Elekta: EBITA and R&D Capitalization

“My expectations were reduced to zero when I was 21. Everything since then has been a bonus.” ―Stephen Hawking

Expectations Not Met and Shares Down 25%

Elekta released its preliminary financial results last week and did not meet expectations. As a result the stock tock a hit, falling from around SEK 76 per share to SEK 55.55 per share, closing the week at SEK 59.

Skärmavbild 2015-05-17 kl. 12.22.25

Below a snapshot from the earnings release from Elekta dated May 13, 2015 (see here for complete version).

Elekta releases preliminary financial results

Preliminary full-year report May – April 2014/15

*Results significantly below guidance primarily due to weak performance in the US; large orders did not close as anticipated; delays in deliveries from order backlog.
*Preliminary order bookings came in at SEK 11,900 M (12,253), a decrease of 3 percent. Based on constant exchange rates the decrease was 13 percent.
*Preliminary net sales amounted to SEK 10,800 M (10,694), equivalent to an increase of 1 percent. Based on constant exchange rates the decrease was 8 percent.
*EBITA is expected to be approximately SEK 1,400 M, before non-recurring items.
*Preliminary cash flow after continuous investments amounted to approximately SEK 800 M (494).
*Niklas Savander has, with immediate effect, stepped down as CEO. Tomas Puusepp has been appointed as new CEO.

This post will take a look at Elekta’s earlier decision to change to EBITA for guidance, something I found out about when looking at annual reports, transcripts of earnings calls, and from doing a few Google searches.

The thing I have been thinking on, and still is, is if EBITA is the most useful measure or not? At the moment, I’m not really sure. What I know is that research and development (R&D) plays a crucial part, for maintaining and growing revenues. Also, a greater part of the total R&D expenditures are capitalized and amortized, instead of being expensed as incurred. So, amortization expense in this case seems to be a real economic expense. If R&D amortization is a real economic expense, why choose EBITA?

Switching to EBITA in Guidance

In the beginning of the annual report (see here fore annual report 2013/14) you’ll find two graphs, one showing the historical development in EBITA and EBITA-margin (before non-recurring items), the other showing the total return for the stock. Both graphs show a pretty good historical development in EBITA, EBITA-margin and total stock return, even if the rise in the total return seems to have been running at a higher rate compared to growth in EBITA.

Skärmavbild 2015-05-17 kl. 12.45.14

See image below for a comparison of margins for EBIT, EBITA and EBITDA. Profit margins have all increased and shown a pretty good path during the fiscal years 2004/05 and 2013/14 (the earnings release referred to above is for fiscal year 2014/15, that is the most recent year not included in the graph below).

Skärmavbild 2015-05-18 kl. 20.23.45

During the same time period amortization expense in the P&L has increased, see graph below. Depreciation has also increased, but at a much slower rate.

Skärmavbild 2015-05-18 kl. 21.35.54

A comparison of depreciation and amortization to sales shows that at the same time as depreciation has been pretty stable, amortization expense as a percent of total revenues has increased.

Skärmavbild 2015-05-18 kl. 21.43.51

Below is a conversation about the change to EBITA as a key metric for guidance. Remember that this conversation is taken from the Elekta Q4 conference call for fiscal year 2012/13 held on Wednesday the 5th of June, 2013 (Source: Seeking Alpha) (emphasis added). So, it’s about two years old by now.

Richard Koch – Kepler Cheuvreux

Hi, what is the reasoning for switching to EBITA in your guidance and what level of amortization do you expect in this current fiscal year?

Tomas Puusepp

Handing over to Håkan, Richard.

Håkan Bergström

Hi, Richard. I mean, the logic behind any sort of level of P&L and we can always discuss and obviously you will have all the insight, all the relevant levels anyway. Why we start to focus little bit more on the EBITDA is because we think it’s clear on the underlying performance of our business, particularly when we do the big R&D project and it’s also sort of correlates better to cash generation and cash flow.

The specifics on the amortization, of course we have a plan, but we are not disclosing that that is very closely linked to the R&D projects. But I think you can expect that to go up a bit as compared to this year. But we will give you a more flavor late when we have full visibility on the different projects, but particularly maybe there are more projects.

[…]

Kristofer Liljeberg – Carnegie Investment Bank

Yeah, good morning. Kristofer Liljeberg from Carnegie. First, a follow­-up on Richard’s question about EBITDA. Is your definition of EBITDA, do you adjust for all amortization of intangibles and not only acquisition-­related?

Håkan Bergström

All.

Kristofer Liljeberg – Carnegie Investment Bank

All, okay, and the guidance for EBITDA of 7% approximately reported, would that be for much if you were guiding for EBIT instead?

Håkan Bergström

On that – we are right now, I’d say it’s pretty much the same. We will get back if we need to.

