Goodwill Hunting: Beware Potential Asset Impairment Charges

I was listening to the Vulcan Materials (VMC) call yesterday wondering when someone might ask the question I wanted answered. The company executed a massive acquisition last year, piling goodwill onto its balance sheet. With business down so much, the company, in conducting its annual "impairment test", might find that it needs to write down the carrying cost.

The company stated that it didn't need to make an adjustment this year, though clearly this is purely management discretion. This is important, because a writedown can trigger a violation of bank covenants (as debt to equity rises after the equity is reduced). Further, it can hurt valuation ratios such as price to book value.

I described my major theme of "big bad balance sheets" in December. As I have been writing frequently about my concerns that many companies outside of the Financial sector will struggle immensely this year with balance sheet concerns, I want to continue the dialogue by identifying companies with high debt loads, high goodwill and deteriorating fundamentals. If you own these stocks, you should attempt to better understand how a potential company writedown might impact its ability to borrow, its cost to borrow and its likelihood to continue paying dividends. Here are the parameters I employed:

• Intangibles/Equity > 70%
• Debt/Cap > 40% (Net > 25%)
• EPS decline for 2009 >15%
• Market Cap > $600mm

The list yielded 74 names, but several are from different shares of stock for the same company. Also, I would point out that good things can happen to bad companies, as one of the stocks, Advanced Medical Optics (EYE), recently received an acquisition offer. (click on chart to enlarge)

The list encompasses candidates from many sectors and across all market capitalizations. I included a couple of columns on dividends to help highlight one of the risks (a dividend reduction). Note that many of these are high-yielding stocks, with several of them having very high payout ratios. Remember, there is no FDIC insurance on those dividends!

As I stated before, this list is a good starting place to identify companies that may be at risk of an impairment to their goodwill. The deal looked so good back when it was done, but the current economics might not support the original purchase price. The consequences of a write-down may not be signficant, but if the company has substantial debt it can lead to violations of its agreements with its lenders and require repayment of debt or higher borrowing costs.

Additionally, companies may be restricted in their ability to pay dividends. I believe that my thresholds are actually not low enough and would be concerned with companies that have goodwill representing 50% instead of the 70% I employed in order to keep the number of companies hitting the screen to below 75. Also, there are many companies that haven't reported and have stale earnings forecasts that kept them from meeting the "-15% EPS" parameter. One that comes to mind is Weight Watchers (WTW), which I recommended as a sale in Mid-January. Another caveat is that I was unable to include stocks with negative equity, but there are several of those that would meet the criteria otherwise. If I remove the down EPS parameter and change the goodwill ratio to 50%, the number of stocks rises to a stunning 294. While companies may avoid it for now, many of them will be taking the charges in early 2010 if this economic crisis persists. Don't get caught holding the bag!

Disclosure: No position in any stock mentioned or in the graphic.

Comments

[Jim Hawthorne:]

Thanks for your work, Alan! Much appreciated and worth further examination.

But I was surprised not to see more oil&gas stocks listed, as many of these companies took on considerable debt loads through new lease acquisitions, renewals, new drilling and existing well renovations and revivals when oil passes the $90/Bbl mark and showed no end in sight!

Care to comment?

Feb 11 08:43 AM

[Jake Berzon:]

I was surprised to see some of the big names on the list that I had previously purged from my portfolio over different concerns.

Feb 11 09:34 AM

[PROXIMO:]

I'd really like to see the information on the list. Unfortunately, my computer must be a real P.O.S. because the list is too fuzzy for me to make out. Thanks for the article anyway.

Feb 11 09:49 AM

[Alan Brochs...:]

Thanks for your question. I did some work on the overall energy sector in December or January and found it to actually have in aggregate superior balance sheet metrics to other sectors (just behind IT and Health). Anytime one makes a screen, he or she risks omitting certain variables. Two big ones that should be examined more closely are WFT and RIG, which certainly fit the bill as you described but didn't make the list due to thresholds. XTO is a serial acquirer, yet their balance sheet has very little in terms of intangibles. Of course, there could be asset impairments there as well, but I don't believe the tests are as rigid as for goodwill.


On Feb 11 08:43 AM Jim Hawthorne wrote:

> Thanks for your work, Alan! Much appreciated and worth further examination.
>
>
> But I was surprised not to see more oil&gas stocks listed, as
> many of these companies took on considerable debt loads through new
> lease acquisitions, renewals, new drilling and existing well renovations
> and revivals when oil passes the $90/Bbl mark and showed no end in
> sight!
>
> Care to comment?

