Thought Leadership Panel: What s the Matter with MLP Non-GAAP Metrics?

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1 Thought Leadership Panel: What s the Matter with MLP Non-GAAP Metrics? February 26, 2014 CFRA Julie Hilt Hannink, CFA JulieHilt.Hannink@cfraresearch.com Hedgeye Risk Management Kevin Kaiser kkaiser@hedgeye.com

2 companies manipulate financials Most commonly cited motivations to do so include: Manipulate Earnings for Internal and External Expectations Conceal Financial Deterioration and Bad Operating Decisions Inflate Stock Price Dress-up for Equity or Debt Financing Increase Executive Compensation 2

3 cutting corners is common Approximately 46% of global respondents in a recent Ernst & Young Fraud Survey agree that company management is likely to cut corners to meet targets* CFOs are even more pessimistic agreeing 52%! Total CFO Compliance Internal audit Legal 46% % Other Survey Findings When presented with a list of possibly questionable actions that may help the business survive, the survey also found 47% of CFOs felt one or more could be justified in an economic downturn Worryingly, 15% of CFOs surveyed would be willing to make cash payments to win or retain business and 4% view misstating a company's financial performance as justifiable to help a business survive % Tend to disagree % Strongly disagree % Tend to agree % Strongly agree 3 Source: Ernst & Young Fraud Investigation and Dispute Services, 12 th Annual Global Fraud Survey

4 and cooking the books is costly On average, firms lose 38% of their market values when news of financial misconduct is reported 100% 25% 9% 3% 62% Pre-Misconduct Reputation Loss Adjustment Loss Legal Loss Post-Misconduct 4 Source: The Cost to Firms of Cooking the Books, Jonathan M. Karpoff, D. Scott Lee, and Gerald S. Martin

5 manipulation techniques vary Majority of accounting irregularities involve revenue recognition (61%) and overstatement of assets (51%) 70% 60% 50% 40% 30% 20% 10% 0% 61% 51% Improper revenue Overstatement of assets recognition (ex. (ex. accounts receivable Fictitious revenues, overstatements due to recording prematurely) revenue fraud) Methods Used to Misstate Financial Statements* SEC alleged fraud involving 347 companies 31% Understatement of expenses/ liabilities 20% 18% Other miscellaneous techniques (acquisitions, joint ventures, netting of amounts, etc.) Disguised through use of related party transactions 14% Misappropriation of assets 1% Inappropriate disclosure (with no financial statement line item effects) Source: COSO 2010 Fraud Study; Fraudulent Financial Reporting ; An Analysis of U.S. Public Companies *Because the financial statement frauds at the sample companies often involved more than one fraud technique, the sum of the percentages reported exceed 100 percent. 5

6 and no industry is immune TMT and Consumer Business sectors comprised 37% and 29%, respectively, of total AAERs* from Alleged Fraud Schemes by Industry Identified in AAERs* ( ) 14% TMT 550 Technology Consumer Business Manufacturing % Telecom Media 59% Life Science and Health Care 122 Financial Services 120 Energy and Resources Real Estate Aviation & Transport Services Public Sector Source: Deloitte Forensic Center. Ten Things About Financial Statement Fraud third edition, *AAER = Accounting and Auditing Enforcement Releases by the U.S. Securities and Exchange Commission 6

7 non-gaap metrics abound SEC adopted new rules regarding non-gaap metrics as part of the Sarbanes-Oxley Act of Regulation G addresses disclosures in press releases and presentation while Item 10(e) of Regulation S-K addresses use of non-gaap metrics in SEC filed documents. Key requirements are: Presentation of most directly comparable GAAP measure Reconciliation to most directly comparable GAAP measure Formation of Financial Reporting and Audit Task force in 2013 with non-gaap metrics being a key concern. Many non-gaap items across numerous industries: Same store sales consumer companies/retail/restaurants EBITDA plethora of industries Distributable Cash Flow MLPs Concern over MLP non-gaap metrics: Apparent on-going SEC inquiry into LINE non-gaap items Definition and disclosure changes being seen at various MLPs 7

8 discussion Overview of MLP non-gaap Metrics Non GAAP Metrics EBITDA Adjusted EBITDA DCF Related Non GAAP Measures Distribution Coverage Ratio Excess Coverage Maintenance Capex Maintenance CapEx Definition Drawbacks: disclosure and transparency Potential standards DD&A : Irrelevant for MLPs? Partnership Agreement Metrics Available Cash Operating/Capital Surplus Cash from Operations Cash from Interim Capital GAAP Metrics Net Income Cash Flow from Operations Other MLP Issues Distribution cuts including IDR forgiveness Conflicts of interest Limited fiduciary duties good faith is maximum requirement Acquisition accounting Changes in disclosure and accounting methods SEC potential focus SEC Task Force: Enforcement vs. Corporate Finance SEC s concerns misrepresentations LINN inquiry: A watershed moment?

9 Client Services: (212) cservices@cfraresearch.com The content of this report and the opinions expressed within are those of CFRA. This analysis has not been submitted to, nor received approval from, the United States Securities and Exchange Commission or any other regulatory body. While CFRA exercised due care in compiling this analysis, CFRA AND ALL RELATED ENTITIES SPECIFICALLY DISCLAIM ALL WARRANTIES, EXPRESS OR IMPLIED, regarding the accuracy, completeness or usefulness of this information. and assumes no liability with respect to the consequences of relying on this information for investment or other purposes. In particular, the research provided is not intended to constitute an offer, solicitation or advice to buy or sell securities. CFRA s financial data provider for financial companies is SNL FINANCIAL LC. CONTAINS COPYRIGHTED AND TRADE SECRET MATERIAL DISTRIBUTED UNDER LICENSE FROM SNL. FOR RECIPIENT S INTERNAL USE ONLY CFRA, CFRA Accounting Lens, CFRA Legal Edge, CFRA Score, and all other CFRA product names are the trademarks, registered trademarks, or service marks of CFRA or its affiliates in the United States and other jurisdictions. CFRA Score may be protected by U.S. Patent No. 7,974,894 and/or other patents. If you have any comments or questions, please contact cservices@cfraresearch.com.

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