qoe-normalization

Quality of Earnings — Normalization

This skill governs the first-pass quality-of-earnings review of a target's historical financials. Its job is to establish a defensible normalized adjusted EBITDA — the earnings base the valuation multiple applies to — and to surface what is wrong, unverified, or unsustainable in the reported numbers.

What this is, and is not

In a real transaction, a confirmatory quality-of-earnings audit is performed by a specialist accounting firm with access to the general ledger, bank statements, and management. This skill does not replace that. It is a first-pass internal review from the historical statements and owner-provided facts, sized to inform a screening decision and to scope what confirmatory diligence must test. Say so in the output. Reported earnings are owner-provided and unaudited unless stated otherwise — label them that way.

Source-handling note (PDF / scanned financials)

Target financials in this segment commonly arrive as PDFs, scanned tax returns, QuickBooks exports, or photographed pages. Fable 5's document extraction is strong — ingest these files directly and tie every figure to its page/source — but treat extraction as not the same as verification, and keep the owner-supplied/unaudited label. Tie every figure in the bridge to a specific source (file name, page, line), preserve the owner-provided / unaudited label through every downstream number, and surface input problems rather than papering over them: cash-basis books, missing months, unsegregated COVID/ESSER relief income, commingled owner expenses, route-level revenue that does not roll up cleanly to the P&L. If a figure cannot be tied to a source, mark it Unverified and ask, rather than guess.

The adjusted-EBITDA bridge

The valuation multiple applies to normalized adjusted EBITDA, not to reported operating income or reported net income. Build the bridge explicitly, for every historical year, so the trend is visible and the most representative run-rate year can be identified.

The bridge runs:

Reported operating income
  + Depreciation & amortization        (non-cash)
  + Interest                           (a financing item; EBITDA is pre-financing)
  +/- Owner / officer compensation      (normalize to market-replacement cost)
  -  One-time & non-operating items     (remove)
  +/- Related-party adjustments         (normalize to market)
  = Normalized adjusted EBITDA

Every line is a labeled adjustment with a rationale. Do not collapse adjustments into a single normalized number — the bridge has to be legible to a reviewer who will challenge each line.

Owner / officer compensation normalization

This is usually the largest adjustment and the one most exposed to judgment. The reported owner compensation is rarely the right number, and it often swings year to year.

Do not simply delete owner compensation. Normalize it:

1. Identify the roles the owner actually performs. In a small student-transportation operator the owner commonly holds several — district relationships and contract renewals, general management, operations/dispatch oversight, safety and DOT/FMCSA compliance, HR and driver recruiting, insurance and benefits administration, sometimes shop/fleet oversight.
2. Cost each role at a market-replacement rate. What would the business pay an arm's-length employee to do each function? Anchor these to market compensation for the roles and the region.
3. Net against the owner's go-forward role. If the owner is staying on — for example, in a district-relationship or transition role post-close — that portion of their function is a real, continuing cost and is not added back. Only the excess of reported compensation over the market-replacement cost of the go-forward organization is the adjustment.
4. Present it as an assumption with its components shown. The reviewer and the owner must be able to see the role-by-role build, not just a net figure. Flag it explicitly for owner and diligence confirmation.

Add-back discipline — defensible vs. scrutinize

Build an add-back register and label every item. An add-back is defensible only if it is both non-recurring and verifiable. Everything else is scrutinize.

• Defensible — genuine one-time items (pandemic-relief income such as PPP forgiveness or unsegregated ESSER pass-throughs, one-time legal settlements, a non-recurring insurance recovery, a one-time gain on a bus or property sale), and genuinely discretionary owner perks run through the business that will not continue.
• Scrutinize — "pro forma" run-rate adjustments, claimed synergies (synergies are buyer value, not seller earnings — they do not belong in the seller's normalized EBITDA; the Summit insurance + route-density + procurement stack is captured separately in the integration thesis, not in the seller's standalone normalized base), items presented as one-time that recur across multiple years, and any adjustment that cannot be tied to a source.

Be conservative. An inflated add-back inflates EBITDA, inflates the implied purchase price at any multiple, and is the first thing a confirmatory QoE will cut. Erring toward "scrutinize" protects the analysis.

Revenue-quality scrutiny

Normalized EBITDA is only as good as the revenue under it. In contracted student transportation the target effectively is its contract book, so revenue-quality work is contract-book work. Assess:

• Recognition — how revenue is recognized, and whether the basis distorts it (see the cash-basis section below). Per-route / per-bus-per-day / per-hour contracts billed across ~180 school days; confirm escalators (~1-3%, occasionally to ~5%) and fuel pass-throughs are reflected as billed, not pro-forma'd in.
• District concentration — top-1 and top-5 district share of revenue. Heavy concentration is a risk flag and a repricing factor; for very small operators, a single-district loss can be terminal.
• Contract book vs. transactional — the split between multi-year district contracts (the contracted core — home-to-school routing, special-needs / IEP transport, McKinney-Vento) and lumpier transactional work (activity / charter / athletics, ad-hoc trips). The hierarchy is in the student-transportation-market skill.
• Contract-expiry waterfall and bid history — when each district contract expires (including +1/+2 one-year extensions on a 3-5 year base), and the net routes won/lost across the last 1-3 bid seasons. This is the cleanest single tell on portfolio health and pricing adequacy vs. cost inflation; ~95% sector renewal is the benchmark to test against.
• Relief-income segregation — ESSER pass-throughs, FEMA reimbursements, and PPP forgiveness must be identified and pulled out; if the books commingle them with route revenue, flag it and treat the affected years as Conflicting until segregated.
• Trend — the year-to-year revenue movement. A recent-year decline must be explained — lost a district at re-bid, route attrition, driver-shortage-driven service cuts, or end of relief funding — not passed over.
• Backlog — signed contracts and remaining contract years, and whether the implied run-rate is consistent with reported revenue.

