loss on warrant derivative liability

[gary17]

Hi, I was wondering if someone can explain to me, in very , very simple terms, what does "warrant derivative liability" and "loss on warrant derivative liability" mean in the income statement

 

Thanks

Gary

[Tim Eriksen]

If a company issued warrants as part of an acquisition, accounting policy required the change in the value of the warrants to be reported quarterly in the income statement.  Essentially the warrants are marked-to-market at quarter end.  If the company's share price went up in the quarter the liability went up.  If the price of the stock went down the warrant there can be a benefit. 

 

It seems stupid to me.  As it penalizes earnings when things are good, and benefits earnings when the the stock drops.  I ignore it since it is non-cash except for when it is material to diluted shares.

 

Here is an example for Contura Energy.  It also notes that FASB apparently issued a change in July 2017 regarding this.

 

On July 26, 2016 (the “Initial Issue Date”), the Company issued 810,811 warrants, each with an initial exercise price of $55.93 per share of common stock and exercisable for one share of the Company’s common stock, par value $0.01 per share.  The warrants are exercisable for cash or on a cashless basis at any time from the Initial Issue Date until July 26, 2023. For the period from July 26, 2016 to December 31, 2016, the warrants were classified within non-current liabilities in our Consolidated Balance Sheet as a derivative liability and were initially and subsequently marked to market with changes in value reflected in

earnings.

 

The fair value of the warrant liability for the period from July 26, 2016 to December 31, 2016 was estimated using a Black-Scholes pricing model, with changes in value reflected in earnings. The inputs included in the Black-Scholes pricing model used in the valuation of the warrants included the Company stock price, the stated exercise price, the expected term, the annual risk-free rate based on the U.S. Constant Maturity Curve, and annualized equity volatility. The annualized volatility was calculated by observing volatilities for comparable companies with adjustment for size and leverage. The annualized volatility as of December 31, 2016 decreased relative to the annualized volatility used as of the Acquisition Date due to improvement in the Company’s leverage ratio. However, due to significant increases in the Company’s stock price as of December 31, 2016 the Company recognized a cumulative mark-to-market loss on the derivative liability of approximately $33,975 recorded in other expenses within costs and expenses in the Condensed Consolidated Statements of Operations for the period from July 26, 2016 to December 31, 2016. As of December 31, 2016, the warrants derivative liability balance was approximately $35,141 classified within non-current liabilities in our Condensed Consolidated Balance Sheet.

 

During July of 2017, the FASB issued ASU 2017-11, which provided updates for Accounting for Certain Financial Instruments with Down Round features. Pursuant to ASU 2017-11, the Company’s warrants are considered equity instruments, eliminating the derivative liability treatment and the mark-to-market adjustment requirements. The Company early adopted ASU 2017-11 for the period ended June 30, 2017, with retrospective adjustments to the Condensed Consolidated Balance Sheet through an adjustment of approximately $33,975 to retained earnings as of the beginning of the current fiscal year for all prior

period mark-to-market adjustments and adjustments to the Condensed Consolidated Statement of Operations through the reversal of all year-to-date mark-to-market adjustments. Pursuant to the adoption of ASU 2017-11, as of June 30, 2017, the Company’s warrants value at approximately $1,161 are classified within additional paid-in capital in the Condensed Consolidated Balance Sheet.

[gary17]

Thanks Tim , much appreciated --

[Packer16]

This is also true of earn-outs.  You miss the target and you get an income gain from not paying out the earn-out.  This in part is why earnings are meaningless.  There is an interesting article in latest FAJ that shows that there is no correlation between stock returns and earnings misses or overperformance.

 

Packer

[gary17]

Thanks Packer, Tim--

On a related question -- so i often look at operating cash --  net income + depreciation + amortization  and then subtract cap ex that's needed to make the business competitive....  i think WEB called this "owner's earning"

 

would it make sense to add the loss on warrant derivative liability back?

 

I also see a lot of companies use "stock based compensation" which is also a non-cash item... should that be added into the owner's earnings calculation?

