Global merger and acquisition volumes reached their third-highest year on record in 2018, continuing a trend that has seen dealmaking steadily increase since the financial crisis. All this M&A means that there are huge amounts of goodwill sitting on companies’ balance sheets — which bring the potential of similarly large impairments with them. We think investors should be paying this more attention.
So far, the scale of impairments has not been a big concern. With interest rates still at historically low levels and the global economy growing strongly in recent years, investors have largely been content to assume that firms have paid fair prices for the acquisitions they have made.
Today, however, the sustainability of global growth appears far from certain. So the rosy assumptions on which many balance sheets rest look less assured. And that could have serious implications for corporate profitability in the future.
Curtailed profits have obvious implications for share prices. But impairments are not only a concern for equity investors. They can also trigger bond covenants — entailing new equity raises, renegotiation of covenants or ratings downgrades. Accordingly, all investors should take them seriously.
Recently, we have started to see some eye-catching — indeed, eye-watering — impairments. General Electric (GE) is an obvious example. In October, the company wrote off $23bn from the acquisition of Alstom. This acquisition had cost GE just $10.1bn, but Alstom’s hefty liabilities resulted in a negative book value even before the impairment.
Then there’s the case of Kraft Heinz. In February, the company recorded a $7.3bn goodwill impairment. The impact on its share price was immediate; its stock lost more than a quarter of its value on the day of the announcement.
What is interesting is that the main cause of the GE and Kraft impairments related to large acquisitions conducted in 2015. Indeed there is some evidence inferring that impairment charges are perhaps more likely two to three years post transaction.
So, do these high-profile examples herald a wave of significant impairments elsewhere? We think they might. For one thing, the size of the recent M&A boom means there’s a much higher proportion of goodwill on balance sheets than in the past. In the recent buying bonanza, the premium paid above a target’s book value was typically well above 20 per cent. If GDP growth slows and cost pressures rise, justifying such large asset values is going to prove more difficult.
Impairments are not always bad news in themselves. Sometimes they occur because incoming management teams are keen to write off goodwill so that they can start with a clean slate — as was the case with GE. Conversely, though, incumbent managements can be reluctant to recognise impairments, because this is tantamount to admitting that they have overpaid for assets. And who wants to admit to a mistake?
We think it’s particularly important to look out for instances in which a company is revising down its future earnings but not taking goodwill impairment charges. Given the subjectivity afforded to company managements in testing goodwill, a lack of impairments can’t be used to assume that all is well. This is especially true when writedowns become widespread in a given sector. Are the exceptions genuinely different or, given the ample room for manoeuvre afforded to managements by the testing process, are they hiding something?
Some sectors are likely to be more vulnerable to impairments than others. In our screening, we focus on companies with goodwill as a high percentage of total reported assets. We overlay this with an analysis of sectoral margins, focusing particularly on high exposure to rising labour costs. Our analysis suggests that healthcare, technology and media companies may be among those most at risk.
This sector-based screening helps. Ultimately, though, there’s no substitute for subjecting individual companies’ accounting disclosures to rigorous analysis. This needs to involve scrutiny of the discount rate applied and the impact that any change in it will have on the valuation of the goodwill on the balance sheet. Particular attention needs to be given to whether the discount rates reflect the current cost of capital.
It’s also important to engage with audit firms, to ascertain their view of the management’s attitude to impairment tests. How many investors fully read all the audit statements in financial statements? Perhaps investors should put pressure on companies and hence indirectly their auditors to include more disclosure surrounding how the audit has considered goodwill assessments.
Comparisons with sector peers can be illuminating too, and the focus on goodwill impairment tests should form part of a wider forensic-accounting screen that covers other factors such as off-balance-sheet financing and material provisions.
None of this is easy, and there are no short-cuts. But for bottom-up investors with the requisite skills, energy and resources, a focus on goodwill impairment may yield vital insights into future profitability — and into the performance of bonds and shares.
Nicholas Kordowski is head of non-financials fixed-income research at Aberdeen Standard Investments
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