Watching Goodwill Go Bad
The late 1990s will undoubtedly go down in history as one of the largest economic booms in modern history. From 1996 to the latter part of 2000, companies grew at an unprecedented pace, stocks rose to unparalleled heights, and corporate and personal incomes increased to record-setting levels. But was this growth all good? Or did some companies overpay for it by merging with and acquiring companies at too high a price?During the economic bubble, Wall Street rewarded companies with rapid growth. However, in many cases, shareholder value was measured almost solely as a function of growth. Companies were focused on new-economy success factors such as winner-take-all strategies, increasing returns to scale, and expanding their products and services on the Internet. Many lost sight of profitability and cash generation.
A Good Idea at the Time
Because the market put such a premium on growth and because rapid growth is so difficult to achieve organically, many companies focused their growth strategies around mergers and acquisitions (M&A). Most of the value acquired through such M&A activities became an asset on the balance sheet referred to as goodwill. The magnitude of M&A activity during this period translated into a substantial increase in goodwill. This increase was largely unnoticed, however, because growth-rate expectations at the time were extremely high. Thus, high levels of goodwill could hide in the enormous market capitalization of many of these companies.
But the tide changed in 2001, and the air has gone out of the bubble. As market capitalization recedes, what was once submerged now becomes visible and that is the goodwill companies have booked for their acquisitions. We believe, and have reason to fear, that companies in many cases overpaid for these M&A activities.
We also believe that this huge capital investment, for the most part, has not transformed the profitability of companies. Therefore, it has not led to significant shareholder value creation nor can it remain unaffected in the downturn.
Instead, the decline in the value from acquisitions booked as goodwill led to huge capital investment write-offs in many cases. Consequently, the largest losses ever recorded by global companies, as well as a string of high-profile bankruptcies, ensued. A case in point is the $44.6 billion loss reported by AOL Time Warner in 2002 as a consequence of a $54 billion goodwill write-off related to the acquisition of AOL. This write-down represents the value creation that Time Warner once expected from acquiring AOL but that it can no longer realize.
The Challenge for Companies
Since the economic bubble collapsed, the future value (FV) of most companies has declined drastically.1 In other words, the value of expected future growth beyond the value of cash flows from current operations estimated by the market has reduced significantly. In addition, equity markets are depressed, and capital markets are much tighter. However, goodwill for most companies has not decreased on par with these factors.
Under these new economic and market conditions, companies can no longer claim to expect the high growth rates of the late 90s. They are faced with two difficult options to bring goodwill in line with current market conditions. The first is goodwill impairment (GWI), which translates into a decrease in assets and a direct expense affecting the bottom line. Writing down goodwill brings a companys assets and growth in line with current growth expectations. However, it signals poor synergies and a destruction of value as a result of the poor M&A decisions on the part of the company. Fortune magazine estimates that goodwill impairment in the Fortune 500 could result in $235 billion of lost profits in 2003, leaving just under $70 billion of profits for these companies for the year.
The alternative is to derive more value out of current operations through value-targeting analysis. Value targeting helps a company determine whether the asset it paid for yields the expected cash flows adjusted for the risk associated with generating those cash flows. If the result of the analysis is that the cash flows are below expectations, measures can be and need to be taken to better leverage the asset in question. For example, if an acquired entity fails to produce the cash flows estimated during the deal-making period, value-targeting analysis will help identify the causes of the failure and the corresponding corrective actions, e.g., reduce overhead costs, streamline operations, optimize working capital, etc.
The Implications of Impairment
Goodwill and intangible assets often represent a considerable portion of an enterprises value, and recent accounting changes to FASB 142 will have an important effect on the valuation of some companies.2
The major change is that amortization of goodwill will no longer be permitted. In the past, goodwill has been amortized over its useful life, up to a period of 40 years. Instead, goodwill and other intangibles from past or future mergers and acquisitions will now be subject to testing for impairment of value. Businesses must perform this test on an annual basis, with only a few exceptions. Furthermore, this process must be conducted at the goodwill impairment-reporting-unit level, defined as the lowest level of an entity (e.g., goodwill impairment business units, subsidiaries, operating units, divisions, etc.).
