Foreign What's up guys and welcome back to Wall Street Millennial On this channel, we cover everything related to stocks and investing 2022 has not been a great year for the stock market. Perhaps the single hardest hit investor has been Kathy Woods Ark Invest their Flagship arcade Innovation ETF has lost almost 70 percent of its value since the beginning of 2022. This was a stunning Fall From Grace. When the ETF peaked in February of 2021, it was one of the best performing funds in the market and amassed over 50 billion dollars in assets.

As the ETF continued to fall throughout 2022, the Talking Heads of the financial news media started criticizing her investment strategy and the large losses she incurred for her clients, most of whom are individual investors. The main criticism is that she buys stocks that she views as Innovative. With seemingly little regards to their financial performance or valuations. she created a portfolio of companies that are almost all losing money.

This became a recipe for disaster as the FED started increasing the cost of capital by raising interest rate. Instead of giving in to her detractors, Wood has doubled down on our strategy, buying more and more into money losing tech stocks. She says that old school investors are too obsessed with accounting metrics like profitability and cash flow. Traditional valuation methods fail to recognize the true value of her disruptive innovation stocks.

In fact, not only does she say her Innovation stocks are not overvalued, she goes so far as to say they represent deep value. Deep value refers to stocks that trade at very low price to earnings multiples. But how can this possibly be the case when most of her Holdings don't have any earnings at all? On December 1st, 2022, Wood wrote an article on the Arc Invest website where she explains what she means by this. She concedes that the vast majority of her stocks are reporting negative even off according to generally accepted accounting principles or Gaap.

Ebitda stands for earnings before interest, taxes, depreciation, and amortization and is widely viewed as a metric for core profitability of a company. On this metric, her portfolio looks like a disaster. However, she created a new metric called adjusted Ebitda. After the adjustments, the vast majority of the stocks are profitable and most of the are substantially profitable.

The problem with adjusted Financial metrics is that they are not standardized. 10 different analysts can make adjustments and you get 10 different results. So the adjusted numbers mean nothing. Unless you understand how they were calculated in this video.

We'll take a deep dive into how exactly Kathy Wood came up with her adjustment and judge whether or not they make any sense. There are five main adjustments that Kathy Wood makes to reported earnings numbers. Firstly, she adjusts the research and development expense as a percentage of Revenue down to the average for companies in the NASDAQ 100.. she makes similar adjustments for both sales and marketing expense as well as stock based compensation.

She strips out non-cash impairment charges. And finally, she treats deferred revenue as if it were actual. Revenue The idea is that early stage technology companies spend disproportionately large amounts on research and development compared to their current. Revenue The average company in the Arc ETF spends 29 of its revenue on R D compared to an average of 12 percent for companies in the NASDAQ 100.

These R D expenses will hopefully lead to new products which will generate Revenue down the line, but these revenues are in the future, so short-term profitability takes a hit. Would apply similar logic to sales and marketing expense. Her portfolio companies spend 33 percent of their revenue on sales and marketing almost double what mature tech companies spent like R D. Wood views this as an investment, not an expense because these sales efforts will acquire new customers which will generate Revenue in the future.

Arc Portfolio companies spend on average 23 percent of their revenue on stock based compensation more than seven times what NASDAQ 100 companies spent. She argues that stock based compensation is an investment used to attract talented workers and thus should not be treated as an expense. This claim is far more dubious. It's undoubtedly true that Tech startups use stock-based compensation to attract talent, but large established companies also need to attract Talent The main difference is that mature companies have abundant cash, which allows them to pay high cash salaries to their workers.

Early stage startups need to provide competitive salaries to attract high-skilled workers, but they don't have the cash to afford that, so they compensate by offering more generous stock based compensation. Just like central banks are theoretically free to print as much money as they want, companies are free to issue as much stock as they want. Of course, this does not come without a cost Shopify which is an Arc portfolio. Company has been losing money for years to conserve cash.

They've relied heavily on stock-based compensation, which is in large part responsible for the 50 increase in the number of shares outstanding over the past five years. This drastically dilutes the ownership Stakes of of existing shareholders. From a shareholder's perspective, it doesn't make a whole lot of difference whether employees are paid in cash or stock. It still represents a real economic cost.

Either way, the fourth adjustment she makes is stripping out non-cash impairments. For example, in March of this year, Teledoc took a six billion dollar impairment charge on Goodwill related to their prior acquisition of Livongo. This impairment loss is greater than the company's entire market cap. However, this was a non-cash impairment and did not have a real impact on the company's financial situation.