Feb 11 12:03 PM

[Alan Brochs...:]

Proximo, did you try clicking on it again? It magnifies the image. You can also go to my blog and try it there (ab.typepad.com). I have just updated my blog with a link to the table so that you can download the PDF.


On Feb 11 09:49 AM PROXIMO wrote:

> I'd really like to see the information on the list. Unfortunately,
> my computer must be a real P.O.S. because the list is too fuzzy for
> me to make out. Thanks for the article anyway.

Feb 11 12:05 PM

[PROXIMO:]

Thanks Alan--Your blog is much clearer on my screen. Enjoyed the article.


On Feb 11 12:05 PM Alan Brochstein wrote:

> Proximo, did you try clicking on it again? It magnifies the image.
> You can also go to my blog and try it there (ab.typepad.com).
> I have just updated my blog with a link to the table so that you
> can download the PDF.
>
>
> On Feb 11 09:49 AM PROXIMO wrote:

Feb 11 03:30 PM

[PROXIMO:]

Alan-- I just downloaded the PDF and printed it along with your article. They came out perfect. Thanks.


On Feb 11 12:05 PM Alan Brochstein wrote:

> Proximo, did you try clicking on it again? It magnifies the image.
> You can also go to my blog and try it there (ab.typepad.com).
> I have just updated my blog with a link to the table so that you
> can download the PDF.
>
>
> On Feb 11 09:49 AM PROXIMO wrote:

Feb 11 03:37 PM

[Alan Brochs...:]

After the close today, Masco (MAS), which made the screen and is actually a company I have followed for quite some time, cut their dividend over 2/3 citing challenging economy and a debt maturity in early 2010.

Feb 11 04:23 PM

[Alan Brochs...:]

No problem - glad that worked!


On Feb 11 03:37 PM PROXIMO wrote:

> Alan-- I just downloaded the PDF and printed it along with your article.
> They came out perfect. Thanks.

Feb 11 04:24 PM

[Moon Kil Woong:]

Good work. Thanks for the data.

I think many companies should realize real estate asset impairment, but non-core property companies just aren't doing it. It is funny that they are so quick to realize property gains when they need to beat earnings and the real estate market is up but never to the opposite. Accounting allows a lot of wiggle room in reporting real earnings.

Buyer beware. Passive property acquisition and investment was a big part of many non-property businesses. And I'm not just talking E-Trade.

Feb 11 08:43 PM

[Alan Brochs...:]

Excellent point. I probably mistitled this article, as I was really just addressing a single type of asset impairment, but I have previously discussed the many that all companies will face to some degree: Inventory write-downs, AR write-downs, PP&E write-downs, hits to pension assets, deferred tax credits that become worthless, and investment losses. It's a reason that "tangible book value" isn't the be-all end-all but rather just a key metric. As companies begin losing money on their operations (or making a lot less than their cost of capital), many of the productive assets by their very nature become worth less. Thankfully, I suppose, most companies don't have to "mark-to-market" their long-term assets! They do, however, have to adjust for many of the items I highlighted. This is a vicious economic downturn - start thinking about things in a different light than to which you are accustomed and I believe that you will see some of the same continued downside to stocks that I envision (not you, Constructe, but anyone reading this comment). Thanks for your input!


On Feb 11 08:43 PM constructe wrote:

> Good work. Thanks for the data.
>
> I think many companies should realize real estate asset impairment,
> but non-core property companies just aren't doing it. It is funny
> that they are so quick to realize property gains when they need to
> beat earnings and the real estate market is up but never to the opposite.
> Accounting allows a lot of wiggle room in reporting real earnings.
>
>
> Buyer beware. Passive property acquisition and investment was a big
> part of many non-property businesses. And I'm not just talking E-Trade.

Feb 12 06:11 AM

[savelongisl...:]

How about RRD?
Over 3 billion in GW.

Feb 13 08:56 PM

[Alan Brochs...:]

Yes, RRD definitely fits the profile. It's intangibles exceed its equity. The reason it didn't make this list is that they haven't reported 2008 Q4 and my screener works on "next year" rather than a "calendar year" and is looking at 2008 vs 2007 at this point still. One of the parameters was for a decline of 15% or more in EPS in 2009, and this one definitely meets that criteria but was excluded.

As I tried to convey, this list is only a small (very small) subset of a larger group of companies with challenging balance sheets.

Feb 14 07:06 AM