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Obvious but often overlooked

20/09/2016

We got much more feedback about this post than usual, especially from the analyst community. Here’s a typical response, making a good point about the impact from valuation: 

“Couldn’t agree more! Nothing is more frustrating than having to disect and reconstruct a UK SMIDcap Tech results release! No question in my mind that it leads to a valuation discount… comparability to US peers is always going to be key.”


If you are a European tech company, the simplest but most overlooked way to get the attention of US investors is to present your financials like a tech company. ‘Sounds obvious but it’s often not practised. What we mean, is that all the big tech companies, on both sides of the Atlantic, present their income statements using “functional expense” rather than “nature of expense” layout, as shown in the diagram. None use EBITDA as a financial KPI. So, if you don’t already, think about updating the way you present your numbers to break down one more barrier between you and your investors. Contact us if you’d like talk about this. 

Functional-expense layout income statements have been around for decades, and it baffles us that investment banks don’t push companies in this direction when European tech companies float on the stock market.

“Nature-of-expense accounting is well suited to retailers or widget makers, but doesn’t help much when analysing a business where the investment engine is people working on R&D rather than on a shop floor. How, the investor will ask, can you say you are a tech business without putting R&D on your income statement? It’s impossible if you display nature-of-expense because much of R&D is staff costs.

There are further problems for investors with nature-of-expense presentation, especially when coupled with IFRS and reliance on EBITDA as a financial KPI. As far as we are aware, EBITDA came to prominence in Europe in the 1990’s during the European telecom privatisation wave (perhaps it was earlier? Do let us know). It was used by equity analysts to strip out the effect of different fixed asset depreciation rates for this capital intensive industry, and became a pretax operating cash flow proxy.

Roll forward 20 years and it has permeated the mid-cap European technology industry. We are mystified as to why and generally find the reason given by banks and executives is “because everyone else does”. But EBITDA fails as an operating cash flow proxy for European tech companies because of capitalised R&D.

Capitalisation of development costs is common under IFRS accounting, Not all of R&D can be capitalised and it is anyway a subjective allocation. The two UK FTSE100 tech stocks, Sage and (until recently) ARM, choose not to capitalise R&D at all, stating that by the time a product is developed enough to be assured of future revenue, most of the development cost has been spent (see details in footnotes below).

Any capitalised R&D, or amortisation of that R&D, is not included as a cost in EBITDA. This inflates EBITDA but leaves us with a metric that doesn’t actually mean anything – it is neither the correct figure for operating profit, nor a proxy for operating cash flow. Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway is pretty forthright about EBITDA:

“I think that, every time you see the word EBITDA,
you should substitute the word ‘bullshit’ earnings.”

You will still find investors who are fine with EBITDA,  but maybe that explains why they don’t have Berkshire’s track record (see also our previous post on investor performance). US investors are, anyway, not used to capitalised R&D because it is uncommon under US GAAP.

It saddens us to see good companies present their numbers in a way that makes US tech investors think twice. Our recommendation, public or private, would be to move to functional-expense reporting, and if capitalising R&D, make sure that figure is prominently disclosed so that the full R&D expense can be easily calculated and compared with US peers.

The biggest push back we see to this disclosure is from accounting departments which aren’t set up to allocate expenses along functional as well as nature-of-expense lines. But if this is the case, you have to ask yourself how you can manage your technology business without knowing what is your total cost of selling, marketing, and R&D.

Related links
European IPO in the US – so last century
Why UK fund managers don’t get technology and what to do about it
Adjust your IR to attract foreign investors

Capitalised expense policies

ARM
The Group believes its current process for developing products is essentially completed concurrently with the establishment of technological feasibility, which is evidenced by a working model. Accordingly, development costs incurred after the establishment of technological feasibility have not been significant and, therefore, no costs have been capitalised to date
(Annual report 2014).

Sage
Generally, commercial viability of new products is not proven until all high risk development issues have been resolved through testing pre-launch versions of the product. As a result, technical feasibility is proven only after completion of the detailed design phase and formal approval, which occurs just before the products are ready to go to market. Accordingly, development costs have not been capitalised.
(Annual Report 2015)

Oakhall was established by top-rated equity research analysts to help CEOs and CFOs better analyse their own business and strategies, and articulate them to stakeholders. Founder Andrew Griffin spent almost two decades as a technology equity analyst, ultimately as managing director of European technology equity research at Bank of America Merrill Lynch, before working in investor relations, corporate development and market intelligence for a UK listed software company.