When MDC Partners released its year-end earnings report in February, 2014, the news was upbeat: record results that included growth in cash flow and profits. It was "another year of exceptionally strong performance for MDC Partners," the company's founder and CEO, Miles Nadal, said in a press release.
But that announcement would change MDC in ways few would realize. Within days, a whistleblower filed a complaint with the U.S. Securities and Exchange Commission, the top regulator of the New York City based company. Not long after, SEC staff began questioning MDC about the way it presented its earnings and accounted for its profitability. That led to a subpoena from the SEC, questions about compensation and pledges by Mr. Nadal to repay millions of dollars of his compensation.
Mr. Nadal, 57, resigned as chief executive this week, leaving the advertising conglomerate he created in 1986 and foregoing a multimillion dollar severance package. It was an ignoble departure for Mr. Nadal, a high-flying executive known for his lavish lifestyle who earned more than $70-million (U.S.) since 2011 and is well-known in Toronto for his charitable activities.
With new leadership and a public commitment to co-operating with the investigation, MDC may have reassured investors that the worst is over. Several analysts say the shares, depressed by all the bad news, are a buy. But a close look at MDC's presentation of its financial results reveals unusual accounting methods that call into question the company's financial health. Investors are left pondering; What, exactly, did Mr. Nadal build in all these years of running MDC?
Certainly, the headlines in the news release for the results of the 2013 fiscal year suggested a strong enterprise. The company reported "EBITDA growth," referring to earnings before interest, taxes, depreciation and amortization, of 33.1 per cent, to $159.4-million. "Free cash flow growth" was an even-more-remarkable 82 per cent, to $91.6-million. All that profit and cash-flow growth helped the company boost its dividend by 12.5 per cent.
It was only on page five that investors might have found that the company's 2013 bottom line, under generally accepted accounting principles, or GAAP, was a net loss of $148.9-million, up from a net loss of $85.4-million in 2012. Its operating loss, also calculated under GAAP, was just under $32-million, double the nearly $16-million operating loss of 2012.
While the size of MDC's net loss was unusual for the company, the general result was not. From 2005 to 2014, a period when the company was winning wide acclaim for its focus on acquiring successful, high-calibre advertising and marketing agencies, the company posted net losses in nine of those 10 years, according to Standard & Poor's Capital IQ. Only a $100,000 profit in 2008 offset what would add up to $444-million in losses in the decade.
Net income includes the interest expenses MDC pays on the debt it has incurred to build its empire; those figures, nearly $280-million in the decade, have helped swing the company to a loss. But on an operating basis, which excludes interest and taxes, the company is not terribly profitable: It has recorded an aggregate $299.5-million in operating profit on nearly $7.3-billion in revenue, an operating margin of just over 4 per cent. (Last year's operating margin of 8.5 per cent was, to MDC's credit, the highest of the past decade.)
Little wonder, then, that MDC prefers to emphasize EBITDA, which attempts to measure the earnings of a business independent of some of the decisions of its management. By stripping out interest, it equalizes companies that are highly leveraged, versus debt-free. By removing depreciation and amortization, EBITDA ignores the "sunk costs" of buildings and equipment that are already paid.
But MDC's problem, however, was how it chose to define EBITDA and other measures.
In May, 2014, the staff of the SEC's corporation finance division sent MDC chief financial officer David Doft a four-page letter with questions about the company's annual report and its earnings release. There is no assurance that the staff of corporation finance, which is separate from the SEC's enforcement division, was acting directly on the whistleblower's tip, nor is it certain that the subpoena that followed five months later related to any of the queries in the letters. (The company declined to comment on the SEC investigation and related matters, and Mr. Nadal did not respond to requests for comment).
The dialogue that ensued from May to September, however, reflected the SEC staff's skepticism about the appropriateness of MDC's disclosures. And it ended with MDC flatly refusing to change its accounting for cash flow, despite a number of queries and a conference phone call with SEC staff.
In that 2013 year-end release, MDC's EBITDA excluded not only interest, taxes, depreciation and amortization, but also stock-based compensation and acquisition costs. Those extra items were large: In the fourth quarter, for example, the company had just $6.4-million in depreciation and amortization, but $2.4-million in stock compensation and $27.6-million in what it called "deferred acquisition consideration adjustments." These are part of earn-out agreements or other post-acquisition payments to the owners of the firms MDC acquired.