Excluding non-cash impairments is uncontroversial and most Financial analysts exclude them in most cases. While Wood's decision to exclude non-cash impairment charges was uncontroversial, her next adjustment is anything but. When calculating her version of adjusted ebitda, she treats deferred revenue as if it were regular. Revenue So what does this actually mean? Let's suppose you own a vacation home that you rent out on Airbnb Somebody books to stay in your house three months in advance and pays you the rental fee today.

The customer transfers you the money today, but you have not yet provided the service to them. Under Gaap accounting rules, this money you received is classified as deferred revenue and does not yet show up on your income statement. Even though you've already received the money, You only recognize the revenue once the customers have completed their stay at your Airbnb. Even though no money changed hands at the time, you recognize the revenue only when the good or service has actually been provided.

While this might sound like a mundane accounting technicality, the timing of when you recognize Revenue can have a huge impact on your reported profitability. And we'll see shortly why. Kathy Wood Wants to recognize deferred revenue immediately after applying Kathy Woods adjustments. almost all of Arc invests unprofitable companies magically appear to become profitable.

To see exactly what these adjustments do, we'll focus on one company Roblox which went from a 650 million dollar loss to a 600 million dollar profit by applying Woods adjustments. This chart shows Roblox's financial performance for the 12-month period ended September 30th, 2022 as reported on their audited and GAP compliant financial statements. During this period The Company generated about 2.2 billion dollars of Revenue after subtracting all their expenses and adding back their non-cash depreciation And amortization expense, they had gap ebida of negative 652 million dollars. Long story short, the company is losing money and a lot of it.

Now let's look at the same chart, but include Kathy Woods adjustments. As a disclaimer: Arc Invest has not published detailed calculations showing how they came up with their adjusted numbers. We did our own calculations based on the information provided in Kathy Woods article. So there may be a different between our calculations and theirs, but we try to be as rigorous as possible and our final results come very close to theirs.

After applying Wood's adjustments, Roblox made adjusted ebitda of positive 602 million dollars. This is 1.2 billion dollars more than their Gapy, but not so. where'd this money come from? Roblox has a massive R D budget representing 36 percent of its Revenue Kathy Wood Adjusted this down to 12 to be in line with the NASDAQ 100 average. Interestingly, Roblox's sales and marketing budget is very low, representing only five percent of Revenue.

This is probably because there is so much user generated content on platforms like YouTube that Roblox doesn't need to spend much on paid advertising. Roblox's sales and marketing expenditure is less than the average for the NASDAQ 100, so Woods adjustment acts unfavorably on them. Roblox spends heavily on stock based compensation Kathy Wood adjusts the stock based compensation expense downward. And finally, Roblox has a huge amount of deferred revenue, which would treats as if it is recognized.

Revenue Adding all this together, we get 602 million dollars of adjusted ebitda, or more than 1.2 billion dollars more than their Gap ebitda. However, once you dig down into the weeds Woods adjusted ebitda is so divorced from the economic reality as to be almost completely worthless. Wood makes adjustments to research and development, sales, and marketing, and stock based compensation to be in line with the NASDAQ 100 average. The problem is most of Roblox's stock based compensation expense is already allocated into research and development.

so she is double. Counting Stock based compensation is paid to employees who work in various Departments of the company. Thus, the stock based compensation expense for each employee is allocated to the department that he or she works for. In the case of Roblox, the majority of their stock based compensation is paid to employees who work in research and development.

So by adjusting down both the research and development as well as the stock-based compensation expenses, Kathy Wood double counted the adjustment. But perhaps a single, most egregious adjustment she makes is treating the 528 million dollars worth of deferred revenue as if it were already recognized. Roblox generates substantially all of its Revenue by selling the in-game virtual currency Robux to its users. Players can use these Robux to purchase in-game items such as skins for their avatars and tools they can use in-game Roblox Recognizes Revenue when the in-game items are purchased, which happens after the player purchases Robux However, it can take months or even years for a player to spend his or her.

Robux Because of this, Roblox almost always has a large amount of deferred revenue. a On the surface, it might look reasonable to treat deferred revenue as if it were already recognized. After all, Roblox gets the cash immediately upon selling the Robux. So what's the harm of recognizing the revenue when they receive the cash? But there are two big problems.

