Sprint Nextel: An Example of Why One Needs to be Careful with Book Values
This is pretty obvious for any vetern investors but it's a good lesson for newbies such as myself. Whenever one relies heavily on book value--most contrarian investors would--one needs to be really careful about what is contained in the book value. In particular, one needs to get their mind wrapped around goodwill and intangible assets on the balance sheet.
Intangibles and goodwill are a double-edged sword. The ideal investment, as Buffett has implied, would consist of mostly intangible assets. Among other things, having lower tangible assets generally means that you can expand the business without pumping much money into the business. You don't need to tie up billions building factories or rail networks, or whatever; and shareholder returns tend to be much safer during tough times. The intangible investments favoured by Buffett are consumer branded companies, who derive a huge chunk of their value from intangibles (brand names, secret formulas, patents, and the like.) Other industries such as investment banking or computer software have even less tangible assets but those do not fall into Buffett's play pen. So that's the good side of having high intangibles on the balance sheet.
One downside to having high intangibles or goodwill on the balance sheet is that it is hard to know what the true value of them are. Ok, so Coca-Cola is a very strong brand and about half of its balance sheet consists of goodwill and intangible assets. How does one know that the balance sheet values are representative of reality? How can one be certain that a high goodwill is not simply because management overpaid for acquisitions?
The other problem with intangibles and goodwill is that if the company goes bankrupt, those assets may not have much value. The brands may have a value to GM but half its brands may be worthless during a liquidation. This is why extremely conservative investors, such as Benjamin Graham, focused on tangible book value.
A very good example of the risk of relying blindly on book value is with Sprint Nextel (S). I had kept an eye on Sprint for almost an year now. Its stock price has contantly declined for years and it was trading at a really attractive pric-to-book-value ratio. But if one blindly bought Sprint last year due to its seemingly attractive book value, it would have been a disaster.
Sprint's problems are rooted with its takeover of Nextel a few years back. People tend to talk about the AOL-Time-Warner merger when discussing horrible mergers but the Sprint-Nextel one is a more typical one. As always there are two parties to a merger and one side may win while another loses. My comments on success or failure are based on the outcome of the combined firm. For instance, the AOL-TW merger was really good for AOL shareholders and it was a brilliant move by Steve Case of AOL. If it weren't for the merger, AOL would have been worth far less than what it was and might have even been on the verge of bankruptcy. The fact that Time Warner shareholders ended up looking like sheep that were fleeced kind of makes it obvious who the big losers were.
Like all bad mergers Sprint wrote down its Nextel investment as shown below:
If one simply looked at the book value of Sprint, they would have completely missed the big goodwill value ascribed to the Nextel merger. Almost 50% of the book value simply evaported in one day. What may have seemed attractive from a book value point of view turned out to be an illusion. So now you can see why some investors tend to focus on tangible book value (but as noted above, tangible book value completely misses the earnings power and strength of some companies.)
The difficulty is that it is not easy to figure out what the goodwill or intangible assets represent and whether it is overvalued. Of the numerous stocks mentioned on this blog, I have difficulties with two of them.
One of the tough ones for me is Torstar (TSX: TS.B), which is a newspaper company in Canada. I will note that what I say applies to nearly all media companies. If you strip out its strategic investments, almost half of Torstar's book value is in goodwill (there may be some slight differences in the accounting defintion of goodwill and intangibles between Canada and USA--not sure.) Will we see major writedowns in any of this goodwill? It's hard to say. Torstar may write down its investment in money-losing Transit TV but that's a small portion of the goodwill. How about the rest? Don't really know. You can see the difficulty. I'm still quite interested in this company, although the fact that the stock ran up almost 50% in the last month forces me to wait. My guess is that the stock will sell off in the future when earnings weaken or if the TSX continues to sell off and some poor, hapless, investor--almost always an overleveraged hedge fund or a poorly performing mutual fund--faces a margin call or redemptions.
Another company I have mentioned before is Sears Holdings (SHLD). Almost 40% of the book value is in goodwill and intangible assets, with around 10% in goodwill. I haven't looked deeply at Sears but it's not clear to me if any of this is overvalued and will be written off in the future. The difficulty with Sears is that a big chunk of the intangibles and goodwill is likely coming from their strong brands. Some of their brands, such as Land's End, seem to be quite strong so I don't see any impairments or writedowns related to them. But how do you know what they are really worth? It's hard to say. Its present price to book value is 1.1x but its price to tangible book value would be around 2.2x. (of course, some argue that items such as real estate are undervalued but my discussion here is simply to look at goodwill/intangibles.)
Intangibles and goodwill are a double-edged sword. The ideal investment, as Buffett has implied, would consist of mostly intangible assets. Among other things, having lower tangible assets generally means that you can expand the business without pumping much money into the business. You don't need to tie up billions building factories or rail networks, or whatever; and shareholder returns tend to be much safer during tough times. The intangible investments favoured by Buffett are consumer branded companies, who derive a huge chunk of their value from intangibles (brand names, secret formulas, patents, and the like.) Other industries such as investment banking or computer software have even less tangible assets but those do not fall into Buffett's play pen. So that's the good side of having high intangibles on the balance sheet.
One downside to having high intangibles or goodwill on the balance sheet is that it is hard to know what the true value of them are. Ok, so Coca-Cola is a very strong brand and about half of its balance sheet consists of goodwill and intangible assets. How does one know that the balance sheet values are representative of reality? How can one be certain that a high goodwill is not simply because management overpaid for acquisitions?
