As an accountant, I am keenly aware that goodwill is not the most exciting topic in the world. However, for investors in Kinder Morgan (NYSE:KMI), my analysis suggests that topic of goodwill is about to get a lot more interesting in 2016.
What is Goodwill?
For starters, let's define what goodwill is. From an accounting perspective, goodwill is an intangible asset that arises when one company purchases another company at a premium. For example, let's say company "A" acquires company "B" for $2B. The accountants of "A" will review the tangible assets of "B" and assign a purchase value to each. If at the end of the day they identify $1.5B of tangible assets, these will be booked as PP&E on the consolidated balance sheet, and the remaining balance of $500M will be assigned to goodwill.
Going forward, the $1.5B of PP&E will be depreciated and expensed over the remaining life of those assets, reducing net income accordingly. Goodwill on the other hand is kept on the balance sheet at the original value. Rather than spreading the cost over a set period of time, goodwill is instead tested periodically for impairment. If the goodwill is determined to be impaired, it is written down to market value.
As is turns out, this is a double edged sword that CFO's generally love, yet have occasional nightmares about. The upside is that a company can purchase assets at a premium price, and if they play their cards right, never have to recognize the cost of the goodwill on the income statement, at least not in the short run. However, when things go wrong, they can get really nasty like when AOL Time Warner wrote off around $100B of goodwill back in 2002.
What is Kinder Morgan's Potential Exposure?
As of the end of Q3-2015, Kinder Morgan had $24.952B of goodwill listed as assets on their balance sheet. Looking back through their financials, it looks like most of this, about $18B is related to the $37B acquisition of El Paso in Q2-2012. Clearly $25B is the high end of the exposure.
Goodwill Impairment Testing
As noted above, while goodwill is not depreciated over a set period of time like most traditional assets. Instead, goodwill is tested periodically for impairment. The general idea of impairment testing is quite simple. You look at the book value of the assets acquired, and compare them to what you could sell them for in today's market. If the market value is higher than the book value (including goodwill), you would take no action. However, if you determined that the market value was lower than the book value, you would then write down goodwill to bring the two into balance.
That sounds simple enough, but in the real world, usually ends up being extremely complicated. A lot of the time assets are simply integrated into the acquiring company and after a year or two are no longer separately identifiable. Even if the business unit remains separate, determining an objective fair market value is a tricky task at best. This task pits a management team with a clear interest in finding no impairment against an auditing staff with a vested interest in not pulling an "Arthur Andersen".
In regards to Kinder Morgan's goodwill, I freely admit that only the company's accountants and auditors at PriceWaterHouseCoopers have access to the detailed information necessary to accurately determine know how close Kinder Morgan is to having to write off some or all of their $25B of goodwill.
That said, it doesn't take a genius, or an external auditor to see that Kinder Morgan's $25B of goodwill is way out of line with its current $29B market capitalization. Historically the number one trigger of goodwill impairment is a drop in stock price. Enter Kinder Morgan. Since closing Q4-2014 at $42.31, Kinder Morgan's stock has fallen 69%, closing at just $13.00 Friday 1/15/2016. The reason stock price collapses often trigger goodwill impairments is simple. While determining the market value of a single asset or division of a company may be tricky, determining the market value of the company as a whole is as simple as looking at the closing bell, so this is often used as the first step in an impairment test. If the market value of the enterprise exceeds book value by a material amount, it is a pretty good indicator that goodwill related to prior acquisitions is not impaired. However, if your stock drops 69% in a little over a year, it's a pretty good indicator that you may have a problem.
Using Kinder Morgan as an example, they ended Q3-2015 with a stock price of $27.68 and a market capitalization of about $61B. With a book value of about $36B, at an enterprise level, they could point to the healthy premium the market was valuing them at and quickly shut down any discussion of a goodwill write down. It is obviously a bit more complicated than that, but generally this is about how it works.
However, fast forwarding to the as of today unreleased Q4-2015 financials, that conversation likely gets far more interesting. The stock ended the quarter down about 45% at $14.92 with a market capitalization of around $33B. If we assume the book value was more or less unchanged at $36B, the argument from above is not nearly as convincing now that the market is valuing the enterprise at or even under book value. As noted above, only the Kinder Morgan accountants and auditors know where that line is, but I suspect they were dangerously close at the end of Q4-2015, and after losing another 13% to start Q1-2016, the likelihood of impairment is growing.
By now you can clearly see the problem. In 2012, Kinder Morgan, a $20B company at the time acquired El Paso for a reported $37B. Three and a half years later, following yet another $71B acquisition and billions more in expansion capital, the entire company is now valued by the market at only $29B as of the 1/15/2016 close. If we take a wild guess and say that the 2012 El Paso acquisition represents 1/3 of the companies value, that would put a current market value of the El Paso acquisition at ~$10B. Depending on the current book value of the remaining El Paso assets, a strong case could likely be made that the entire balance of goodwill related to the 2012 El Paso acquisition should be written off either in Q4-2015, or in future quarters if Kinder Morgan's Stock does not recover to the ~$20 range.
While the likelihood, timing, and magnitude of a Kinder Morgan goodwill impairment are debatable, one thing should be made very clear, a goodwill write off is a noncash charge and would therefore have no impact on their celebrated cash flow. As such, while it would certainly make headlines, a goodwill write off even of the entire $25B balance in theory should have a negligible impact on the company. After all, a goodwill impairment is more or less just the accountants admitting what the market has already decided, that the assets involved are now worth less than what was paid for them.
On the other hand, even if the cash impact is zero, a goodwill write off of any amount will not be seen as good news for this embattled company. Any bad news of this magnitude could drive the stock price down further, raise refinancing costs, and steepen the companies downward spiral.
While I haven't seen anything else written recently about Kinder Morgan's goodwill, I actually suspect that many institutional investors are well aware of this risk, and that this is actually an undiscussed but driving factor in the Q4 price collapse. If so, some of this could already be priced in. Regardless, I would steer clear of Kinder Morgan for the foreseeable future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.