30 Aug 2019
What is goodwill? In the accounting sense, it’s an intangible asset that arises as a result of mergers and acquisitions (M&A). Essentially, goodwill is the difference between the price paid for a company and its book value. It is recorded on the buyer’s balance sheet, and its value must be tested each year and adjusted accordingly. Any change results in a write-down of this value, which is recorded as an impairment – effectively, a loss.
We think that the potential for significant goodwill impairments needs more attention from investors. Why? Well, in recent years, we’ve seen a prolonged period of robust M&A. This means that there’s a huge amount of goodwill sitting on companies’ balance sheets.
So far, this hasn’t been a big concern. With interest rates still at historically low levels and the global economy growing strongly in recent years, investors have largely been content to assume that firms have paid fair prices for the acquisitions that they’ve made. Today, however, the sustainability of global growth looks far from certain. So the rosy assumptions on which many balance sheets rest look less assured. And that could have serious implications for corporate profitability in the future.
Curtailed profits have obvious implications for share prices. But impairments are not only a concern for equity investors. They can also trigger bond covenants – entailing new equity raises, renegotiation of covenants or ratings downgrades. Accordingly, all investors should take them seriously.
Recently, we’ve started to see some eye-catching – indeed, eye-watering – impairments. General Electric (GE) is an obvious example. In October last year, the company wrote off $23 billion from the acquisition of Alstom in 2015. This acquisition had cost GE just $10.1 billion, but Alstom’s hefty liabilities resulted in a negative book value even before the impairment.
Then there’s the case of Kraft Heinz. This February, the company recorded a $7.3 billion goodwill impairment. The impact on its share price was immediate; its stock lost more than a quarter of its value on the day of the announcement.
Do these high-profile examples herald a wave of significant impairments elsewhere? We think they might. For one thing, the size of the recent M&A boom means there’s a much higher proportion of goodwill on balance sheets than in the past. In the recent buying bonanza, the premium paid above a target’s book value was typically well above 20%. If GDP growth slows and cost pressures rise, justifying such large asset values is going to prove more difficult.
We think it’s particularly important to look out for instances in which a company is revising down its future earnings but not taking goodwill impairment charges. Given the subjectivity afforded to company managements in testing goodwill, a lack of impairments can’t be used to assume that all is well. This is especially true when write-downs become widespread in a given sector. Are the exceptions genuinely different or, given the ample room for manoeuvre afforded to managements by the testing process, are they hiding something?
Some sectors are likely to be more vulnerable to impairments than others. In our screening, we focus on companies with goodwill as a high percentage of total reported assets . We overlay this with an analysis of sectoral margins, focusing particularly on high exposure to rising labour costs. Our analysis suggests that healthcare, technology and media companies may be among those most at risk.
This sector-based screening helps. Ultimately, though, there’s no substitute for subjecting individual companies’ accounting disclosures to rigorous analysis. This needs to involve scrutiny of the discount rate applied and the impact that any change in it will have on the valuation of the goodwill on the balance sheet. Particular attention needs to be given to whether the discount rates reflect the current cost of capital.
It’s also important to engage with audit firms, to ascertain their view of the management’s attitude to impairment tests. Comparisons with sector peers can be illuminating too, and the focus on goodwill impairment tests should form part of a wider forensic-accounting screen that covers other factors such as off-balance-sheet financing and material provisions.
None of this is easy, and there are no short cuts. But for bottom-up investors with the requisite skills, energy and resources, a focus on goodwill impairment may yield vital insights into future profitability – and into the performance of bonds and shares alike.