The other problem with intangibles and goodwill is that if the company goes bankrupt, those assets may not have much value. The brands may have a value to GM but half its brands may be worthless during a liquidation. This is why extremely conservative investors, such as Benjamin Graham, focused on tangible book value.
A very good example of the risk of relying blindly on book value is with Sprint Nextel (S). I had kept an eye on Sprint for almost an year now. Its stock price has contantly declined for years and it was trading at a really attractive pric-to-book-value ratio. But if one blindly bought Sprint last year due to its seemingly attractive book value, it would have been a disaster.
Sprint's problems are rooted with its takeover of Nextel a few years back. People tend to talk about the AOL-Time-Warner merger when discussing horrible mergers but the Sprint-Nextel one is a more typical one. As always there are two parties to a merger and one side may win while another loses. My comments on success or failure are based on the outcome of the combined firm. For instance, the AOL-TW merger was really good for AOL shareholders and it was a brilliant move by Steve Case of AOL. If it weren't for the merger, AOL would have been worth far less than what it was and might have even been on the verge of bankruptcy. The fact that Time Warner shareholders ended up looking like sheep that were fleeced kind of makes it obvious who the big losers were.
Like all bad mergers Sprint wrote down its Nextel investment as shown below:
If one simply looked at the book value of Sprint, they would have completely missed the big goodwill value ascribed to the Nextel merger. Almost 50% of the book value simply evaported in one day. What may have seemed attractive from a book value point of view turned out to be an illusion. So now you can see why some investors tend to focus on tangible book value (but as noted above, tangible book value completely misses the earnings power and strength of some companies.)
The difficulty is that it is not easy to figure out what the goodwill or intangible assets represent and whether it is overvalued. Of the numerous stocks mentioned on this blog, I have difficulties with two of them.
One of the tough ones for me is Torstar (TSX: TS.B), which is a newspaper company in Canada. I will note that what I say applies to nearly all media companies. If you strip out its strategic investments, almost half of Torstar's book value is in goodwill (there may be some slight differences in the accounting defintion of goodwill and intangibles between Canada and USA--not sure.) Will we see major writedowns in any of this goodwill? It's hard to say. Torstar may write down its investment in money-losing Transit TV but that's a small portion of the goodwill. How about the rest? Don't really know. You can see the difficulty. I'm still quite interested in this company, although the fact that the stock ran up almost 50% in the last month forces me to wait. My guess is that the stock will sell off in the future when earnings weaken or if the TSX continues to sell off and some poor, hapless, investor--almost always an overleveraged hedge fund or a poorly performing mutual fund--faces a margin call or redemptions.
Another company I have mentioned before is Sears Holdings (SHLD). Almost 40% of the book value is in goodwill and intangible assets, with around 10% in goodwill. I haven't looked deeply at Sears but it's not clear to me if any of this is overvalued and will be written off in the future. The difficulty with Sears is that a big chunk of the intangibles and goodwill is likely coming from their strong brands. Some of their brands, such as Land's End, seem to be quite strong so I don't see any impairments or writedowns related to them. But how do you know what they are really worth? It's hard to say. Its present price to book value is 1.1x but its price to tangible book value would be around 2.2x. (of course, some argue that items such as real estate are undervalued but my discussion here is simply to look at goodwill/intangibles.)
It's easy. You write down the intangibles to zero and use the resulting asset value less debt as the basis for your valuation. You probably also need to write down some inventory. As long as the company is pretty close the the adjusted book value you have a safe investment.
ReplyDeleteYeah, that's what's called tangible book value. But the problem with that is the following:
ReplyDelete(i) You won't find too many companies satisfying those conditions.
(ii) You will rule out really good companies that can generate a lot of earnings.
So the difficulty is not in ignoring intangibles; rather, it's putting a price on intangibles. Your idea is to put a price of zero on them. That's fine from an extreme safety point of view. But you clearly would have missed investing in Coca-Cola, American Express, Disney, Microsoft, or countless other success stories over the years.
I think writing down intangibles to zero is only "feasible" for small-caps. There are very few large-caps (except in some select distress situations) that trade anywhere near tangible book value. For example, S&P 500 price to book value is around 2.5 right now and my wild guess is that its price to tangible book is probably 4. That means the S&P 500 would have to drop by 75% to get close to tangible book value. Clearly this isn't going to happen to the index (barring a depression) and even distressed companies aren't anywhere near that.
Having said all that, your suggestion provides extreme safety and is worth pursuing in select distress situations.
Siravaram - That's a good reply!!
ReplyDeleteMy point is that if you're going to factor in the balance sheet then you should look at tangible book. Otherwise use another valuation method. If your analysis is based on assets and liabilities then they need to be real assets and liabilities otherwise use DCF or DDM (and glance at the balance sheet to check for unreasonable leverage).
The original posting was asking how to discount intangibles. My answer is - if you want to use a net asset value approach then zero. Otherwise use another approach that doesn't require a valuation of intangibles.
Microsoft, Coke, Pfizer etc wouldn't have been purchased based on any methodology that used the balance sheet as they are not useful methodologies for a real, cash generating, going concern.
Let's re-open this topic for discussion...it is now trading much below tangible book value.
ReplyDeleteGood idea but its balance sheet is of dubious nature. If you just look at tangible book value, it is negative!
ReplyDelete