[…]

Veronika Dubajova – Goldman Sachs

Good morning gentlemen. Veronika here and thank you so much for taking my questions. I have two, if I can. One, I want to clarify couple things on the R&D spend increase and what that means for EBITDA versus EBIT. So, Håkan, just maybe thinking about the increase that you are talking about in terms of the 10% of revenues, can I just confirm you are referring to the incurred costs there not what appears in the P&L? Is that correct?

Håkan Bergström

That is correct.

Veronika Dubajova – Goldman Sachs

Okay, perfect. I just wanted to make sure I was on the right page there. And if I look at where sort of you’ve been with amortization of R&D historically, would we see a significant change in the pattern in terms of what gets incurred – what gets expensed versus what gets capitalized? I mean, are the projects that you were taking on in this 20% increase more likely to be primarily capitalized than incurred?

Håkan Bergström

It’s always hard to forecast projects of this size as you hopefully are aware the R&D capitalization goes with tollgates. And, based on the tollgates you capitalize and obviously after that you amortize. I think for now, one shouldn’t expect any sort of major change in the pattern, obviously I mean, we are going to do more R&D. So it’d be more on both sides anyway. But I think we will need to get more clear to everybody going forward. But for now, I don’t think that should be the major concern.

Veronika Dubajova – Goldman Sachs

Okay, okay. And if you look at the growth in amortization year­-on-­year, 2013 versus 2012 was the increase primarily related to acquisitions or was it – can you split it out between acquisitions and R&D because if I look at your amortization…

Håkan Bergström

This is mostly R&D.

Veronika Dubajova – Goldman Sachs

Mostly R&D, okay. That’s very helpful. And my second question is on the North American margin, and I am just wondering if you think you can go back to the 37% here or there was 35% the new normal in the short, medium term?

Håkan Bergström

As I think almost explained, it’s also, I mean it’s not just North America, this is Americas as you see and obviously I mean, it’s a little bit of a difference. In North America, I mean, this is medical device tax, is not helping us in terms of margin. I think one can see even in sort of the South American improvement in the margin. So, at least I am cautiously optimistic on getting back to the level that we have seen.

[…]

Michael Jungling – Morgan Stanley

Thank you and good morning. I have a question on outlook and secondly on receivables factoring. Does the receivables factoring, when you do it, impact your gross profit? And then secondly on outlook, can you give us the following three guidance points?

If I look at the EBITDA starting point for the guidance, is it fair to assume that you’ve taken the EBIT of SEK2,012 million meaning including restructuring charges and then you are asking us to add back SEK211 million. So, therefore, the starting point for your EBITDA guidance is the number SEK2,223 million.

Then also on outlook on tax rate, can you give us some guidance for the fiscal year 2014? If I look at the fourth quarter it was quite a good tax rate. Is that abnormal or is that more of a guide going forward? And then also in outlook, can you give us an indication whether there’ll be any non-­recurring items that are in your guidance of 10% constant currency growth?

Tomas Puusepp

Hi, Mike, I’ll hand it over to Håkan. There is a few questions, it was little more than two.

Håkan Bergström

Yeah, I will answer two. Starting with, I mean, it sounded like you said, when you do the factoring on receivables, we tell you that we don’t do. So I think that is the question. But obviously if you have a cost related to the receivable, it’s typically done in the financials net, but as we don’t do it and I think that’s the answer.

And, you gave us bit of numbers and I sort of prefer that, I mean, we can do it with each of you, but we do it sort of individually to see what you compare with. But the operating result or the EBIT that we have for this year excluding then on recurring was SEK 2058 million.

I have an EBITDA number which I need to get confirmed to SEK 2.300, but we can go through that and confirm that that’s the one you should use. We can take that offline with each of you.

On the tax rate, there is quite a lot of activity, I mean, obviously within Elekta but also in different geographies. So the tax rate is going down. We expect around say, 23%, 24% for the current 2013, 2014 and around the 23% level.

But it’s actually is trending down. So, if we speak half year from now, we can have seen sort of some upside on that one. Non­recurring, the US lawsuit continues. We will see if that is material or not. I can’t really forecast whatsoever when it comes to that. If that continues, we probably will have that as a non-­recurring for the fiscal year.

Research and development

Also, I found a slide from CFRA Research about Elekta’s R&D capitalization, that shows that the capitalization rate of R&D has increased during Q3FY11 and Q3FY14. Click image below to enlarge.

Skärmavbild 2015-05-16 kl. 14.40.55

See here for full presentation.

So, the question to consider for investors is: Is EBITA really the most useful measure for a company with rising research and development and a higher capitalization ratio?

I’m not saying it’s not useful, the question is just “how useful”. Maybe EBITA is the best ratio to focus on (for management and investors), or maybe it’s not. And if EBITA isn’t the most useful measure, what measure should focus be on?

What do you think? Feel free to share your thoughts in the comment section.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments. 

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