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For companies mulling write-offs, economic turmoil is a terrible thing to waste.
S.L. Mintz, CFO Magazine
January 1, 2009
When boards of directors convene to review a dismal 2008, many will vote to leave shareholders with even less. They may have little choice. At dozens of public companies, market values now languish below book values, a situation that makes write-offs likely. While many CFOs may balk at such a move, regulators and stakeholders are increasingly demanding that balance sheets get a makeover. As a result, finance departments are wielding scalpels, knives, and even the occasional ax. Their specific focus: goodwill.
That was the case at Mohawk Industries, the country's second largest rug and carpet maker. "The stock-price decline below book value really drove us toward an early assessment of goodwill," says CFO Frank Boykin. Despite some misgivings about whether a stock-price drop was a sufficient cause for goodwill impairment, Boykin launched an expensive and onerous review process that involved more than two dozen managers from across the company, not to mention some high-priced external advisers.
An assistant controller managed the two-step process nearly full time for a month and a half. The first step was to calculate discounted cash flows and earnings multiples at business-unit levels, in the hopes that they would, when consolidated, nearly match the stock price. When they fell too far short, Mohawk embarked on a comprehensive step two. "You assess every asset and liability on your books and compare the sum of those fair-value calculations with the value you came up with for the total enterprise. Whatever is left is now your new goodwill," Boykin says. "That number drives the impairment charge, the difference between old goodwill and new goodwill."
Plenty of Company
In November, Mohawk announced a preliminary $1.4 billion impairment charge covering goodwill and other intangible assets. It reduced the book value of goodwill by 45 percent and equity by 27 percent. Mindful that a further drop in stock price could result in more charges down the road, Boykin's chief satisfaction lies in moving on. "I am happy that it is behind us," he says. "Our team did an excellent job in a very short time."
Write-offs surged in the throes of the 2001 recession as companies pared book value by $51 billion, or 20 times all the write-offs recorded from 1994 through 2000. The trend was partly driven by a last chance to toss out impaired assets under looser rules: in January 2002, FAS 142 and 144 kicked in, covering disposal of goodwill, intangibles, and long-lived assets that did not live as long as planned. Write-offs ticked down steadily, to less than $2.5 billion, until a fivefold increase in 2007 provided a harbinger of 2008. Today, the prospect of substantially reduced cash flow makes goodwill more vulnerable to write-offs than it has been in years.
Mohawk's symptoms surfaced in the third quarter of 2007; by early December 2008, market capital at more than one in six S&P 500 companies languished below tangible book value, including such household names as International Paper, Valero Energy, Alcoa, Office Depot, Tyson Foods, Motorola, and Goodyear.
When to Play the Card?
When companies must adjust book values downward, goodwill serves up a juicy target. Topped by General Electric with more than $81 billion, 419 S&P 500 companies posted total goodwill worth $1.8 trillion as 2008 rolled to a close. Median goodwill was $1.2 billion.
Unlike depreciable tangible and intangible assets, goodwill can reside forever on balance sheets with no amortization to cause a drag on earnings. A tough business climate with mounting impairment reminds managers that goodwill is expendable.
No wonder, then, that many companies have begun chipping away at goodwill. A $171 million write-off extinguished the remaining goodwill at Morris Publishing. Coping with less demand for its travel services, Orbitz Worldwide took a $297 million charge for impairment of goodwill and intangible assets. Griffon Corp., a diversified supplier of electronic information, specialty plastics, and garage doors, lopped off $13 million of goodwill in its garage-door business.
Goodwill write-offs have long been a card that companies can play in any number of situations, from compensating for losses to allowing a new CEO to start fresh, or fresher. But in playing the card solely as a response to declining stock prices, are companies being shrewd, or rash? "The big question is whether, and to what extent, market cap is a good proxy for underlying asset values," says corporate tax expert Robert Willens.
Accounting rules leave room for interpretation. Most finance executives flatly reject market fluctuations as sufficient cause alone to jettison assets. "Is the share price reflecting the fundamentals? The answer is no," says CFO Wayne R. Brownlee of Potash Inc., the world's leading producer of the main ingredient in fertilizer. International Paper's chief accounting officer, Fred Bleier, concurs. "It's just hard to understand that if your share price decreases 20 percent in one day that really reflects some kind of decline in your economic value," he says. "If you were in liquidation mode, it would be a valid approach. In an operating mode, where you have cycles, real fair value to an entity running its business is more related to expected cash generation than to the trading price today."
But Wall Street tends to take the view that market value and fair value are synonymous. "Most analysts assume that they are equivalent," says Willens, "with the result that market declines we've experienced should presage goodwill impairment and lead to massive goodwill write-downs." And Bleier agrees that a plunging share price — International Paper fell from $30 a share in September to $11 in early December — does indicate a potential for impairment.
Far from preserving value, says Ray Ball, a finance professor at the University of Chicago's Booth Graduate School of Business, suppressing write-offs can forestall recovery. Japanese regulators learned that lesson when their economy collapsed into recession nearly two decades ago. By allowing Japanese companies to retain investments on their books at cost even after the country's stock market cratered, says Ball, regulators drained away any incentive to address overvalued assets. "Write-offs force CFOs to identify their valuable assets," Ball insists. "Decisions that make books more consistent with economic reality accelerate recovery."
Academics across the country tend to agree. "The recent trouble will result in a lot of firms reducing goodwill," says Southern Methodist University professor Doug Hanna, who has studied so-called big-bath write-offs over three decades. "We have a period now when the entire market is expecting firms to report [poor] results," he says. "It opens doors to get rid of a lot of bad things at once."