 

It's funny Warren talks about owner's earning, but I also believe I read he said don't use ebitda, use real GAAP earnings...  (I guess ebitda and owner's earning not quite the same, but they are both nonGAAP

 

TIA

 

Gary

[Tim Eriksen]

I add back the charge or benefit from warrant liability and adjust the share count (and cash from the exercise). 

 

Stock based compensation while not a cash expense is certainly real.  I would not add it back.

 

Buffett has always added back items that were non-cash due to accounting quirks such as intangible/goodwill amortization and presumably taxes when there is NOLs, in order to get owners earnings.

 

Buffett and Munger hate the use of EBITDA.  EBITDA is a whole different ball game since interest and taxes, except as noted above, are real costs, and depreciation is usually 100% real as well.  Only when depreciation clearly exceeds economic reality should any adjustment be made, and even then you have to be careful.     

[LC]

I add back the charge or benefit from warrant liability and adjust the share count (and cash from the exercise). 

 

Stock based compensation while not a cash expense is certainly real.  I would not add it back.

 

Buffett has always added back items that were non-cash due to accounting quirks such as intangible/goodwill amortization and presumably taxes when there is NOLs, in order to get owners earnings.

 

Buffett and Munger hate the use of EBITDA.  EBITDA is a whole different ball game since interest and taxes, except as noted above, are real costs, and depreciation is usually 100% real as well.  Only when depreciation clearly exceeds economic reality should any adjustment be made, and even then you have to be careful.   

In addition, depreciation usually understates true maintenance capex costs.

[gary17]

I add back the charge or benefit from warrant liability and adjust the share count (and cash from the exercise). 

 

Stock based compensation while not a cash expense is certainly real.  I would not add it back.

 

Buffett has always added back items that were non-cash due to accounting quirks such as intangible/goodwill amortization and presumably taxes when there is NOLs, in order to get owners earnings.

 

Buffett and Munger hate the use of EBITDA.  EBITDA is a whole different ball game since interest and taxes, except as noted above, are real costs, and depreciation is usually 100% real as well.  Only when depreciation clearly exceeds economic reality should any adjustment be made, and even then you have to be careful.   

In addition, depreciation usually understates true maintenance capex costs.

 

LC, can you please provide an example ? Like a very basic one -

thanks

[LC]

I add back the charge or benefit from warrant liability and adjust the share count (and cash from the exercise). 

 

Stock based compensation while not a cash expense is certainly real.  I would not add it back.

 

Buffett has always added back items that were non-cash due to accounting quirks such as intangible/goodwill amortization and presumably taxes when there is NOLs, in order to get owners earnings.

 

Buffett and Munger hate the use of EBITDA.  EBITDA is a whole different ball game since interest and taxes, except as noted above, are real costs, and depreciation is usually 100% real as well.  Only when depreciation clearly exceeds economic reality should any adjustment be made, and even then you have to be careful.   

In addition, depreciation usually understates true maintenance capex costs.

 

LC, can you please provide an example ? Like a very basic one -

thanks

Well, the general theory is that inflation will cause prices to go up. So when you're replacing some asset in the future, you will be paying more for it. Buffett wrote a really good article on inflation back in the 70s:

http://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/

 

For a practical example, take any company without growth capex and compare their annual depreciation vs. capex. Let me see if I can find a good example...

 

Ok found one. I just screened for companies with 5yr sales growth under 10% (i.e. not a lot of growth) and sorted by market cap. Walmart was #5 on the list. Take a look at the CF statement:

 

http://www.rocketfinancial.com/Financials.aspx?fID=4876&p=2&pw=160866&rID=3

 

Capex: -10,619.0 -11,477.0 -12,174.0 -13,115.0 -12,898.0 -13,510.0 -12,699.0 Depr.: 10,080.0   9,454.0   9,173.0   8,870.0 8,478.0 8,106.0 7,641.0

 

Generally capex has been higher than depreciation. Recently the gap is falling which could provide some insights (or not). I don't really follow Walmart but I don't see their business model changing drastically over the last few years, so my first guess is they are under-investing in their stores.