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Going With the Flow

A new accounting proposal could change the way stocks are valued - but for better or worse?
Ronald Fink, CFO Magazine
October 1, 1999

You've heard these arguments before. On one hand, finance executives and equity analysts worry that investors fail to ignore the impact of goodwill amortization on earnings. On the other hand, standard setters and accounting experts contend that goodwill is an asset that belongs firmly on the balance sheet.

Now, a proposal from the Financial Accounting Standards Board would enable companies to report, on the income statement, a fully diluted earnings-per-share figure without goodwill, even when goodwill appears on the balance sheet. At first glance, the proposal might seem relevant only for companies bedeviled by earnings hits following the demise of pooling. But analysts say the proposal will have a much broader impact.

The reason, says Robert Willens, a tax and accounting adviser at Lehman Brothers Inc., in New York, is that it represents "a big step" on FASB's part toward establishing a generally accepted accounting principle for reporting cash flow on the income statement. At present, lacking a standard for showing cash flow, analysts have come up with definitions of their own. These vary widely, depending primarily on the industry covered. Adding to the confusion, some companies have developed their own cash-flow definitions, which may differ from those of analysts. "They'll try to convince analysts to use their preferred version, and cut out of conference calls those who don't go along," notes Martin Fridson, a high-yield bond strategist at Merrill Lynch & Co. The range of definitions can lead to apples-to-oranges comparisons of corporate performance, and mislead investors.

"You can define cash flow lots and lots of different ways," says Rick Escherich, a managing director in J.P. Morgan & Co.'s mergers and acquisitions group, in New York, "so this will help a great deal."

Is Cash King?
Demand for a more formal standard is growing, at least in the industries that use cash-flow analysis most widely. A recent survey by J.P. Morgan found that 55 large companies reported some type of cash-earnings number in the first seven months of 1998, 60 percent more than during a similar period the year before.

The survey also found that 72 percent of 178 analyst reports from such brokerage firms as Merrill Lynch and Salomon Smith Barney published a cash-earnings multiple of some kind. In some industries, namely media and publishing companies, real estate investment trusts, and energy companies other than integrated oil concerns, that figure jumps to 94 percent. Indeed, some analysts at such brokerage houses as Keefe, Bruyette & Woods; J.P. Morgan; Goldman, Sachs; and Credit Suisse First Boston have gone so far as to jettison earnings in favor of cash flow when valuing stocks.

Whether investors should ignore goodwill is another matter (and one far too complicated to address here). But one thing is clear: The proposal would enable companies that are aggressively pursuing acquisitions--and paying big premiums over a target's book value into the bargain--to report much larger cash earnings compared with the traditional kind on their income statements.

Consider AT&T's results. Had the company been able to exclude $184 million in goodwill from its acquisitions of Tele-Communications Inc. and IBM Global Network last year, AT&T's fully diluted earnings per share for the quarter ended last June 30 would have been 53 cents, not 49 cents. And the increase over the year- earlier quarter would have been 26 percent, not 17 percent. For the first six months of the year, AT&T's earnings would have been 95 cents instead of only 88 cents, and the higher number would have represented a 7 percent increase compared with the first six months of 1998, instead of a 1 percent decline.

What's more, the effect would have been twice as great after taking into account another proposal that is also part of FASB's business- combinations project. This would halve the amortization period for goodwill from 40 years to 20. As it stands, AT&T faces still more goodwill amortization, since the company has yet to account for its $62 billion acquisition of MediaOne earlier this year. Based on the premium that price represented over MediaOne's book value at the time, as much as $34 billion more goodwill could soon appear on AT&T's balance sheet.

But under FASB's proposals for amortizing and reporting goodwill, AT&T would be able to add back as much as $1.7 billion or so a year in earnings for that deal alone. This would amount to about 52 additional cents a share when considered on a cash basis.

Dan Somers, AT&T's CFO, declined a request for an interview to discuss the potential impact of the FASB rule on investor perceptions of the company. But analysts say the cash- earnings number is likely to draw more attention away from the traditional earnings number reported by AT&T. Willens goes so far as to predict that cash earnings will soon become "the primary performance number" used in stock valuation.

To be sure, AT&T is something of an anomaly, since so many other blockbuster deals in recent years were accounted for as poolings, which allowed the acquirers to combine their targets' assets at their current market value rather than at historic cost. AT&T didn't use enough stock in financing these deals to qualify for pooling-of-interest treatment.

But the example of AT&T shows the difference that FASB's proposal will make once companies can no longer take advantage of pooling. Other examples of high-profile companies where significant goodwill amortization puts them in a similar position include Coca-Cola Enterprises, Genentech, Walt Disney, and MCI WorldCom. (Their CFOs declined comment.)

A P/E Deflater
Yet, one might wonder, why all the fuss, when so many companies and analysts contend that goodwill doesn't matter? The short answer is that a standard for cash earnings will help them get investors to agree that it doesn't matter, even in industries in which cash-flow analysis isn't so prevalent.