Our belief is that companies did overpay for mergers and acquisitions during the economic boom and are at risk of facing goodwill impairment under the new, tougher economic conditions. To test our theory, we conducted research using goodwill data and company performance data to explore which companies — and we suspected many — destroyed rather than created shareholder value after a merger or acquisition during the economic bubble of 1996-2000.
To analyze the impact of mergers and acquisitions on companies overall performance, we analyzed the companies financial information in terms of their future value. We expected our analysis would help us identify the companies heading toward goodwill impairment.
We wanted to test our belief that a large number of companies are facing, or will soon face, significant levels of goodwill impairment due to a number of converging factors:
The first step in our analysis was to test whether the data showed the growing mergers and acquisitions during the 1996-1999 period, the subsequent decline in M&A activity, and the beginning of goodwill impairment after the economic bubble. Please refer to the About Our Research section at the end of this article for more information on our terms, definitions, and methodology.
Goodwill Impairment Analysis
We tested this hypothesis by analyzing the goodwill/future-value ratio (GW/FV) for all companies from 1996 to 2001. A high GW/FV reflects high expectations for future growth fueled by the merged/acquired entity. We believe that companies with a high ratio are more likely to face goodwill impairment in the near future.
The companies in each industry were then divided into three tiers. This was applied consistently to all industries.
Top tier: High M&A activity: GW/FV > 50%
Middle tier: Significant M&A activity: 50% ? GW/FV ? 15%
Third tier: No to low M&A activity: GW/FV < 15%
We ranked the companies according to their M&A activity and took the industry average for the top two tiers. This industry average thus reflects the M&A activities for acquisitive firms only. Please refer to Figures 1 and 2 for the historical industry averages. These exhibits confirms our hypothesis and clearly shows a decrease in the GW/FV from 2000 to 2001. This is due mainly to the fact that future value increased more significantly than goodwill, while current value decreased slightly or remained flat. In other words, investors were still expecting positive growth in the future, although current profits were low.
The most acquisitive industries were consumer durables and apparel; retailing; capital goods; and food, beverage, and tobacco. The pharmaceutical and media industries have medium M&A activity, which is fueled by research and development for pharmaceutical companies and by mergers and small acquisitions for media entities. The technology, software, and telecommunications industries are at the bottom of the second tier. This is due to the fact that for these industries, the end of the Internet boom heralded the end of M&A activity. These industries have thus had a much more rapid decrease in their current value, although their future value remains high.
Overall, however, the industry analysis confirms the trend that we postulated: M&A activities, and therefore goodwill amounts, increased during the economic boom and generally decreased thereafter. Certain industries, however, were hit harder and faster than others (e.g., software and technology industries). The accounting crisis (e.g., Enron) that impacted the energy industry is also evident: the GW/FV decreased dramatically in 1999 as a result of government lawsuits, loss of consumer confidence, and a general writing down of future-growth expectations and market value.
Identifying High-Risk Industries
Within each industry, we ranked companies according to the level of goodwill-impairment risk that they faced. We then determined the percent of top-tier and middle-tier companies within each industry (see Figure 3). The results are closely correlated with the results from the previous industry analysis: the technology and software industries are at the bottom, since they have already written down a significant amount of goodwill, whereas the consumer durables and apparel, media, and capital goods industries are about to face that problem.
The GW/FV test can also be applied at the industry or company level. This ratio tells us the likelihood a company will face goodwill impairment, but it does not tell us whether this impairment will be critical to the companys financial survival. To incorporate this additional dimension, we calculated the companys goodwill over current value (GW/CV), which measures the relative magnitude of goodwill to the companys current operations.3 Thus, a high GW/CV means that a companys current growth is fueled predominantly by mergers and acquisitions and that the impact of goodwill impairment will be more significant.
