HOW GOOD IS GOODWILL?

By maintaining a skeptical attitude to the value of intangible assets through­out the New Economy excitement of the late Nineties, Moody’s and Stan­dard & Poor’s were bucking the trend.

In reality, the stock market euphoria that preceded Uniphase’s mind­boggling write-off illustrated in classic fashion the reasons for rating agency skepticism toward goodwill. Through stock-for-stock acquisitions, the sharp rise in equity prices during the late 1990s was transformed into in­creased balance sheet values, despite the usual assumption that fluctuations in a company’s stock price do not alter its stated net worth. It was a form of financial alchemy as remarkable as the transmutation of proceeds from stock sales into revenues described in Chapter 3.

The link between rising stock prices and escalating goodwill is illus­trated by the fictitious example in Exhibit 2.1. In Scenario I, the shares of Associated Amalgamator Corporation (“Amalgamator”) and United Con­solidator Inc. (“Consolidator”) are both trading at multiples of 1.0 times book value per share.

Let us now examine a key indicator of credit quality. Prior to the acquisi­tion, Amalgamator’s ratio of total assets to total liabilities (see Chapter 13) is 1.25 times whereas the comparable figure for Consolidator is 1.18 times. The stock-for-stock acquisition introduces no new hard assets (e.g., cash, inventories or factories). Neither does the transaction eliminate any existing liabilities. Logically, then, Consolidator’s 1.18 times ratio should drag down Amalgamator’s 1.25 times ratio, resulting in a figure somewhere in between for the combined companies.

In fact, though, the total-assets-to-total-liabilities ratio after the deal is 1.25 times. By paying a premium to Consolidator’s tangible asset value,

Amalgamator creates $20 million of goodwill. This intangible asset repre­sents just 1.4% of the combined companies’ total assets, but that suffices to enable Amalgamator to acquire a company with a weaker debt-quality ratio without showing any deterioration on that measure.

If this outcome seems perverse, consider Scenario II.

As in Scenario I, Amalgamator pays a premium of 33½% above the prevailing market price to acquire Consolidator. The premium is calculated on a higher market capitalization, however. Consequently, the purchase price rises from $80 million to $120 million. Instead of creating $20 million of goodwill, the acquisition gives rise to a $60 million intangible asset.

When the conservative bond investors calculate the combined com­panies’ ratio of total assets to total liabilities, they make a startling discov­ery. Somehow, putting together a company boasting a 1.25 times ratio with another sporting a 1.18 times ratio has produced an entity with a ratio of 1.28 times. Moreover, a minute of experimentation with the numbers will show that the ratio would be higher still if Amalgamator had bought Con­solidator at a higher price. Seemingly, the simplest way for a company to improve its credit quality is to make stock-for-stock acquisitions at grossly excessive prices.

Naturally, this absurd conclusion embodies a fallacy. In reality, the re­ceivables, inventories, and machinery available to be sold to satisfy credi­tors’ claims are no greater in Scenario II than in Scenario I. Given that the total-assets-to-total-liabilities ratio is lower at Consolidator than at Amal­gamator, the combined companies’ ratio logically must be lower than at Amalgamator. Common sense further states that Amalgamator cannot truly have better credit quality if it overpays for Consolidator than if it ac­quires the company at a fair price.

As it happens, there is a simple way out of the logical conundrum.

Calculating ratios on a tangibles-only basis is not equivalent to saying that the intangibles have no value. Amalgamator will likely recoup all or most of the $60 million accounted for as goodwill if it turns around and sells Consolidator tomorrow. Such a transaction is hardly likely, however. A sale several years hence, after stock prices have fallen from today’s lofty lev­els, is a more plausible scenario. Under such conditions, the full $60 million probably will not be recoverable.

Even leaving aside the possibility of a plunge in stock prices, it makes eminent sense to eliminate or sharply downplay the value of goodwill in a balance-sheet-based analysis of credit quality. Unlike inventories or accounts receivable, goodwill is not an asset that can be readily sold or fac­tored to raise cash. Neither can a company enter into a sale-leaseback of its goodwill, as it can with its plant and equipment. In short, goodwill is not a separable asset that management can either convert into cash or use to raise cash to extricate itself from a financial tight spot. Therefore, the relevance of goodwill to an analysis of asset protection is questionable.

On the whole, the rating agencies appear to have shown sound judg­ment during the 1990s by resisting the New Economy’s siren song. While enthusiasm mounted for all sorts of intangible assets, they continued to gear their analysis to tangible-assets-only versions of key balance sheet ratios.

More generally, asset write-offs do not cause ratings to fall. Occasion­ally, to be sure, the announcement of a write-off coincides with the disclo­sure of a previously unrevealed impairment of value, ordinarily arising from operating problems. That sort of development may trigger a down­grade. In addition, a write-off sometimes coincides with a decision to close down certain operations. The associated severance costs (payments to ter­minated employees) may represent a substantial cash outlay that does weaken the company’s financial position. Finally, a write-off can put a company in violation of a debt covenant (see Chapter 12). Nervous lenders may exploit the technical default by canceling the company’s credit lines, precipitating a liquidity crisis. In and of itself, however, adjusting the bal­ance sheet to economic reality does not represent a reduction in credit pro­tection measures.