $100 million in cash on Pubcos balance sheet is not fully available to the shareholders of the pubco. Disbursal of that cash is subject to the shareholders agreement which governs the JV.
Now if that JV has $300 million in revenue and $100 million in Net Income… On the income statement the full revenues and expenses of the JV are recorded at 100% to the pubco. As is 100% of the Interest, Depreciation and Taxes of JV are recorded at pubco. The $300 million in revenue less $200 million in expenses falls to the $100 million Net Income line of the pubco. Then $49 million is attributed to Non-Controlling Interest and the resultant Net Comprehensive Income to the pubco and its shareholders is $51 million.
Any positive EBITDA generated by the JV is not available to pay the debt nor taxes at pubco level. In order to get the surplus EBITDA out of the JV and up to the pubco a distribution would need to be made from the JV and that disbursement would come from the pubco’s 51%.
With EBITDA calculations start from the Net Income line versus Net Comprehensive Income line that surplus EBITDA is accounted at 100% from the JV despite the pubco and its shareholders only being able to access 51% of the surplus. Again, control/consoldiation versus ownership.
With that behind us, let us look at some examples.
Aphria February 28, 2021
I highlighted the NCI above and in the following:
The $47,452 for Aphria Diamond JV partner for the nine months lines up with the Income Statement YTD in Note 21. In the Feb 28, 2021 quarter alone, Double Diamond (APHA’s 49% Partner) portion of Net Income was $18 million. A nice chunk of change. How much of that is Adjusted EBITDA? If this was not IFRS, you could assume Adjusted EBITDA was higher than Net Income with the ITDA added back. However, Aphria Diamond likely has considerable Gain on Biologicals in the adjustments to Adjusted EBITDA. Hopefully, the switch to GAAP will provide more clarity.
Let’s look at Cresco Labs December 31, 2020 annual statement which is GAAP:
And the pertinent section of Note 11:
Cresco Labs, LLC (LLC) is owned by the founders of CL, whereas shareholders of the public company hold shares in Cresco Labs Inc. (British Columbia). These shares of LLC are transferring over time to CL (thus they have “control” despite owning less than 50%. See below).
Cresco Ownership Chart:
Cresco Labs Ownership %
The founders presently own 50.02% of Cresco Labs, LLC while Cresco Labs Inc. (the pubco), and their shareholders own 49.98%. The founders also have all those Super Voting Shares that Molly likes to talk about in “Structure & Current State”.
There are also lesser NCI’s in CL that generate + Net Income (two sets of two Illinois dispensaries under Med Mar). But given the nominal present amount, I will not be discussing same.
What stood out when I spread CL and Aphria is that the JV’s seem to do better than the parent company when it came to Net Income. Which got me to thinking…. Why does EBITDA not use what is attributable to the shareholder versus what is attributable to shareholders AND the JV partners?
Answer: Accounting Rules. The “E” in EBITDA stands for Net Income not Comprehensive Net Income.
Hey guess what? Earnings Per Share also uses Net Income (eg. before deducting the JV partners share of Net Income) and not Comprehensive Net Income. So, it is not really Earnings Per Share attributable to you the shareholder as moniker would presume, it’s the EPS of the consolidated entity that the pubco controls that is being reported. (I hope your mind was as blown away by the EPS calculation as mine was. Think about it, shares are owned by shareholders and EPS is generated from the control line of Net Income, which includes JVs with less than 100% ownership, and not the ownership line of Net Comprehensive Income.)
Why should you care?
If a company is telling you they are “profitable” because they showed an EBITDA of $50 million yet the partners (which you do not own) get a chunk of that, is it really reflective of the profitability accruing to the shareholder? It certainly is not. Nor is the EBITDA completely fungible and able to travel from JV to pubco. It is siloed until disbursed. And just because you have accounting “control” does not mean you have unilateral ability or authority to disburse money as you see fit.
Let us look at CL and APHA EBITDA calculation as if the starting point was Comprehensive Net Income versus Net Income.
Note: Cresco routinely has “adjustments” that I disagree with or I cannot track back to the financials and/or MDA. If a company wants to addback an item via “adjustments” I want to know what it is? Is it operational or not? Is it reoccurring or not? I am using my math for Cresco not theirs. If you want clarity on this, please review Quarter in Pictures. For Aphria, I balance back to their financials.
Well, ain’t that a difference! But what does it mean?
