NetScout's Capital Structure: Too Much Goodwill?

Summary

• Despite the tax savings, Reverse Morris Trusts are no guarantee of success. As we know, two unrelated parties in well-publicized Reverse Morris Trusts experienced significant financial distress post-transaction.
• Tax savings can't save a bad - or expensive - deal.
• With the goodwill value of its Comms transaction over 66% of the total purchase price, the Comms transaction may not represent good value for shareholders.
• Worse, over half of its capital structure is comprised of goodwill.
• Based on its capital structure, combined with its recent insider sales, I believe NetScout presents a poor risk-reward profile for investors.

NetScout's (NASDAQ:NTCT) recent earnings call included some conservative guidance for 2018. Given the risks of its capital structure - in part due to the goodwill incurred from its recent Danaher (DHR) transaction and overall goodwill representing over 50% of its capital structure - as well as some recent insider sales, I believe that investors would do well to skip this name and seek value elsewhere.

Danaher Transaction

As many of you know, one of the first things I look at when I analyze a company is to see whether it has recently and/or substantially diluted its shareholder base. Dilution mutes investor return, and should, in my opinion, be avoided at virtually all costs. As you can imagine, then, I wasn't pleased to read about NetScout's recent Reverse Morris Trust transaction. As described in its 10-K:

On July 14, 2015, we completed the Comms Transaction, which was structured as a Reverse Morris Trust transaction whereby Danaher contributed the Communications Business to Newco. The total equity consideration was approximately $2.3 billion based on issuing approximately 62.5 million new shares of NetScout common stock to the holders of common units of Newco, based on the July 13, 2015 NetScout common stock closing share price of $36.89 per share.

A Reverse Morris Trust is a tax savings strategy that occurs when a parent company creates a subsidiary to spin off unwanted assets; that subsidiary is sold to an unrelated company; then, the unrelated company issues more than 50% of its shares to shareholders of the original parent company.

Despite the tax savings, Reverse Morris Trusts are no guarantee of success. Notably, the two unrelated parties in recent, well-publicized Reverse Morris Trust transactions - Citadel Broadcasting Company (buying ABC Radio from Disney (DIS)) and FairPoint Communications (FRP) (buying lines from Verizon (VZ)) - experienced significant financial distress post-merger. Tax savings can't save a bad deal.

And a company incurring significant goodwill when acquiring looks to me like a bad deal.

Acquisitions are challenging things to get right, and when they go wrong, things can get costly. Research suggests that the majority of acquisitions fail. This paragraph from an article in the Journal of Management offers an explanation as to why. In short, complexity.

The answer is that acquisitions are far more complex than activities at the operating level, such as manufacturing, pricing, and distribution. The acquisition process consists of many interdependent subactivities, such as due diligence, negotiation, financing, and integration, each of which is complex in itself (Hitt et al., 2001).

Acquisitions often represent increased complexity for the acquirer. Increased complexity often represents increased vulnerability. Combine the fact that most acquisitions fail with the fact that acquisitions funded with equity tend to be unfavorable for shareholders and add the fact that goodwill is through the roof (below) and you can probably surmise my opinion of this deal.

In short, my opinion is that we have a subpar risk-return relationship for investors.

Ultimately, one reason comes down to money. Post-acquisition restructuring charges can be costly. Synergies are never guaranteed. Long-term debt has already risen to $300m annually. In my opinion, it's bad enough news when a company dilutes the shareholder base. This is especially true, in my opinion, when it engages in optimistic acquisitions that drive up the price. And as we can see below, NetScout has paid significant acquisition premiums.

Capital Structure

In my opinion, goodwill - the value that arises when a company pays a premium to acquire another - is an ongoing problem for investors, as there is the ongoing risk of goodwill write-downs. As an article suggests in Accounting & Finance:

[...] firms generally fail to achieve post-merger improvements in performance; our results may reflect the market discounting the value of goodwill when it becomes evident the acquisition has not added value.

The possibility that goodwill does not represent economic benefits is consistent with corporate acquisitions not achieving operational improvements for the combined firm, and is supported by findings in the takeover literature. [...] Similarly, studies using share market returns to assess performance have consistently found that acquirers do not achieve improved performance after the acquisition. [...] Evidence that acquiring firms earn significant negative returns post-takeover has also been found in the US [...].

As the chart below demonstrates, goodwill spiked following the Danaher acquisition:

NTCT Goodwill (Quarterly) data by YCharts

The table below breaks down the Danaher acquisition from NetScout's 10-K.