Opportunity is knocking loudly now, says Kristi Minnick, an assistant professor at Bentley College. Minnick put historical write-offs under a microscope in her 2005 Ph.D. thesis, "Write-offs and Corporate Governance." When stocks give back a half decade of gains, she says, write-offs go almost unnoticed. "Markets would not be punitive in any way, shape, or form," Minnick insists. The chance to unload impaired assets without rattling the stock market resembles bulk waste day in the suburbs, when everything unwanted gets carted away, no questions asked.
During the first half of 2008, goodwill write-offs averaged $652 million, according to data gathered by Los Angeles—based investment bank Houlihan Lokey. The median disposal charge was $211 million. A $6.1 billion write-off by Delta Air Lines erased almost half of its goodwill balance, a fairly typical ratio. Average and median goodwill impairments as percentages of goodwill balances, according to Houlihan Lokey, were 48.5 percent and 46.5 percent, respectively.
When companies record goodwill impairment, cash has long since left the building. Charges are noncash by definition, vestiges of transactions past — and not just targets' excessive price tags. Paying with overpriced shares may lead to most goodwill write-offs, according to a study by Feng Gu of the State University of New York (Buffalo) and Baruch Lev of New York University's Stern School of Business. They determined that "overpriced shares provide buyers and management of the buyers with strong incentives to acquire businesses, even at excessive prices and doubtful strategic fit, in order to buy themselves out of the overpriced share predicament and postpone the inevitable price correction by portraying continued growth."
Because goodwill write-offs impose no cash impact, companies can limp away from massive events, as Sprint did last March after bidding goodbye to $30 billion of goodwill, which stemmed largely from its 2005 acquisition of Nextel, or as Time Warner did in 2002 following its disastrous AOL merger. Sprint's write-off ripped $29 billion from shareholders' equity.
Companies typically refrain from write-offs for two reasons: stockholders and lenders. In a post-Sarbox world, says one attorney, companies that may once have resisted write-offs for fear that they give off a distinct whiff of failure may have little choice but to move ahead if impairments have become visible. Any legal basis for not disclosing has gone away. Timely disclosure now is part of the job, and an obligation. "Since Sarbox, companies cannot disclose fast enough," the attorney says. "Nobody wants to go to jail."
While no CFO wants to go to prison, some may still be tempted to manage market reaction, and on some level you can't blame them. After a $24 million goodwill write-off early in 2008 (a third of its goodwill balance), Courier Corp. suffered a 21 percent slump in its stock price. But these days that kind of market reaction may be the exception, because investors, says Bentley's Minnick, can differentiate between write-offs that will improve performance and write-offs that won't.
In the Houlihan Lokey study, average goodwill write-offs in the first half of 2008 reduced stock price by 4 percent on the first full trading day. One-third of the sample saw a relative stock-price change of less than 2.5 percent. Meanwhile, 10 companies enjoyed an average 4.5 percent bump in their stock prices, with Harris Interactive realizing a 10.5 percent increase.
One key to minimizing the damage is to communicate regularly with investors. "You will not see material reaction in the stock price if management has been disclosing realignment," says Larry Levine, director of corporate finance and business-valuation services at McGladrey Pullen. "In an efficient market you would not expect the price to move, or movement would be de minimis at most."
In fact, write-offs can be perceived as a form of good news, says management consultant Eric Olsen of Boston Consulting Group. They may eject obsolete inventory, bad receivables, or other baggage that investors know about and the market price reflects. "Take that write-off," says Olsen. "It's good news because you are not surprising the Street. You're saying to shareholders, 'We're with you; we'll address this issue now.'" Conversely, Olsen says, write-offs can also be perceived as totally unexpected bad news, as when they reveal that working capital is not under control.
While shareholders may react favorably based on their perception of future prosperity, lenders react to write-offs in a different way. They wield legal contracts that impose penalties if goodwill write-offs violate asset-based covenants. "When a real loss is written on the balance sheet," says the University of Chicago's Ball, "lenders can enforce their contractual rights." Write-offs alert lenders that loans are skating on thinner ice and may risk a technical default or a harsh change in terms.
Mohawk's recent write-off shrank total 2007 assets by 16 percent, but CFO Boykin knew his credit line was safe. "Our debt-to-capitalization ratio stays below 60 percent," says Boykin. "Even with the write-off we had plenty of room. But you must take a look at that early in the process."
Like them or not, as a response to a besieged stock price, goodwill write-offs promote penance and renewal. They own up to past mistakes, repair balance sheets, and help restore investor confidence. As corporate decisions go, to err is human, to take a goodwill write-off is sublime.
S.L. Mintz is a deputy editor of CFO.
When Write-Offs Go Wrong
While goodwill write-offs have many virtues, don't assume they will generate tax benefits. Sprint reported that the "substantial majority" of its giant write-off produced no tax benefit at all.
Benefits accrue only when a transaction that produced goodwill was set up initially as a taxable purchase of the target's assets, a rare occurrence. Undertaken with unbridled optimism, like most mergers, Sprint's merger with Nextel was never structured to produce tax benefits if it failed. "The goodwill impairment charge," says corporate tax expert Robert Willens, "had the effect of penalizing Sprint's net income and shareholders' equity without an accompanying tax benefit: the worst of all worlds."
Even when recording impairment of tangible or intangible assets, write-offs can be tricky. "There is no automatic deduction," warns corporate tax accountant Paul Beecy at Grant Thornton. Deductions ordinarily occur when an asset becomes worthless and means absolutely zero. In that case, Beecy advises, get rid of it to forestall any doubt about your conviction. There may be some opportunities for partial worthlessness, but they don't apply just because a viable customer is short of cash and does not want to pay. "Unless you dispose of the asset," says Beecy, "you are facing an uphill battle." — S.L.M.
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