SuperModels Community
Join the discussion in the MSN Money SuperModels Community.
|  | | Price | 13.170 | | | Change | +0.160 | |
Research Wizard
Add to MSN Stock List
Message Board
|  | | Price | 24.920 | | | Change | +0.110 | |
Research Wizard
Add to MSN Stock List
Message Board
|  | | Price | 2.090 | | | Change | -0.050 | |
Research Wizard
Add to MSN Stock List
Message Board
Related sites
Kellogg 10K (This is an RTF file. It may open in your browser -- if not, you can save it to your machine and open it with Microsoft Word.)
| | SuperModels
20 stocks in the path of a 'goodwill asteroid'
New rules are changing how companies write down goodwill -- the premium they paid when buying other companies -- and a lot of earnings will take a catastrophic hit.
By Jon D. Markman
One of the gravest fears of investors today is being totaled by an asteroid event -- moments when a stock gets pushed to the edge of extinction by a bolt from the blue, such as a drug application rejection, a securities probe revelation or a surprise earnings restatement.
Yet many shareholders seem blithely unaware that at least one asteroid speeding toward their companies is entirely foreseeable: the likelihood that management will have to write down a decent-sized chunk of their net worth sometime this year and perhaps rather soon.
This unfortunate prospect is faced, potentially, by companies such as AOL Time Warner (AOL, news, msgs), Allied Waste Industries (AW, news, msgs), Georgia-Pacific (GP, news, msgs) and Cendant (CD, news, msgs) that have accumulated a great deal of goodwill on their balance sheets over the past few years. Thats accountant-speak for the amount a company pays for another company over its book value because of expectations that some of its intangible assets -- such as patented technology, a prized brand name or desirable executives -- will prove valuable in a concrete, earnings-enhancing sort of way.
New accounting rules
Companies carry goodwill on their balance sheets as if it were an asset as solid as a piece of machinery and, thus, is one of many items balanced against liabilities such as long-term debt to measure shareholder equity, or book value. Just as hard assets are depreciated, or expensed, by a certain amount each year to account for their diminished value as they age, intangibles have long been amortized by a certain amount annually to account for their waning value.
The value of machinery rarely dissipates quickly, but the value of goodwill can evaporate in a flash if a company determines that it paid too much for intangible assets -- e.g., if a patent or brand turns out not to be as defensible as originally believed, or demand for a new technology falters. As you can imagine, companies typically dont want to admit they overpaid. But once they do, they must write down the vanished value so that the "Intangibles" lines on their balance sheets reflect fair-market pricing. If the write-down leaves a companys assets at a level lower than liabilities, the company is left with a negative net worth, which, as you would expect, is frowned upon, and often results in a dramatically lower stock price.
Until last year, companies tried to avoid recording goodwill after acquisitions by using a method of accounting called pooling of interests. In these stock-for-stock deals, companies were allowed to record the acquirees assets at book value even though the value of the stock it had given up was greater than the amount of real stuff its shareholders received. The advantage: No need to drag down earnings each quarter by amortizing, or expensing, goodwill.
The rulebook changed this year, however, and pooling went the way of the dodo; now companies are forced to record goodwill on their books. As a compromise to serial acquirers, who have a powerful lobby, the Financial Accounting Standards Board (FASB) decided companies would no longer have to amortize goodwill regularly against earnings. Instead, a new standard -- encompassed in Rule 142 -- requires companies to test goodwill for impairment periodically.
Essentially, this means that while the diminished value of goodwill wont count against a companys earnings annually anymore, companies might need to write down huge gobs of it from time to time when accountants decide they cant ignore the fact that an acquisition didnt turn out as planned. It also means that, because FASB 142 does not dictate a set of strictly objective rules for calculating impairment, write-downs will be somewhat subjective in both timing and amount.
Don't fall for these 3 ploys
Many market skeptics therefore believe that FASB 142, which was intended to improve earnings transparency, may in some cases actually result in more egregious earnings manipulation than ever. Donn Vickrey, vice president at Camelback Research Alliance, the supplier of StockScouter ratings to MSN Money, says he sees three ways that companies interested in managing their earnings could end-run shareholders utilizing the new rule:- The big bath. In this approach, companies will write off a big portion of the goodwill on their books, telling investors it is an insignificant paper loss that should have no impact on the firms share price. The benefit: Future write-offs would be unnecessary and the companys earnings stream could be more effectively smoothed out in future periods. This approach would work only if it does not put the company at risk of violating debt covenants that require it to maintain a certain ratio of assets versus liabilities.
- Cosmetic earnings boost. Under FASB 142, many companies will record earnings that appear higher than last year because of the elimination of goodwill amortization. However, the increase will be purely cosmetic, as the companys underlying cash flow and profitability would remain unchanged. Investors should thus ensure they are comparing prior periods with the current period on an apples-to-apples basis by eliminating goodwill amortization from comparable year-earlier financial statements. The amount might be buried in footnotes to the balance sheet, though Kellogg (K, news, msgs) explains the issue clearly in its latest 10K in the section devoted to its acquisition of cookie maker Keebler in March 2001. (See link at left.) Kellogg says it recorded $90.4 million in intangible amortization expense during 2001 and would have recorded $121 million in 2002 had it not adopted FASB 142 at the start of the year.
- Avoid a write-off. Some companies might take advantage of the new rule by avoiding a goodwill write-off as long as possible to prevent the big charge to earnings. Since the tests for impairment are subjective, Camelback believes it will not be hard for firms to avoid write-offs in the short run -- a strategy that could both help them avoid violations in debt covenants and potentially provide a boost in executive compensation formulas.