When we back out Net Income that accrues ONLY to the founders of Cresco Labs and not CL shareholders, EBITDA drops from a healthy 19% to 3%. CL has combined Interest and Taxes in the Dec. 31, 2020 Q of $25 million. Adj EBITDA is no longer sufficient to cover that. The financials of Cresco Labs Inc. consolidate those from Cresco Labs LLC, we do not get to see the financial statements of LLC.
For Aphria this is a little more precarious. When we back out Net Income that accrues ONLY to the Double Diamond and not APHA shareholders, EBITDA drops from a positive $13 million to a negative $6 million. I won’t even bring taxes and interest into this discussion as Aphria does not have a positive EBITDA when adjusted for NCI, and taxes and interest would be backed out of EBITDA in any event. I do know Aphria Diamond has a standalone loan that would have interest and principal payable by the JV.
Blue, get to the point!
I have always said investors CANNOT trust Adjusted EBITDA reported by a company because “adjustments” are subject to management discretion and each company has their own adjustments. But this opens a whole new can of worms. This is not an “adjustment” this is the starting point for EBITDA.
The Adjusted EBITDA calculation when NCI is not deducted slants to the favor of a pubco with profitable JV’s. They “report” a higher adjusted EBITDA despite the fact the shareholders relying on the information might not be getting 100% benefit accruing. You get to spread the JV’s Net Income out over your share base versus a bigger share base needed as if you owned 100% of the JV.
In CL case, the founders get a nice Net Income, at the expense of their shareholders until such time as 100% of Cresco Labs LLC shares transfer to CL. In F2020, the founders had a Net income of $43 million, while shareholders got negative $81 million. Does any of that Net Income get paid out to the founders? I cannot tell, which is my point. I am trying to find a public document that confirms this point.
In Aphria’s case, Double Diamond in the last Q had a Net income of $18 million, while Aphria shareholders got negative $385 million in Net Income. This could be a little more problematic as Aphria Diamond is a JV of the operating company versus Cresco Labs LLC being situated above some, but not all, of the operating companies.
In both cases the JV partner is making out considerably better that the pubco on paper.
Given that CL’s NCI for LLC, which is a rather big number, is above an operating company level and operating subsidiaries roll up into it, the surplus Net Income and EBITDA should be captured more so than if it siloed in a JV that reports up into it. So high NCI at LLC level for CL is less problematic as it is siloed between operating entities and pubco. However, I asked a CFO of a pubco if leakage in this type of arrangement to Adjusted EBITDA could still occur and was told “yes”. How much would simply be conjecture.
For Aphria and their shareholders this is a little different. Their big NCI generator is in an operational level JV, and unlike CL there is no agreement to transfer ownership over time. The surplus EBITDA generated from Aphria Diamond, if any, is siloed. The surplus, if one exists, could be applied to debt which reduces the 100% consolidated debt on Aphria’s balance sheet. But the surplus, without a distribution, is land locked within the JV and is not available to service debt at the Aphria level.
In the event of financial distress at CL or APHA will the JV send a portion of their Net Income back to help pay the bills? Again, where the JV sits in the operating structure will influence this. As does where the debt sits (and where any guarantors or co-borrowers reside) in the corporate structure. But if the JV has to bail out a parent entity … payments (over any % ownership disbursement) likely will not be without some value sent back to them in return.
I often say EBITDA is a metric/tool. It was established to compare peers across different tax regimes, debt to equity structures, and levels of PPE (and its resultant depreciation). It is used by bankers in financial covenants and as a proxy metric for debt servicing (eg. repaying interest and principal).
Unfortunately, Adjusted EBITDA is being used as a proxy by most public companies for profitability. They are using a screwdriver to hammer nails and the retail investor does not know the difference.
In conclusion, consolidated financial statements and the resultant EBITDA might not be conveying to shareholders what they own. I trust that you can see this in the two examples above. Future quarterly analysis with be including this for subscribers.
As always, understand how the numbers are generated and what risks are being included and excluded. If I were to invest in CL I would want more clarity on this item. As an existing investor in Aphria, this light turning on will have me cautious about adding to my exposure, especially with corporate level Aphria debt not able to access the full Adjusted EBITDA, if any, generated by Aphria Diamond.
TLDR: Shareholders are being mislead into thinking Adjusted EBITDA is 100% accruing to them. With NCI in the mix that could well be false. Earnings Per Share is also calculated for the consolidated entity AND NOT the shareholder of the pubco.
The preceding is the opinion of the author and is in no way intended to be a recommendation to buy or sell any security or derivative. The author has a position in Aphria and will not start one or divest in the next five days. The author does not have a position in Cresco Labs and will not start one or divest in the next five days.
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