Goodwill write-offs likely to increase

The Globe & Mail has a good article on goodwill write-offs that are occuring. The details depend on the accounting standards of a particular country but I believe what is covered in the article applies to both Canada and America. It's a really good article for newbies like me who aren't that focused on accounting and regulatory changes. Let me quote some of the points that I felt were insightful.


What is goodwill?

Near the middle of the article, the following definition of goodwill is given:

While goodwill is a fuzzy concept, in strictly balance sheet terms it represents the gap between the fair value of an asset and the price its owner paid to acquire it. When a company acquires assets at a price above their fair value, the excess is recorded as goodwill - the implication being that the asset's prospects for future growth in cash generation justify the premium paid, and thus have value in themselves.

I like to think of goodwill as the premium paid to acquire assets in the past. Management and investment banks who cut the deal will say the premium was worth it but the cynic in me says that management tends to overpay for assets so the goodwill is almost always a loss. Historically, goodwill hasn't mattered much. In fact, if you read some of Benjamin Graham's writing, you'll get the feeling that Graham didn't care much for goodwill. Over time, the nature of industry has changed so goodwill has become more prominent. Mergers & acquisitions seem far more common in the last few decades (I need to double-check this) and a lot of valuable assets of modern industry are intangibles that are hard to value (so it's easy to overpay for them.) For instance, the technology and pharmaceutical/biotech sectors are a big chunk of America's economy. One can see how easy it is to overpay when buying, say, an online company or a biotech firm with very litle tangible asset and everything based on future prospects.

Value investors and certain contrarian investors rely on book values heavily. If you are one such person, it is important to always check to see if goodwill (as well as intangibles in some cases) are a big portion of the book value. This is especially important when someone is screening for stocks. One popular screen is to look for stocks trading at, say, 66% of book value. It makes a huge difference if most of the book value of a company trading at 2/3 of book value consists of goodwill.


Goodwill write-offs will increase

In the last few years, the accounting regulators were not only introducing mark-to-market accounting; they also seem to have passed rules requiring changes to the way goodwill is written off.

Goodwill writedowns typically accelerate during bear markets, as companies adjust their assessment of the cash-generating potential of assets purchased during better times to reflect the new, much less rose-coloured reality. But this time around, goodwill charges are headed for unprecedented heights, because regulators changed the rules governing the accounting for goodwill since the last bear market.

Before 2002, companies were required to amortize goodwill on their books annually, so it would eventually shrink to nothing over time. In 2002, U.S. and Canadian accounting regulators decided to allow companies to carry goodwill perpetually on their balance sheets, but required them to run an annual test to determine if there were any underlying change in valuations that had undermined those goodwill estimates, known as a goodwill impairment.

If warning indicators crop up in between annual impairment tests - such as a sharp drop in market value, or a serious deterioration in business conditions - regulators have directed companies to test immediately to see if a goodwill writedown is required.

I don't think this change is a boondoggle like mark-to-market accounting. I think the goodwill change actually makes sense, whereas the mark-to-market accounting change mainly makese sense to those that worship the God of Efficient Markets. Goodwill will be written off to zero regardless of the scenario. What is new is that it may be abruptly written off due to changes in fair value (most notably the collapse of share prices.)


Companies involved in M&A vulnerable

Companies that were big players in M&A in the last few years will likely write off most of their goodwill:

Compounding the rule change is the fact that during the 2002-07 bull market, companies routinely paid big premiums for acquisitions. Now, many of the growth assumptions that justified those premiums have been turned on their heads, as market values collapsed and economic prospects withered.

This has left many companies carrying goodwill on their books that hasn't been depreciating and, over the space of a few months, has rapidly become impossible to justify.

"If you made an acquisition in the past two or three years and you expected that business to keep growing, or if you paid with your own shares and they have gone down, that could indicate an impairment of goodwill," Ms. Parsons said.

As usual management and investors bankers who justifed most of the deals say that this all a non-cash charge. However, I think it paints a negative picture of past actions. For instance, one of the negative things about Expedia, a stock I am tracking, is their questionable purchases in the last few years. Assuming the present management was largely the same as before, how can passive shareholders be certain that management won't be buying overvalued assets and destroying wealth again? (On a side note, some of Expedia's purchases are fine from a strategic point of view. The ones that pay the price are past or existing shareholders, not the new ones assuming future purchases won't occur at wildly overvalued prices.)

Others share my concern about goodwill write-downs:

Financial executives argue that the writedowns are non-cash charges that don't reflect on a company's operations. But analysts warn that the implications may be more severe.

By definition, a goodwill writedown reflects a permanent impairment in an asset's future cash flow potential, which could imply a risk to dividends. Analysts warn that the writedown of assets may put at risk debt covenants and hurt a company's ability to raise funds, and that it also amounts to an admission by management that it overpaid to acquire assets.

"I would argue that if you're holding the stock [of a company with high exposure to goodwill], you should be concerned about it," said Peter Gibson, vice-chairman and strategist at Desjardins.

So to sum up, goodwill write-downs may accelerate in the future. The most vulnerable are those that paid very high prices for acquisitions. In the last 5 years, that is mostly the commodity businesses, many of which have already started writing off assets (including a massive write-down by ConocoPhilips a few months ago for their Burlington Resources purchase.) The market may already be discounting the goodwill impairment but investors relying on book value should still discount prices on their own.