Firstly, Roblox distributes his products on third-party platforms, including the Apple App Store for the mobile version of its game. Apple charges a 30 fee for all in-app purchases, including the purchase of Robux. Some other platforms charge lower fees, but on average Roblox has to pay about 25 percent of its revenue for these types of fees. The second problem is that Roblox does not create games on its platform.

The games are created by third-party developers who receive 25 of the revenue. Thus, about 50 percent of the revenue that Roblox generates never reaches the bottom line. It instead goes to the distribution platforms like the Apple App Store or the third-party developers in Kathy Woods adjusted ebitdon metric. She recognizes the deferred revenue, but does not recognize the Deferred cost of Revenue or other variable expenses.

To see how ridiculous that is, imagine that you own an e-commerce store. You sell a product for ten dollars and give free shipping. The shipping costs you five dollars so you'll only get five dollars of net after your shipping expense. The customer pays you ten dollars in advance, but you have not yet shipped the product to increase your reported profit.

You recognize the ten dollars of Revenue but you do not recognize the five dollars it will cost you to ship the product. If you reported this on audited financial statements, this would be considered accounting fraud in the case of Arc Invest. These are non-gaap metrics, so they can do whatever they want with no legal ramifications. but there's a reason that Gap standards exist in the first place by pulling forward Revenue Without pulling forward the expenses associated with that Revenue You're painting a false picture about the company's financial performance.

Once you adjust for the double counting of stock based compensation as well as the Deferred cost of Revenue in the developers Revenue share, Roblox's adjusted ebitdot decreases to a negative 56 million dollars, this is still an incredibly generous number number. This is still applying the same logic that Kathy Wood lays out in her article. We are only adjusting for the most egregious and undefendable parts. If anything, the Gap ebitda loss of 652 million dollars is a far more realistic picture of Roblox's actual performance as both stock based compensation and research and development are real expenses.

And the results speak for themselves. With Roblox's share price declining by more than 60 since it went public last year, we use the example of Roblox because it is the most egregious example, but she applied the same flawed methodology to inflate the ebitda of all of her portfolio positions. Even after applying all of Wood's adjustments, seven of the portfolio companies are still unprofitable, including a few biotech companies DraftKings and Robinhood. For each of these seven companies, Wood gives an explanation as to why these stocks are still good, despite the lack of profitability for Robinhood She says quote Robinhood's stock based compensation ballooned at the end of its post-ipo lockup period.

unquote. She uses this to explain Robin Hood's lack of profitability, heavily implying that the company would be profitable otherwise, but this is complete nonsense. When calculating, her version of adjusted ebitda would already normalize stock-based compensation down to 3.2 percent of Revenue. The company's high level of stock based compensation is not even included in the adjusted ebitda, so it would seem that Wood doesn't even understand her own calculations.

The fact of the matter is companies like Roblox and Robinhood, as well as most of the other Arc portfolio companies are unprofitable. in an effort to make things look better than they actually are. Kathy Wood Resorted to applying increasingly unjustifiable accounting adjustments, which are completely divorced from economic reality at the current rate of cash burn, many of Arc's portfolio companies will go bankrupt within a few years, and with some of these stocks having lost more than 90 percent of their value, it will be very difficult for them to raise additional Capital Wood released this chart which shows how much cash your portfolio companies have on hand compared to their annual rates of cash burn and it doesn't look great. Of the 24 companies in her portfolio, 11 of them have less than four years worth of cash on hand.

One of her companies invite has less than 1.5 years of cash on hand. This means that if it doesn't raise additional capital or improve its profitability, within the next year and a half, it will go bankrupt. As a side note, the stock has declined by 97 since its peak, and with a share price of just 1.81 cents is Comfortably reached penny stock status, but I would expect nothing less from a Kathy Woodstock In a final attempt to quell investor concerns, Wood says that these companies can conserve cash by cutting back on sales and marketing research and development, and stock based compensation expense. This would extend their Cash Burn timeline.

With this statement, Wood exposes an egregious lack of understanding of basic accounting. Stock based compensation is a non-cash accounts. Even if you cut this down to zero, it would have no impact on the Cash Burn timeline. It is shocking that someone with seemingly zero expertise in Securities analysis can be managing more than 10 billion dollars of client assets.

Wood got lucky by becoming an early investor in Tesla which worked out for her in a big way, but ever since then her investing strategy has been a complete disaster which has cost her clients tens of billions of dollars worth of losses. Alright guys, that wraps it up for this video. What do you think about? Kathy Wood Let us know in the comments section below. As always, thank you so much for watching and we'll see in the next one! Wall Street Millennial Signing out.