As we can see, goodwill makes up a significant percentage of the total purchase price. This becomes even more clear when we put those numbers in a chart to compare.

Source: Company 10-K, Author's Compilation

With the goodwill value of the acquisition over 66% of the total purchase price, the Comms transaction may not represent value for shareholders.

Further, taking a broader look at NetScout's goodwill, I don't believe NetScout's overall capital structure is much better. Perusing its 10-Q, we see that over half of its capital structure is comprised of goodwill.

Source: Author's Compilation of Quarterly Financial Statement Data

What kind of risk does this present to shareholders? The risk, of course, of incurring an earnings charge due to goodwill impairment. As an article in the Accounting Review points out:

[T]he root cause of many goodwill write-offs is the buyers' overpriced shares at acquisition. Overpriced shares provide managers with strong incentives to exploit the overpricing by acquiring businesses, often paying more than the acquisition's synergies, setting the stage for subsequent goodwill write-offs.

Indeed, goodwill write-downs may be getting worse - not better - over time. As Sloan et al. write in the Review of Accounting Studies:

Given the inherent unverifiability of fair values for intangibles and management's incentives to inflate assets and earnings, it is possible that management will use this new discretion to delay impairments [...] whereby assets are initially capitalized at cost and then only written down in the face of overwhelming evidence of impairment. Such accounting causes the initial overstatement of assets and earnings, and the later understatement of earnings when the aggressive accounting is reversed through large and untimely "big bath" impairments.

Worse, evidence suggests that management does, in fact, delay reporting goodwill impairment until it reaches the point of no return.

[... O]ur evidence suggests that management only report impairments after it is obvious that most of the benefits have expired. This results in systematically overstated goodwill and earnings in the periods following acquisitions. [...] The evidence indicates that managers do not match costs of goodwill with its benefits. Instead, goodwill impairments are delayed until the value of goodwill has expired.

Unfortunately for investors, these impairments are not built into the stock price:

Investors do not appear to fully anticipate predictable goodwill overstatements, since we show that firms with deteriorating operating performance and large goodwill balances have predictable future impairments and negative abnormal stock returns.

Thus, NetScout investors are at risk of taking an earnings hit if its large amounts of goodwill become impaired. Considering the price shareholders paid for that premium in the case of the Comms transaction - the dilution of their ownership stake - NetScout's premium paid becomes even worse for shareholders in my opinion.

Confidence

The recent selling by certain company insiders suggests that they may lack confidence in NetScout's growth prospects.

Date*	Name/Title	Shares	Transaction	Value
02/02/2018	John W. Downing Executive Vice President, Worldwide Sales Operations	3,000	Sale at $28.203 per share.	84,609
02/02/2018	Michael Szabados Chief Operating Officer and President, Service Assurance Business	5,000	Sale at $28.166 per share.	140,830
10/31/2017	John W. Downing Executive Vice President, Worldwide Sales Operations	3,000	Sale at $28.165 per share.	84,495
10/31/2017	Michael Szabados Chief Operating Officer and President, Service Assurance Business	5,000	Sale at $28.186 per share.	140,930
09/04/2017	Anil K. Singhal Chairman of the Board, President and Chief Executive Officer	5,882	Disposition	192,635
08/26/2017	Anil K. Singhal Chairman of the Board, President and Chief Executive Officer	4,902	Disposition	160,050
08/01/2017	John W. Downing Executive Vice President, Worldwide Sales Operations	33,000	Sale at $34.665 per share.	1,143,941
08/01/2017	Michael Szabados Chief Operating Officer and President, Service Assurance Business	5,000	Sale at $34.598 per share.	172,992

Click to enlarge

Source: Morningstar, Author's Compilation

Obviously, insider selling is not itself a reason to sell a company, as there can be many reasons an insider sells. But taken in context with its guidance, pricey acquisitions with synergistic risk, and capital structure that is overweight goodwill, I believe it is better for investors to be cautious.

Conclusion

Despite the tax savings, Reverse Morris Trusts are no guarantee of success; as we know, two unrelated parties in well-publicized Reverse Morris Trusts experienced significant financial distress post-transaction.

With the goodwill value of that acquisition representing over 66% of the purchase price, and NetScout's overall goodwill representing over 50% of its overall capital structure, I think investors would do well to avoid this name in favor of companies with capital structures that pose less vulnerability to impairment-related earnings charges.

Analyst’s 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.