Balance Sheet Goodwill — What is that, again?

I tend to follow companies on Yahoo Finance… It ain’t sexy, but it works and I have been doing so for years.    Although — frankly — most of the contents is drivel, I read most postings on the Yahoo Finance message boards for the companies that I follow, and from time to time I also post (my own drivel!) on these boards.

One of the things that continues to surprise me is how little fundamental accounting and finance understanding — and common sense — most of the people that post on the Yahoo Finance message boards have.   The meaning of fundamental concepts such as revenue and  cash-flow appear to not only escape them, but, horror of horrors, not interest them at all.

As I have written before, I follow Unitek Global Services (Nasdaq: UNTK,) and, therefore, I regularly read the postings on the company’s Yahoo Finance message board.    The story behind Unitek is complex, and probably a worthy subject for a separate blog posting, but, essentially, my assessment is that the company’s equity, which has been hammered since last year, right now constitutes a significant investment opportunity (if you have not done so already you should now rush over to this blog’s About section and read my disclaimer (if you are reading the version of the blog that is optimized for mobile devices, you may need to follow this link,)) albeit speculative in nature, and I have expectations that the coming quarters will mark a turning point for the equity.

 A Provocation

Crosa CC-BY-2.0 via Creative Commons

I was somewhat surprised when a poster published a one-line posting on Unitek’s Yahoo Finance message board, exclaiming, and I quote: “Just wait until they write off the 163 million in GOODWILL.”  As it is often the case with Yahoo Finance message board postings, substantial interpretation is required to make sense of what is being said (or shouted,) and from the context I surmised that “they” were Unitek’s management and/or Board of Directors and “GOODWILL” was the goodwill entry on the balance sheet (and, of course, I assume that the “163 million” referred to $163 million, not, say, 163 million apples.)  Moreover, I surmised that the total capitalization of the word “goodwill” was meant to express or impress outrage, alarm, and/or shock (after all, “the world ends tomorrow” is less potent that “The world ends TOMORROW,”) and I think that there was an insinuation that the company could, somehow, either by design or happenstance, voila, write off this goodwill, causing, of course, a seismic shift on the balance sheet and a related appearant catastrophic earnings result.

Unitek has indeed got a substantial goodwill entry, arising from past mergers and like transactions — as do most “serious” companies.   Unitek also has a good chunk of long-term debt, but as this was not the focus of the outrage, we will let that lie for now.

I am never entirely sure what the purpose is of this type of one-liner posting, in particular since postings of this type mostly appear out of nowhere and are almost never followed up by balanced discussions.   However, I do suspect that the posting at hand implies a fundamental lack of understanding of goodwill if the insinuation is that Unitek’s management and/or Board of Directors can just willy-nilly adjust the goodwill entry.

The reality is that today any company that acquires operations will probably accumulate goodwill as an asset on the balance sheet and, over time, will, as part of an ongoing fair value vs. carrying value evaluation process, probably, tweak the accumulated goodwill asset while adding new goodwill from new acquisitions (in the old days you depreciated the goodwill over, say, 40 years, which had pretty much the effect of automatically draining the goodwill from the balance sheet.) Moreover, accounting rules mandate that, if the fair value is less than carrying value (i.e. if there is an impairment,) then the goodwill value must be reduced so the fair value is equal to carrying value, and the delta, the impairment, must be reported as a separate line item on the income statement, which, of course, impacts net earnings and Earning Per Share.

So the first thing to know is that goodwill impairment does not impact cash-flow directly, but can – in a stupid kind of way – impact the earnings picture. The second thing to know is that some level of adjustment to the goodwill asset is normal. The third thing to know is that, on the flip-side, a negative goodwill is a good thing (it implies a bargain purchase and may be considered income.)

Unitek has acquired properties, and in the process of doing so has added a goodwill entry  to its balance sheet. However, the company’s recent 10K statement shows that the company’s on-going reviews had not caused a material impairment charge and it would therefore seem borderline ludicrous to suggest that the entire +$160 million goodwill (or indeed any reasonable fraction thereof) would be impaired at present or soon.