The combination of the two ratios, when plotted on a two-by-two matrix, yields very compelling insights. The companies that are most at risk are the companies in the top right quadrant with high GW/FV and high GW/CV. This means that their likelihood of goodwill impairment is high, and in the event of a write-down, their current operations will suffer most significantly (see Figure 4). Because each industry has different dynamics and growth expectations, the matrix quadrants were adjusted to the industrys median GW/FV and GW/CV lines.
This analysis can be easily applied to any company to determine the risk of goodwill impairment and its impact.
For illustrative purposes, we have performed this matrix test on three industries: consumer durables and apparel, capital goods, and telecommunications. These three industries are good examples of industries with low, medium, and high levels of M&A activity, respectively. We determined this by analyzing the industry average GW/CV, which tells us the amount of M&A activity relative to current operations, for all 17 industries studied.
Figures 5, 6, and 7 show a significant number of companies in the high-risk/high-impact quadrant for these industries. The consumer durables and apparel industry has many companies in the high-risk quadrants (top left and right). Because this industry produces highly and rapidly commoditized products, organic growth expectations for the industry are low. Thus, a significant amount of future growth is due to M&A activities, even though relative to other industries, the GW/CV is quite low. For this reason, most of the companies in the two high-risk quadrants will most likely be significantly impacted by goodwill impairment.
The telecommunications companies are mainly divided into the lower left and top right quadrants. This would confirm the fact that many telecom companies grew rapidly through acquisitions over the last few years. The top right quadrant contains the companies that will most likely face goodwill impairment. These companies will be hard-hit if they need to write down their goodwill, since acquired growth is such a large component of their current value, and therefore, they need to start implementing strategies to limit its impact now.
The capital goods companies are different from the telecommunications companies in that nearly two-thirds of these companies are in the high-risk quadrants. This would indicate that this industry has yet to act on most of its goodwill-impairment challenges. About half the companies at risk also have large amounts of goodwill versus their current operations, placing them in the high-risk/ high-impact category.
We believe that the GW/FV test and the goodwill-impairment risk/impact matrix provide an easy-to-use, yet effective, tool to determine the likelihood and the magnitude of the impact of goodwill impairment, at both the industry and company levels.
Conclusion and Implications
This preliminary study allowed us to demonstrate that many companies overpaid for their mergers and acquisitions during the economic boom, in light of current market valuations. In the current tougher economic conditions, these companies are starting to face the consequences, being forced to write off goodwill they can no longer justify through high-market capitalization. This is an unfortunate situation for many companies, but not an insurmountable one.
In most cases, companies can limit or eliminate goodwill impairment through more effective post-merger/acquisition integration, optimization of acquired/merged operations and systems, and by closely targeting value to achieve better synergies. This in turn leads to enhanced shareholder value.
Accenture has a methodology that can help identify current merger/acquisition shortcomings and derive customized solutions to rectify problems (see Figure 8).
By further integrating mergers and acquisitions, cultivating financial flexibility, developing an intimate understanding of value-creation levers, and executing accordingly, companies can exceed their M&A goals and thereby significantly limit goodwill impairment. They can gain market share, forge new customer relations, and strengthen their customer and service positions to provide them with a platform for profitable growth as a new or better-integrated company.
However, the implications from goodwill impairment do not affect only companies with medium or high goodwill amounts on their books. Over the next few years, as companies write down their goodwill, companies with little or no goodwill could acquire these assets and/or operations at bargain prices. Thus, companies with low GW/CV could monitor the market and opportunistically acquire assets and play a broader role in industry consolidation.
Goodwill impairments over the next few years will also increase the transparency of assets/operations value in a given industry. Thus, companies can benchmark their own operations against current market value and/or competitors. Goodwill impairment information in financial statements provides additional clarity on the industry and valuable insight on how competitors are faring.
As we continue our study of goodwill impairment and its implications, there are three unanswered questions that companies should think about. First, is there an optimal level of goodwill to future value amount within each industry? Also, as goodwill-impairment tests will now be performed every year, thereby greatly shortening the time to realize projected M&A benefits, will there be a reduction in the prices paid for mergers and acquisitions? Given these new and more stringent demands, will there be a disincentive for companies to acquire assets and/or merge with other companies for long-term strategic growth?
