Goodwill Hunting

Unlike the 1997 movie-this story does not have a happy ending. A January 30, 2013 Citi Credit Research note titled "The Goodwill Game" provides some interesting insights into the extent of recent M&A over-payments. Goodwill is the difference between the price paid and the book value of the assets acquired. It represents a proxy, albeit crude, for the premium paid by the acquirer. It is tested in subsequent years for an impairment charge if the value of the assets declines relative to their original carrying value. The valuation methods used are similar to those Ralph has previously outlined. (See, for example, Estimating Value, Part 1). Recent examples of substantial write-downs include HP's $8.8B charge on the Autonomy and Rio Tinto's $3.5B write-down on mining assets. Alarmingly, the report shows that goodwill growth is out-pacing total asset increases.

The write-downs highlight the importance of the three most important things in an acquisition: price, price and price. Over paying, as represented by goodwill, is the reason why most acquisitions fail to create value for the buyer's shareholders. Management often tries to explain write-downs as unimportant non-cash charges. The cash, however was lost when the over-priced acquisition was made. Furthermore, the write-down reduces managerial accountability for the remaining assets-the out-of-sight-out-of-mind effect. Post write-down, the future operating performance can actually appear to improve. Perhaps, we should consider keeping the investment's original value when determining performance reviews?

The problem is worse still for serial acquirers like HP who, while suffering from depressed share prices, continue to make over priced acquisitions to cover-up a declining business model. Shareholders tired of seeing the wealth wasted in high premium-high goodwill acquisitions should insist that Boards pressure management to stop the madness and return the capital to them via dividends. The kingdom may be smaller, but its citizens will be richer.

Investors should keep a close eye on the level of goodwill creation and write-downs as we continue into the earnings-10K season. It provides an insight into the quality of management and their acquisition proposals. It also raises questions concerning Board oversight and governance of the acquisition process.

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