Unitek aside, goodwill can, of course, be materially impaired and too much goodwill on a balance sheet is certainly something that should be considered carefully by investors.   Motley Fool analyst Rex Moore wrote about this  in Daily Finance, noting the exceptional story of AOL, which in 2002 carried goodwill and other intangible assets of $128 billion out of $209 billion in assets — stemming mostly from the AOL and Time Warner merger in 2000.  As we now know, AOL Time Warner was unable to capture the value implied in the goodwill and ended up writing of the goodwill with catastrophic effect on the per share price of the equity.   Citing Hewitt Heiserman, Rex Moore points out that the the thing to watch is the ratio of intangibles, including goodwill, to total assets, and anytime the ratio goes above 20% the investment should be reviewed carefully.

A Response

Thierry Geoffroy – Creative Commons S.-A. 3.0

Back to Unitek… As I said, the goodwill entry is high.  In fact it is very high.  And, the tangible book value (shareholders’ equity less goodwill and other intangibles) is low… very low.   These ratios are very strong caution flags (generally, if the intangible ratio is low, we may have a future problem, in particular if the company has debt, falling levels of free cash-flow, or is engaged in a share buyback program.)

So, inadvertently, I believe, the mystery poster has put his or her head on the nail, forcing me to revisit and justify my feeling that Unitek’s equity is a good — but, of course, speculative — investment.

Speculative is the operative word, and, yes, risk is high.  Generally, my attraction to the Unitek equity as an investment object is based on the dynamics that has caused the equity to, as I like to put it, fall out of favor (or when I feel poetic, fall from grace,) in the market, precisely when the company’s revenue, cash-flow, leverage and income situation has started to undergo a dramatic improvement, but two things need to be true for an investment in Unitek to provide an acceptable return.  First, the company has to not stumble as the operation picks up steam (since, frankly, because of the company’s debt, the next stumble can result in a broken neck,) and, second, the market has to reverse itself and start favoring the Unitek equity again.  These two conditions are not unusual for equities that I invest in on the (contrarian) basis of them having fallen out of favor, although, normally, I steer clear of companies that have little or no room for stumbling.

In Unitek’s case I assume that operations will be relatively smooth, partly because of a strong backlog profile (which, fortunately, also shields the company somewhat from the current extreme gyrations of the economy) and partly because the management team is strong and appear determined.    The issue is the reversal of the market opinion.  This is uncontrollable and, in my experience, the timing of the reversal is unpredictable.

When I started looking at Unitek, I was conscious of the two conditions and the risk associated with an investment, but because of the provocative message by the Yahoo Financial message board poster, I felt compelled to review the situation again, and that, I think, is healthy.

What Did We Learn and What Can Buffett Teach Us

So generally, we learned (hopefully) something about goodwill (for more details refer to Statement of Financial Accounting Standards (SFAS) No. 142,) but — perhaps more importantly — we learned that random violence on Yahoo Finance message boards can cause us to take a second look at something and, perhaps, just perhaps, avert a disaster.

On a related note, in one of his more funny letters to the shareholders of Berkshire Hathaway, Warren Buffett, in 1984, went into a elaborate discussion of goodwill, and managed to explain the idea and impact of goodwill in his usual folksy, down-to-earth manner.  In spite the change in accounting treatment with the introduction of SFAS 142 in 2002, Mr. Buffett’s musings on goodwill are definitely worth reading as they are both educational and amusing.  Here are some extracts:

  • “…[O]ur first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.”
  • “When an overexcited management purchases a business at a silly price, the same accounting niceties described earlier are observed. Because it can’t go anywhere else, the silliness ends up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled “No-Will”. “
  • “For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets (“In Goods We Trust”). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.”

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2 Comments on “Balance Sheet Goodwill — What is that, again?”

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