Watching goodwill go bad could have significant implications on the value migration in industries over the coming years as the gap between conservative accounting practices and the strategic value of future intangibles widens.
Figure 1: Goodwill/Future Value Ratios for 17 Industries, 1996-2001
Figure 2: Goodwill/Future Value for Industries, 1996-2001
Figure 3: Percentage of Companies That Faced Goodwill Impairment in 2001
Figure 4: Risk and Impact of Goodwill Impairment Matrix
Figure 5: Consumer Durables and Apparel Industry GW/FV Versus GW/CV
Figure 6: Telecommunications Industry GW/FV Versus GW/CV
Figure 7: Capital Goods Industry GW/FV Versus GW/CV
Figure 8: Shareholder Value Creation Levers
Sources
- The 2001 Stern Stewart Performance 1000
- -Appraisal Economics Inc (www.appraisaleconomics.com/)
- Caliber Advisors (www.caliberadvisors.com)
- Accenture Analysis
- Fortune magazine, April 2003
Endnotes
1 Future value is defined as the difference between the enterprise value and the value of current operations. Enterprise value is defined as the market capitalization plus net debt and capitalized leases. Please refer to the Methodology section of the About Our Research sidebar for more detail on these terms.
2 FASB 142 rule governs goodwill impairment treatment. It was adopted on June 29, 2001.
3 Current Value = NOPLAT / (WACC — growth rate). NOPLAT is the current annual operating cash flow. Our CV calculation assumes competitive markets and a constant operating growth rate and projects current cash flows at the current cost of capital and risk level. WACC is the weighted average cost of capital.
About Our Research
To understand our research, clarity must be achieved on a number of terms. Future value represents the companys future growth prospects and thus can be defined according to the following equation:
Future Value = Enterprise Value – Current Value of Operations3
The enterprise value is the sum of the companys equity (market capitalization), net debt, and capitalized operating leases. The companys current value (CV) was assumed to be the companys current cash flows projected into the future and discounted at the companys cost of capital. This calculation thus takes into account the companys current operations.
A companys future value can be broken down into two parts: organic value and acquired value. The first refers to a companys operations and its organic growth potential, namely the cash flows generated over time by the current operations at their organic growth rate. The second refers to the cash flows generated by mergers and acquisitions. This can be summarized by the following equation:
Future Value = Acquired Value (M&A activities) + Organic (Operating) Value
Our main assumption for this study was that goodwill is a good estimate for M&A-related costs, and therefore can be used as a proxy to calculate acquired growth. This assumption permits us to then calculate the companys organic future value, as well as analyze a companys M&A burden or synergy relative to its overall performance.
Methodology
We analyzed the financial results of 999 of the largest companies in the United States leading up to and following the economic boom that began in 1996. The 999 companies were divided into 17 industries. These industries are: banking; capital goods; commercial services and supplies; consumer durables and apparel; energy; food, beverage, and tobacco; health care equipment and services; hotels, restaurants, and leisure; insurance; materials; media; pharmaceuticals and biotechnology; retailing (including food and drugs); software and services; technology hardware and equipment; telecommunication services; and other.
To gauge the impact of the periods strong M&A growth and subsequent decline on goodwill, we analyzed the data using two key ratios. Using goodwill as a proxy for acquired growth, the first ratio tells us what percentage of future value a company derives from its acquisitions. In other words, a large ratio means that a large part of the companys growth is fueled by mergers and acquisitions. Thus, the larger the ratio, the more likely this company will face goodwill impairment in the near future given the tougher current economic conditions.
Goodwill
Future Value x 100
The second ratio yields some information on the magnitude of M&A activities of the company relative to its current operations. In other words, this ratio shows how important mergers and acquisitions are to the companys current growth strategy. Thus, a high ratio means that acquisitive growth is a central component of the companys growth strategy.
Goodwill
Current Value x 100
Using these ratios, we analyzed the data of these 999 companies from 1996 to 2001. However, to get the most accurate results, we had to normalize the data to adjust for abnormalities or large outliers. The three measures we took to normalize the data were:
