John Malone and the Invention of EBITDA
People with limited understanding of business think that business is all about making profits. But those who actually run businesses know that running a business is all about managing cash flows.
Capital Thinking · Issue #793 · View online
In 1972, a 32 year old man named John Malone was offered the top job at Tele-Communications Inc (TCI), a cable company.
He took charge on April Fool’s Day, 1973.
The Games People Play With Cash Flow
Here’s the deal: the link above takes you to the beginning of the article on cash flow (and really, the entire piece is worth your time), but you may want to skip down to the middle of the page and start here instead.
John Malone and the Invention of EBITDA
In 1972, a 32 year old man named John Malone was offered the top job at Tele-Communications Inc (TCI), a cable company. He took charge on April Fool’s Day, 1973.
At the time of his hiring, Malone was president of Jerrold Electronics, a division of General Instrument that supplied cable boxes and credit to the cable systems companies. He had been offered the Jerrold Electronics job when he was 29 years old, just two years earlier.
Before JE, he was at McKinsey Consulting. And before McKinsey, he had a job at AT&T’s famed Bell Labs, where he applied operations research to find optimal company strategies in monopoly markets.
Malone concluded that AT&T should increase its debt load and aggressively reduce its equity base through share repurchases — a highly unorthodox recommendation at the time. His advice was delivered to AT&T’s board and then promptly ignored.
Malone had been thinking about the interplay between debt, profit, cash flow, and corporate taxes for some time.
In 1972, when he was first offered the TCI job, he had already noticed a number of structural properties in the cable industry that piqued his interest:
- The cable industry had highly predictable subscription revenues. Cable television customers in the 60s — especially those in rural communities — were eager to upgrade to cable for better TV reception. These subscribers paid monthly fees and rarely cancelled.
- Cable franchises were essentially a legal right to a local monopoly, which meant that cable system operators had limited competition once it established itself in a given locale.
- The industry itself had very favourable tax characteristics — smart cable operators could shelter their cash flow from taxes by using debt to build new systems, and by aggressively depreciating the costs of construction. Once the depreciation ran out on particular systems, they could then sell them to another operator, where the depreciation clock would start anew.
- Most importantly, the entire market was growing like a weed: over the course of the 60s and into the start of the 70s, subscriber counts had grown over twentyfold.
Of course, Malone didn’t have much time to reflect on these observations. He landed at TCI and found the company at the brink of bankruptcy.
Bob Magness, the founder of TCI, had grown the company over the course of two decades using a ridiculous pile of debt — about 17 times revenues, at the time of Malone’s hiring.
Malone spent his first couple of years at TCI fighting to keep the company alive. He flew into New York every couple of weeks, hat in hand, renegotiating covenants and asking for extensions on debt repayments.
At one point during a meeting with TCI’s bankers, Malone threw his keys on the table and threatened to walk, leaving the company to the banks. The bankers capitulated, granting TCI a much needed extension.
Malone and Magness also had to worry about hostile takeovers, given TCI’s low stock price in the early 70s. They executed a series of complicated financial manoeuvres a year or so after Malone took over, placing a large chunk of stock in a holding company to grant them majority control.
Later, they created a separate class of voting stock. These moves gave them hard control of the company, allowing Malone the freedom to focus on righting its finances.
After three years of hell, TCI was finally pulled back from the brink of financial disaster. And then Malone got to work.
Malone understood a few things about the cable industry that many outsiders didn’t.
First, he understood that cable was like real estate: incredibly high fixed costs up front as you built or bought the systems, and then highly predictable, monopoly cash flows for a long time afterwards.
He understood that if he used debt to finance acquisitions, he could keep growing the company, and use the depreciation on acquired systems (plus the write-offs from the loans itself) to delay paying taxes on that cash flow.
Third, Malone understood that untaxed cash flows from all of those cable subscribers could be used to a) service the debt, b) pay down some of those loans — only when necessary; Malone wanted to keep the debt-to-earnings ratio at a five-to-one level — but more importantly c) demonstrate to creditors that TCI was a worthy debtor.
And finally, Malone understood the benefits of size: the larger TCI got, the lower the cost of acquiring programming (i.e. shows and programs), because it could amortise those costs across its entire subscriber base.
The problem was that Wall Street in the 70s and 80s didn’t get any of this. In 1986, brokerage firm E. F. Hutton refused to publish a report on TCI because “we don’t publish reports on companies or industries that don’t show a profit.”
And indeed, Malone’s strategy required TCI to show a loss for pretty much forever; for the next 25 years, it was never in the black.
Malone went on a charm offensive. He began talking to Wall Street analysts, explaining his logic.
To make his point, Malone created a new accounting metric, something he called ‘earnings before interest, depreciation, and taxes’, or EBITDA.
Mark Robichaux writes, in Cable Cowboy:
Through a combination of logic, jawboning, and sheer force of presence, Malone persuaded Wall Street to take a second look at the cable industry, long shunned because of its nonexistent earnings and heavy debt addiction.
Malone argued, successfully, that after-tax earnings simply didn’t count; what counted was cable’s prodigious cash flow, funding TCI’s continual expansion. Buying cable was like buying real estate. As the value of TCI’s franchises rose, so would the value of its stock. Net income was an invention of accountants, he declared.
Think about it, he’d tell a young analyst: Because TCI had high interest payments and big write-offs on cable equipment, it produced losses, and because it produced losses it paid hardly any taxes to the government. As long as cable operators collected predictable, monopoly rent from customers, met interest payments, and grew from acquisitions, why worry?
Malone liked the mathematics of it: Tax-sheltered cash flow could be leveraged to land more loans to create more tax-sheltered cash flow. A standing joke around TCI was that if TCI ever did report a large profit, Malone would fire the accountants.
Malone was, essentially, a hacker: he stared deeply at the thicket of accounting rules, tax laws, and possible business moves, and found a strategy that exploited the structural realities he found in front of him.
He was the first person to deploy this playbook rigorously, and TCI was amongst the first companies to start using EBITDA as a financial metric.
Malone made good on his promise. Over the next 25 years, TCI went from acquiring cable companies to acquiring and investing in programming channels.
It eventually became the largest cable company in the United States. It never turned a profit.
And the results speak for themselves: from the year that Malone took over, in 1973 to 1998 when AT&T finally bought it for $48 billion, the compound return to TCI’s shareholders was a phenomenal 30.3%, compared to 20.4% for its competition, and 14.3% for the S&P 500 over the same period.
Amongst business people and savvy investors, Malone’s logic dovetails with a famous saying: ‘cash flow is a fact; profit is an opinion’.
Even today, there are people who do not fully understand the games you can play with cash flow.
Or — more importantly — they do not understand the things businesspeople would do for better cash flows.
Cedric Chin
Photo credit: Sharon McCutcheon on Unsplash