The Goodwill Games

There isn't much peace in M&A-land these days, but there may soon be plenty of goodwill. Or at least much more than finance executives are creating today if, as expected, the pooling method of accounting for mergers gets the boot from the Financial Accounting Standards Board (FASB). That's because the alternative, purchase accounting, calls for long-term goodwill amortization and regular impairment tests, which pooling avoids.

But if one looks at current practice, the rules for purchase accounting are badly in need of repair. Companies facing a fresh pile of goodwill are likely to explain it away, share it with partners, write it down over a shorter period, or avoid it altogether through accounting magic.

In consequence, their results are becoming harder and harder to compare, judging from the growing number of companies already playing goodwill games.

IT'S THE CASH THAT COUNTS
Part of the problem lies in measuring goodwill. Loosely defined, it is any premium that a company pays for another company's assets. Even so, finance executives across the corporate spectrum insist that goodwill charges are irrelevant and, by extension, that earnings per share is losing credence as a measure of value creation. After all, cash earnings are what really matter, and investors ignore big noncash write-offs like goodwill impairments anyway, right?

Right, says Rodney Jacobs, CFO and vice chairman of Wells Fargo. "Goodwill doesn't change the cash flows or the economics of a deal. None of [the questions about amortization] should matter, because it's just accounting," he says.

Then why is Wells Fargo going to great lengths to explain its treatment of an $11.3 billion stock purchase last March of First Interstate Bancorp., which more than doubled the assets of the San Francisco­based bank to $108 billion? Answer: It added $7.2 billion of goodwill to Wells's balance sheet. To quell investor anxiety over the effect of the $290 million in annual amortization on earnings per share, management regularly reminds investors that purchase accounting allowed the bank to retain the ability to buy back stock quickly with the regulatory capital created by the goodwill amortization, to better manage its capital ratios, and to return capital to investors through stock buybacks. The bank also reports "cash earnings" to shareholders on a quarterly basis, and suggests they value the bank using that preamortization number instead of EPS. To drive home the point, Wells explained the differences between poolings and purchase accounting, and the irrelevance of goodwill, in a special brochure it sent to shareholders a few months after the merger.

Yet Jacobs says the efforts are not really necessary. "[Explaining goodwill and cash earnings] to investors really turned out to be a nonissue for us. Share values in the market are driven by the smart money," he says, "and the smart money understands the economics of cash flow."

In fact, investors at the moment seem more concerned about the merger's ability to produce cash, as Wells has had a hard time integrating systems and retaining customers.

Yet Wells is far from alone in trying to draw shareholders' eyes up a few entries from the bottom line. NationsBank, the southeastern banking empire based in Charlotte, North Carolina, emphasizes "cash basis" earnings in its reports to shareholders, now that it has booked $6.4 billion of goodwill from the $9.7 billion purchase of Boatmen's Bancshares, of St. Louis.

There is also The Walt Disney Co., which is whittling away at the $18.3 billion of goodwill from its $18.9 billion purchase of ABC Inc. in 1995 to the tune of about $450 million in amortization each year. Yet Disney CFO Richard Nanula--who declined to comment for this article--wrote in the company's 1996 annual report: "Disney believes that the most meaningful measure for valuation purposes is pro forma earnings per share adjusted to exclude the amortization of goodwill associated with the acquisition [of ABC]." That amounted to 66 cents a share last year, reducing Disney's pro forma EPS from $2.89 to $2.33, a 19 percent drop that would have been avoided with the magic of pooling treatment for the transaction. Consider actual reported earnings of $1.96 a share, since the ABC transaction was not completed until February 9, and goodwill reduces EPS by a third.

Disney analysts take Nanula's suggestion to heart, noting that the goodwill charges are predictable, transparent, and noncash. "Amortization is a complete nonissue. My focus is on free cash flow and EBITDA [earnings before interest, taxes, depreciation, and amortization]," says Christopher Dixon, a managing director at PaineWebber. "Do I care how you report earnings? No. I think EPS is pretty worthless. Any sophisticated CFO can hit his earnings numbers any quarter."

GENESIS LIMITS GOODWILL
Other companies are structuring deals in ways that enable them to take on as little goodwill as possible. Geriatric-health-care provider Genesis Health Ventures, with $671 million in 1996 revenues, recently dove into a $1.4 billion joint venture with two venture capital firms to gain control of Multicare Inc., with $532 million in revenues, nearly doubling the number of nursing home beds and pharmacy facilities under the Genesis name. But Genesis took only a 42 percent stake in the transaction for its $300 million of borrowed capital, leaving 58 percent for Texas Pacific Group and Cypress Group to split. Each anted up $210 million for its share. The goodwill on the deal? More than $600 million.

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