Cash Flow Over Earnings as Debt Survival Test

“I started to rely on a single powerful metric, almost like blood pressure in a human, that I thought could instantly, accurately reflect the health of a cable operator: cash flow. The shorthand for this metric would become known as EBITDA—“earnings before interest, taxes, depreciation, and amortization” (and pronounced “ee-bit-dah”). That is, earnings before we deducted all those expenses to lower our tax bill. Robust, tax-sheltered cash flow became the lifeblood for early cable operators, enabling them to manage big upfront capital and operating costs, service their debt, and invest in growth despite the long timelines often required to achieve profitability.”

“I had always looked at the cable-TV business as being fundamentally different from other industries, and more akin to the real estate business, where you buy property and collect rent or lease payments in the form of monthly fees. It was obvious to me that if we were going to be measured on earnings, it would be real tough to stay in the cable industry and grow. We needed to promote a different metric to get investors interested.”

“Earnings might be unimpressive (and therefore the stock price low) but if there is a great deal of depreciation, for example, then cash flow can be high. And it is cash flow, in its ability to service debt by making interest payments, that makes a highly leveraged acquisition viable. In his original issuance of junk bonds, Milken had recognized the importance of cash flow, more than earnings, in assessing whether the leveraged companies he was underwriting would be able to meet their debt payments. Now that he had moved from $25 million offerings to multibillion-dollar deals, the calculation was not so different—just bigger.”

“Milken’s theory was that many companies don’t go broke on the operating-profit line; rather, it is often financial charges that kill them. If there were a way of reducing or removing those charges, these companies might survive and ultimately return to health. Drexel investment banker Paul Levy, who would come to specialize in this area, stated that its key is the concept of the “flexible balance sheet,” or adapting to a company’s changing needs. If a company is being choked by its interest-payment obligations, why not make those payments in common stock? Or why not just exchange the old debt paper for common stock, and eliminate the charges entirely? In this new-age finance, nothing is written in stone. “People used to issue bonds, and after twenty years they would repay them,” Levy said. “That’s hogwash!” The bondholders would tend to accept these offers, no matter how displeasing, because they would find themselves between the proverbial rock and a hard place. As Levy explained, these exchange offers are essentially an arbitrage. If a buyer purchased at par a bond which then came to trade at sixty cents on the dollar, he would probably be willing to exchange it for a piece of paper trading at sixty-five cents—especially if he thought his alternative was to be stuck holding the bonds of a bankrupt company.”