While any public company that does acquisitions will find itself facing decisions about how to account for goodwill impairment, companies with the greatest absolute levels of goodwill -- as well as ones with the greatest amount of goodwill relative to their market capitalization -- will be the most vulnerable in the future to having their earnings blasted by the FASB 142 asteroid.
20 stocks to watch
To identify these firms, we asked Vickrey to screen his S&P Computstat database to find 10 representative mid-cap or large-cap companies in each category. All amounts for goodwill and book value were determined through each companys most recent fiscal year end.
Table 1 shows companies with the highest absolute levels of goodwill. Vickrey notes that in general, companies in the table are either serial acquirers or had completed major acquisitions in the latter stages of the bull market. As a result, he said, it is highly likely that they will need to record an impairment of their goodwill within the next year. To date, he adds, only AOL Time Warner has done so. And interestingly, even after its $54 billion write-down of goodwill related to the Time Warner acquisition, the level of goodwill at the company puts it at the top of the list. (The goodwill level in the table does not reflect the $54 billion charge. Goodwill through March 31 is $80.2 billion).
| Table 1: Companies with the highest absolute level of goodwill | | Company name | Ticker(s) | Goodwill (millions) | Goodwill as a % of book value | | AOL Time Warner | AOL | $127,424 | 84.00% | | Tyco International | TYC | $29,791 | 93.90% | | General Electric | GE | $28,287 | 51.60% | | AT&T | T | $24,675 | 47.70% | | Berkshire Hathaway | BRK.A | $21,407 | 36.90% | | Raytheon | RTN | $12,298 | 101.20% | | Northrop Grumman | NOC | $8,668 | 112.00% | | Allied Waste Industries | AW | $8,557 | 487.60% | | Georgia Pacific | GP | $8,265 | 168.50% | | Cendant | CD | $7,978 | 112.90% |
|
Table 2, below, shows the 10 companies with the highest levels of goodwill relative to their book shareholders equity, or book value. In each case, tangible net worth is negative -- so these companies have a lot less room to maneuver if they determine that the value of goodwill is impaired. Vickrey notes that any significant write-offs would likely result in a negative balance in stockholders equity and could result in adverse changes to their debt ratios -- an event which, though non-fatal, makes lenders very grumpy. Thus, he contends, these companies have a greater incentive to avoid a write-down for goodwill impairment.
| Table 2: Companies with the highest relative level of goodwill | | Company name | Ticker | Goodwill (millions) | Goodwill as a % of book value | | Fisher Scientific International | FSH | $507 | 2177.70% | | Allied Waste Industries | AW | $8,557 | 487.60% | | Crown Cork & Seal | CCK | $3,625 | 450.90% | | Amphenol | APH | $460 | 443.00% | | Argosy Gaming | AGY | $727 | 408.70% | | Unilab | ULAB | $91 | 384.90% | | Equifax | EFX | $516 | 212.00% | | Kellogg | K | $3,070 | 352.20% | | AdvancePCS | ADVP | $1,282 | 316.00% | | AmeriGas Partners | APU | $497 | 244.00% |
|
FASB 142 requires companies to make their first reassessment of the value of goodwill within the first six months of their fiscal year. So for companies that report on a calendar year and face the potential for reporting impairments, the next month and a half could get very interesting. Marc A. Siegel, an analyst at the Center for Financial Research and Analysis, says that old-line industrial companies such as Allied Waste (AW, news, msgs) and Crown Cork (CCK, news, msgs) -- could have a big problem if impairments push them into negative net worth.
I will put all of these companies on a SuperModels watch list and report back over the rest of the year.
Fine Print
Quick update on stocks and portfolios of recent columns: On April 3, I recommended 10 stocks for six-month holds based on high StockScouter ratings. Theyre up 2.2% since, versus a 3.3% decline in the S&P 500 ($INX) and 4.6% decline in the Nasdaq Composite ($COMPX). Top two performers are Fortune Brands (FO, news, msgs) and Cemex (CX, news, msgs), up 14.8% and 8%, respectively; worst performer is Roxio (ROXI, news, msgs), down 12%... Electronic Data Systems (EDS, news, msgs) hasnt gone anywhere since my April 10 column on its earnings quality woes -- still in the mid-$50s. OfficeMax, recommended by value manager Thomas G. Kahn in my Feb. 13 column, has shot up 87% since. 3Com (COMS, news, msgs), another Kahn recommendation, hasnt fared quite as well, but is still up 4%. WorldCom is up 20% since the close of the day it got kicked out of the S&P Many sports bettors wrote in to comment on my Vegas column published on May 8. Said self-described professional sports bettor Garet Bradford: On any given day on CNBC you will see some guy in an expensive suit telling you his stock pick of the week and the whole world waits on every word as like he is some kind of god. Yet if you see someone in my business telling you his pick of the day, he is looked down upon as a scammer and a low-life. Its a double standard. Also received over 100 comments on my May 15 piece about analysts. Said one Merrill Lynch private client manager, who asked not to be identified: You have some valid points. I have worked at Merrill for almost 20 years. Our high net-worth team years ago endorsed an open investment strategy for our $500 million under management --[our choices] are not based on ML research or in-house products unless they pass the objective muster. It is sad that our private client division has to continuously bear the consequences of our capital market division's ups and downs over the years, such as rogue bond traders, Orange County, Long Term Capital Management and now this stupid analyst thing. Long ago I thought one of the wisest cost-cutting programs Merrill could do would be to get rid of all these analysts and provide all the private client financial advisors a subscription to Barrons, and a Bloomberg. I figure it would save the firm about $800 million.
While Jon Markman cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to 7jonmail@microsoft.com.
|
