Why intangibles are better than goodwill
PricewaterhouseCoopers, New York
With most M&A deals, company management is concerned with the level of intangibles recorded and resulting amortisation that can drag on earnings in future periods. Accordingly, most managers focus on the percentage of the purchase price accounted for by goodwill. Generally speaking, the higher this figure is, the better they like it. Goodwill is good, so the thinking goes, because it is not amortised. As a result, there is no obligation to write down its value year on year, with all the adverse effects on earnings this can have.
For many dealmakers therefore, one of their objectives when putting a transaction together is to maximise the amount of goodwill recorded; seemingly, many investors reinforce this behaviour through their focus on short-term earnings metrics.
While such a strategy may be attractive in the short term, it is not one that is designed to give investors a full understanding of the dynamics of the deal, let alone many clues as to how the newly merged entity will perform in the future. In fact, very little information is conveyed as the amount of goodwill recorded increases, other than that the acquired operation will have to sell more of its products or services to yet to be determined customers from currently undeveloped technology, brands and other similar assets. Clearly this represents a riskier proposition than one where you can count on recurring sales to a customer base or an enduring technology or brand in the periods subsequent to the acquisition date.
Perhaps, therefore, it is time for investors to put less emphasis on goodwill and instead to look more closely at transactions where a number of specific intangibles are recorded in terms of their type, as well as their value to the overall deal, even if this does lead to more amortisation than would otherwise have been the case.
The benefits of amortisation
In fact, looking at the decisions being made about the amortisation of intangible assets can in itself be revealing. As amortisation is the process whereby a company spreads the cost of an intangible asset over its expected useful life, a savvy investor can get an interesting angle on just how long a business believes that the asset will be of benefit. Intangibles such as technology and customer relationships, which implicitly detail expected purchasing patterns, can be treated in this way and, when they are, it is possible to gain insight into how long the company expects them to make a meaningful contribution to value creation.
Suppose a customer relationship is being amortised over five years – what does this say about the stickiness of a company’s client base? Maybe the industry is one where customer loyalty is fleeting or short-lived, or perhaps the target has been doing something wrong. By contrast, if the same relationships were to be amortised over a period of 15 years, that could imply a low turnover of customers – something that could well be a source of competitive advantage. In this way, the wise investor, who is not just interested in making a quick buck the following quarter, may want to see a degree of intangible amortisation detailed in a press release announcing the successful completion of a deal: if it is there, particularly at a low level relative to the amount of intangible recorded, this could imply the ability of the acquired operations to generate above-average earnings over the medium and long term.
Learning from intangibles
But specifically identifying intangibles and their value to a deal does not mean that they then have to be amortised. As long as they meet the requirements of the accounting standards – that they are of indefinite value to the company – they can be specifically identified without any resultant write-down. In this scenario, it would provide a great deal of valuable information to investors – namely, that the company believes such indefinite-lived intangible asset contributes to a sustainable stream of future cash flows. The fundamental point about attaching specific values to intangibles is that it allows investors to fashion informed opinions on their value to a business, and whether this is accurately reflected in purchase price, in a way that merely describing intangibles as goodwill can never do.
Take trade names and brands, for example. In many industries the name attached to a product and the connotations it evokes in the purchasing public is often a crucial element to the success of a business. Is it realistic to assess the merits of the acquisition of a brand-rich company without understanding exactly what values the purchaser attached to those brands?
Far-sighted investors, however, will want to know the percentage of the purchase price such brands represented: if they accounted for 25 per cent of the entire price, as opposed to a much lower figure, that would indicate that the relevant names are clearly worth something and that they are likely to have been built up over a long period of time into a competitive advantage. This, in turn, may imply that the company in question has a long-term future. Being armed with an accurate picture of just how intangibles were valued in a deal will give the investor the tools to make this judgement.
Goodwill laid bare
In addition to focusing on intangibles, investors should seek to further understand what goodwill, the residual, could possibly represent. With such focus, it is possible that goodwill will not come across in such a favourable light. Stripped of all quantifiable intangibles, goodwill often comes down to a combination of one or more of the following four factors:
• Workforce value.
• Going-concern value.
• Payment of anticipated synergies between the merging organisations.
All will have to be carefully looked at, and three of them may not have entirely positive connotations. A company’s workforce is a double-edged sword: it can clearly set a company apart from its competitors but it is an asset that goes home every night with the risk that it may not come back. It is therefore a difficult asset to control. Likewise, synergies on the cost and/or revenue side can help to justify a deal (cost synergies are probably more likely as these are more in control of the buyer), but what looks good on paper does not always turn out to work well in practice – those planned-for synergies, therefore, may not actually occur, at least in the way they were planned. Then there is the thorny issue of overpayment. It is not something that the acquirer is going to highlight but, when there is a lot of unexplainable goodwill, investors should begin to question management’s motives.
In fact, the only aspect of goodwill that can unequivocally offer comfort to an investor is the going-concern value of a company. This represents things such as the value of assets in place, institutional knowledge, reputational value not already captured by trade names, and superior location. All these attributes can lead to sources of competitive advantage and sustainable results; and/or they can give an entity the ability to develop hot products, as well as to achieve above-average earnings.
Instead of focusing on the drag to earnings created from amortising intangibles, investors should instead understand such metrics as:
• Intangible assets as a percentage of purchase price.
• Intangible assets as a percentage of intangibles plus goodwill.
• Amortisation of intangibles as a percentage of intangibles.
Such metrics would provide the investor with a significant amount of important information. For example, a greater percentage of intangibles to goodwill may mean that there is a greater likelihood that future projected cash flows for the company will be achieved, giving the investor greater certainty. Then, with regard to amortisation, a lower percentage of amortisation expense to intangibles could indicate the greater staying power of the intangibles, which presumably are linked to the value drivers of the underlying business.
Other metrics can also be developed, but the bottom line is that the greater the acceptance of intangibles and their resulting amortisation, the more opportunity there is for the investor to get to the heart of a deal and therefore to understand whether it will be able to create long-term value.
Investors must drive the change
Intangibles, therefore, can reveal a lot about a company acquisition. They help investors to analyse the purchase price in greater detail, they enable them to get a stronger angle on the company’s future and they put remaining goodwill in sharper light. Investors should, therefore, assess the type, amount and life of intangibles arising from an acquisition to reinforce the value drivers of the target and decide whether the deal is a good one.
In the real world, of course, this is all a long way off. Companies tend to respond to what the investment community wants. And right now they believe it is looking for growing, sustainable earnings that are predictable. And boards of directors understand that the less amortisation there is, the less effect there will be on EPS. So this is what they concentrate on.Companies will change when they feel that investors want them to change. So it is up to investors to ask themselves whether they are really getting the information they need about transactions at the moment. And if they thought about it for just a while, perhaps more than a few of them would realise that they are not. At least, not if they are serious about the long-term.