Monday, January 4, 2010

Goodwill Hunting: How Good is Goodwill

Goodwill? When a company is purchased for more than its tangible book value then the accounting rules require the buyer to record the purchase price over the goodwill as an intangible asset called goodwill on the balance sheet and it is supposed to represent all the intangibles like trademarks, customer relationships etc. I don’t know why these accounting guys call it goodwill bcoz in fact all it does is mislead investors. Sometimes investors just don’t realize that they are also including this intangible while calculating the book value (yeh I admit, earlier I used to make this mistake). But further digging in the balance sheet reveals that sometimes most of the book value consists of goodwill and that’s the first warning sign. Even veteran value investor Michael price in his early days once failed to exclude goodwill from the book value. The story goes like this when he was working with Max Heine, another noted value investor, he came across a company, F&M Schaefer Brewing Company which was trading below book value. Michael was very excited about this and believed it to be a value stock. however Max heine advised him to look closer and so Michael called the guys at Schaefer to know more about the huge intangible stuff they had piled up on their balance sheet. He called and said "I am looking at your balance sheet. Tell me What does the $40 million of intangibles relate to?" to which the Schaefer guy replied "don’t you know our jingle, Schaefer is the one beer to have when you are having more than one."
Be highly skeptical of firms where a significant portion of book value consists of goodwill. Unlike inventories, accounts receivables, Property and other tangible assets goodwill is not an asset that can be readily sold or used to raise cash and therefore doesn’t give enough protection to investors in tough times.
Also a large amount of goodwill inflates the book value and if the management decides that the goodwill is somehow impaired then it would have to be written off and a substantial part of the net-worth would be wiped off in a single stroke. Eventually the write-off would lead to a violation of certain debt covenants causing a liquidity crisis.
Goodwill might be nothing but the desperation of a testosterone crazed CEO to expand his empire and boost his ego. Most acquisitions are overpaid and lack claimed synergies and ultimately they don’t work out.
In 1999 Worldcom had a market value of $125 billion and a book value of
$51 billion which almost entirely consisted of shares issued for acquisitions.
Around 85% of the book value was goodwill and the company was trading at 15 times its tangible net equity. So how did the company fare over the next few years? Well in the summer of 2002 it filed for bankruptcy. Why didn’t the intangibles save it from such a situation? Those weren’t valuable enough once the company found itself in a tight financial spot. It had piled up substantial amount of debt and couldn’t repay it. It just couldn’t use its goodwill to raise cash and repay its debt like it could have done with rest of its tangible assets.
Also the company didn’t have any moat to protect it from the fierce competition in the industry which didn’t allow it to generate adequate amount of cash flow to service its debt. In this case the goodwill essentially was of no advantage to the company.
In 2001AOL Time Warner had around $200 billion of assets of which $128 billion comprised of goodwill from the merger between AOL and Time Warner.
On the balance sheet it had around 64% in goodwill. Over the next few years much of this $128 billion goodwill was written off, which had finally shrunk to $37 billion. This shows that the company admitted that it overpaid for the merger.
So next time beware when you find lots of goodwill on your balance sheet. It might not be good for you.

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