We’ve all heard about the asset write-downs for banks, but this week’s Economist had an interesting piece on asset (goodwill) write-downs for corporations (see Corporate Goodwill Write-downs). As explained by the Economist:
…non-financial firms…face a reckoning on “goodwill” amassed during the long merger wave that subsided last year.
When one firm buys another, the target’s goodwill—essentially the premium paid over its book value—is added to the combined entity’s balance-sheet.
As the economy deteriorates and more firms trade down towards (or even below) their book value, empire-builders are having to mark down the value of assets they splashed out on in rosier times…In this stormy environment, with auditors keener than ever to avoid being seen to go easy on clients, companies are being told to mark down assets if there is any doubt about their value.
My Comment: Just as in housing, the private equity/strategic acquisition wave was long (and bubbly) because it was fueled by cheap capital, and resulted in acquirers overpaying for targets. I discussed some of these overpayment issues in posts from mid-2007 (see Dumbfounded by the Data and Future of Corporate Performance). If firms overpay for acquisition targets – i.e., they pay more than the underlying fundamental + synergy value – the natural result is a write-down.
The Economist article continues:
The sanguine point out that this has no effect on cashflow, since such charges are non-cash items. Moreover, some investors take goodwill write-offs with a pinch of salt, preferring to look past such non-recurring costs and accept the higher “normalised” earnings numbers to which managers understandably cling.
My Comment: With this point I disagree. Sure, the write-down has no immediate cashflow implications. However, it implies that the firm undertook an ill-advised acquisition. Imagine the more solid cash position the firm could have been in had it not undertaken the acquisition. In this sense then, the firm has overpaid and squandered shareholder cash.
Alternatively, a write-down could be indicative of poor execution. It could be that there was the potential to extract synergies from the deal such that the acquisition price was not too high per se; however, the managers were not able to capture that value via the integration process (see Why M&A Deals Go Bad). In such a case managers destroy shareholder value after the purchase.
Whichever way you look at it, goodwill impairment of this sort suggests that managers were not doing right by shareholders when undertaking an acquisition, and that the firm would be better off not having made the acquisition in the first place. That ought not instill much confidence in a firm’s managers.