MDC's calculation method took a $6.6-million operating profit, good for a 3 per cent margin, and boosted it to $43.1-million in EBITDA, a 19.8 per cent margin.
But the SEC's Carlos Pacho said in a letter to the company that "EBITDA" was not the appropriate term. "If you adjust such measure for items other than interest, tax, depreciation, and amortization, please revise the title to 'Adjusted EBITDA.'"
Its "free cash flow" metric excluded some operating items, the SEC said, "so we do not believe that it is appropriate to refer to this measure as 'free cash flows.' Please revise."
Mr. Pacho also told MDC there was a problem with the company's failure to present "the most directly comparable GAAP measures" alongside its preferred metrics.
He added: "Also, we note your reference to 'record results.' However, we note your GAAP loss from continuing operations and net loss. Please revise accordingly."
It sounds dry and nitpicky. But the presentation of earnings is returning as a hot topic at the SEC some years after it took its first corrective steps in the matter. In the 1990s tech bubble, and on through the 2001 Enron scandal, companies took advantage of the lack of a GAAP definition of EBITDA by presenting all sorts of adjusted earnings figures with that term. Wags joked that EBITDA was coming to mean "earnings before expenses" or "earnings before bad stuff."
The Sarbanes-Oxley Act of 2002 required the SEC to adopt rules to govern how companies used these non-GAAP measures. They were introduced in 2003 and included the requirements that the SEC suggested MDC had overlooked. In December, 2013, the chairman of an SEC accounting-fraud task force said it was looking at the use of non-GAAP measures. The Wall Street Journal called his comments "the first indication that the SEC is looking at these metrics with an eye toward possible enforcement cases."
In MDC's early responses to the SEC in 2014, the company quickly agreed to most of the agency's requests. It subsequently relabeled the metric "adjusted EBITDA" and agreed to highlight GAAP measures, including limiting the use of the phrase "record results" to those GAAP metrics. After a phone call with SEC staff, MDC agreed to stop using "free cash flow" and instead called the measure "Adjusted EBITDA Available for General Capital Purposes."
The company stuck to its guns, however, on an accounting treatment that serves to boost its reported operating cash flow. When MDC buys an advertising or marketing agency, it buys the future performance of the people who run it. MDC offers an upfront payment to the agency owners, then supplements it by paying the owners, who have typically become MDC employees, additional cash or stock when the agency meets or exceeds the earnings MDC expected.
That, to many people, looks like a form of compensation that belongs in the operating expenses of the company. And indeed, it is the "deferred acquisition consideration adjustments" – the extra payments for beating the expected earnings performance – that it stripped out when calculating EBITDA (and now removes from adjusted EBITDA).
MDC says the payments are more like seller-financed debt. So in the cash-flow statement, the company records these extra payments not as operating costs, but as financing costs. That serves to increase the company's operating cash flow.
SEC staff told MDC to reclassify those payments as operating expenses in the cash flow statement. After a phone call with staff, MDC refused, saying the accounting literature had no specific guidance on the matter and that it had found several other companies that treated these earn-out payments the same way.
It is these earn-outs, actually, that complicate net income for the company. When MDC buys an agency, it makes an estimate for what its future profit-based payments will be. If the agency's earnings are higher than expected, the payouts are higher than was estimated, and the company must book a higher expense, dampening profits. Conversely, if an acquired agency's earnings are lower than expected, the payouts are lower, and the company books a gain on the lower expense.
That is why the message from MDC has, for some time, been that GAAP earnings do not matter. "Our strategy is to maximize cash generation," Mr. Nadal told analysts in the fourth quarter of 2011, according to a transcript. "It has not been to maximize GAAP [earnings per share]."
But much of the cash that appears in MDC's preferred earnings measures is gone: From 2011 to 2014, the company paid $301-million in "acquisition-related payments," all recorded in the financing cash flows. Meanwhile, the net losses under GAAP have created negative retained earnings of $521-million as of March 31. The company's tangible book value – its tangible assets, minus its liabilities – is negative per share.
If MDC keeps up the kind of success Mr. Nadal trumpeted, those numbers will only get worse under his successors.