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
Allied Waste Industries
( GP) and
( CD) that have accumulated a great deal of goodwill on their balance sheets over the past few years. That's 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 therefore it 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 don't 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 writedown leaves a company's 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 acquiree's 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 that 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 won't count against a company's earnings annually anymore, companies might need to write down huge gobs of it from time to time when accountants decide they can't ignore the fact that an acquisition didn't turn out as planned. It also means that because FASB 142 does not dictate a set of strictly objective rules for calculating impairment, writedowns will be somewhat subjective in both timing and amount.
Don't Fall for These Three Ploys
As a result, many market skeptics 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, a provider of analytical tools and consulting services for financial information, says he sees three ways that companies interested in managing their earnings could end-run shareholders using 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 firm's share price. The benefit: Future write-offs would be unnecessary, and the company's 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 vs. liabilities.
Cosmetic earnings boost.
Under FASB 142, many companies will record earnings that appear higher than last year's because of the elimination of goodwill amortization. However, the increase will be purely cosmetic, as the company's 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
explains the issue clearly in its latest 10-k in the section devoted to its acquisition of cookie maker Keebler in March 2001. 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.
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 company's 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 2, below, shows the 10 companies with the highest levels of goodwill relative to their book shareholder's 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 stockholder's equity and could result in adverse changes to their debt ratios -- an event which, though not fatal, makes lenders very grumpy. Thus, he contends, these companies have a greater incentive to avoid a writedown for goodwill impairment.
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
( AW) and
-- 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.
As originally published, this story contained an error. Please see
Corrections and Clarifications.
At the time of publication, Jon Markman owned or controlled shares in none of the equities mentioned in this column.