Working-capital normalization

Review the accounts-receivable (district A/R, often slow-pay), parts/fuel inventory, and accounts-payable trend across the historical years and propose a normalized working-capital peg — the level of working capital the business needs to operate. This matters to the deal: the buyer funds a normalized level of working capital, and a peg set wrong moves real money at close. Note any unusual movement (a receivables build tied to a slow-paying district, a parts-inventory swing tied to a fleet refresh) and whether it is operational or a timing artifact.

Margin and expense analysis

Examine the gross-margin trend and scrutinize the operating expense lines, with attention to the lines that swing year to year — owner compensation, driver wages and benefits, fuel, maintenance and parts, insurance, depreciation, professional fees, yard/terminal rent. A volatile expense line is either a normalization candidate or a sign of inconsistent bookkeeping; either way it needs an explanation. Pay particular attention to driver wages vs. contract escalators (the central operating squeeze in the sector) and insurance (a primary day-one synergy lever for a strategic acquirer, but in the standalone numbers it is what the seller actually paid).

Maintenance capex disclosure

School-bus operators are maximally asset-heavy: buses run roughly $110-130K diesel and ~$300-400K electric, with multi-year useful lives, and the fleet must be continuously refreshed. EBITDA alone overstates cash earnings — EBITDA minus maintenance capex is the truer cash figure. Report both, disclose the maintenance-capex assumption explicitly, and flag it as a diligence item. (Comparable signal: NEXS sold at roughly 5x EV/EBITDA but ~50x EV/EBIT — the gap is depreciation, and depreciation in this sector is real, ongoing fleet replacement, not an accounting artifact.)

Cash-basis financials — flag, do not reconstruct

If the financials are cash-basis, or the company does not perform a hard monthly close, flag it prominently as a limitation. Do not reconstruct the statements on an accrual basis. State the specific distortions to expect:

• Revenue and expenses are recognized when cash moves, not when earned or incurred — so reported revenue and margin in any given year reflect collection and payment timing, not operating performance. District-payment timing in particular can distort year-end figures.
• Work that spans a school-year boundary (summer activity work invoiced in one fiscal year, paid in the next; July/August driver wages against a September route start) is the most distorted.
• Expense recognition can be lumpy for the same reason — a fuel pre-buy, an insurance renewal, a bus purchase.

Carry this caveat into every figure that depends on the financials, and recommend an accrual-basis review as a confirmatory-diligence item. The pipeline names this risk; it does not fix it.

Red-flag catalog

Surface, prominently, anything in this category — these reprice or stop a deal: district concentration (especially top-1); a declining revenue or margin trend without a clean explanation; net routes lost at recent re-bid without a strategic reason; safety/claims tail — accident frequency, at-fault trends, deduction or penalty history with districts, FMCSA rating trajectory (a final FMCSA "Unsatisfactory" / Out-of-Service Order is contract-existential); add-backs that do not hold up to scrutiny; owner dependence so deep the district relationships may not transition; related-party arrangements (owner-leased yard, owner-affiliated fuel or parts supplier) that are not at market; commingled or unsegregated relief income (ESSER, PPP, FEMA); cash-basis accounting without a hard close; and any inconsistency between the income statement, the balance sheet, and the owner's narrative.

Reporting public adverse facts (accidents, litigation, deduction history, FMCSA ratings) is legitimate corp-dev diligence — record them crisply and factually, keep caveats concise, and do not soften or omit them.

Output

A QoE Findings Memo: earnings-quality summary with the headline normalized adjusted EBITDA and the year it rests on; the adjusted-EBITDA bridge by year; the add-back register with each item marked defensible or scrutinize; the owner-compensation normalization with components shown; the revenue-quality assessment (contract book, district concentration, bid-season net wins/losses, relief-income segregation); the normalized working-capital peg; EBITDA minus maintenance capex alongside headline EBITDA; the accounting-quality limitations with the cash-basis flag prominent if applicable; and the red-flag and diligence list. Lead with the finding; this memo is the earnings basis for the valuation and the IC model.

A step is done only when concrete artifacts exist — the bridge file is written, every figure is tied to a labeled source, the add-back register is populated, the red-flag list names specific items — not when the analysis is asserted to have been performed. Self-assertion is not completion.

Worked example

A worked example (an illustrative / hypothetical mid-Atlantic student-transportation operator) is in examples.md in this skill's directory — load it if you want a concrete illustration of the bridge and add-back discipline. Treat the numbers as illustrative, not as a real Summit deal.