J.P. Morgan's Escherich notes that in industries experiencing the most M&A activity these days, including financial services, high technology, and health care, most companies are still valued on the basis of traditional price/earnings multiples. In fact, less than a third of the analyst reports for companies in those industries included cash-earnings multiples, according to the survey.

Since hits to earnings from goodwill amortization inflate those companies' P/E multiples, Escherich contends that their stocks may look overpriced to investors that fail to take the amortization amounts into account. When cash earnings are used as the denominator instead of earnings after goodwill amortization, those P/Es automatically fall even with no change in the stock prices.

However, it's one thing to hail FASB's proposal as a big step toward solving the "problem" of goodwill by helping investors to ignore it. It's quite another to suggest that investors will now have something close to a standard for cash flow. In fact, the proposed measure is far more limited than the most widely used approximation of that item -- earnings before interest, taxes, depreciation, and amortization. That, quite obviously, adds back to the bottom line a lot more than goodwill.

Analysts sometimes add interest back into the measure when companies are heavily leveraged. In other cases, they add back depreciation and amortization (including goodwill) on the assumption that those charges are for assets that will rise in value, whereas taxes and interest are irretrievable. In still another variation, Michael Mauboussin, chief U.S. investment strategist at Credit Suisse First Boston, distinguishes between cash flow from earnings (from sales and operating margin, less taxes) and cash from investments (capital expenditure, changes in working capital, and acquisitions or divestitures), and insists that both should be measured.

Choose Your Flavor
In any case, because the yardstick proposed by FASB doesn't address any noncash charges besides goodwill, critics contend that the measure falls too far short of a company's total cash earnings to be accepted as a standard for cash flow. The basic problem is that investors may mistake earnings without goodwill amortization for all cash earnings, even when other noncash charges greatly reduce them.

Jack Ciesielski, publisher of The Analyst's Accounting Observer, a Baltimore-based newsletter, notes that the "hoopla" over FASB's apparent embrace of cash earnings ignores the fact that "they're really only cash-flavored earnings pretty far removed from the real thing." He adds: "Anyone can see that by turning to a company's statement of cash flows."

And at a time when companies are calling attention to all kinds of financial results besides earnings per share in their quarterly earnings reports, Ciesielski says it's misguided to allow companies to report such a measure. He goes so far as to suggest that the proposal is more likely to increase rather than reduce their confusion about underlying performance. "We [already] have this trend of companies excluding a lot of things from earnings in their press reports," he says, adding that the new FASB rule "only supports the bad reporting that companies are doing."

If the proposal is approved as currently drafted, it could go into effect as early as the end of next year. The draft proposal was due to be released as this issue went to press, with comments from the public due by December 7. Hearings are scheduled for next February. Only after FASB's review would the rule become effective. Maybe by then it will be easier to tell whether it will do more good than harm.

----------------------------------------------- --------------------------------- Goodwill Shunting?
Critics of FASB's latest version of its business-combinations project take issue with more than just the ability it would grant companies to report earnings per share with and without the impact of goodwill amortization.

Jack Ciesielski, publisher of The Analyst's Accounting Observer, says the proposal would also give companies too much leeway to reduce the amount of goodwill they have to amortize in the first place. That's because the proposal would take the additional step of allowing companies to assign an indefinite life for certain intangibles, such as trademarks. Specifically, the proposal notes that intangibles shown to have supporting cash flows could be amortized in more than 20 years; those with an indefinite life need not be amortized at all. In either case, the amount of goodwill a company would need to amortize in no more than 20 years would be reduced.

Proponents say such a move is long overdue, because the current accounting system fails to reflect the fact that profits are increasingly dependent on brands and other intangible assets that may increase, rather than decline, in value. But Ciesielski says that without a standard approach to valuing such assets, assigning useful lives to them "is putting the cart way ahead of the horse."

In fact, FASB seems to have proposed its earnings-before-goodwill rule simply to mollify CFOs and other corporate leaders upset over the prospective loss of pooling-of- interest treatment. Earlier, the standard setters had compromised on a proposal to slash the period over which goodwill could be amortized from 40 to 10 years, but even 20 years evidently does not sit well with finance executives.

Still, Ciesielski notes that, at least as the proposal currently stands, goodwill on the books prior to the effective date will continue to be amortized under the current time frame.

----------------------------------------------- --------------------------------- Old Coke or New?
The Coca-Cola Co. and Coca-Cola Enterprises, Inc. (CCE), the bottler Coke spun off in 1986, together provide a stark example of the effect that goodwill can have on stock valuation. On the basis of their price/earnings multiples, CCE trades at a significant premium to Coca- Cola, even though Coke is the larger, more global, and higher-value-added entity.

Only after one strips out all the goodwill on CCE's balance sheet as a result of the acquisitions it has made does that multiple fall below Coke's. Of course, a high P/E multiple may or may not be deserved. In this case, CCE paid significant premiums for acquisitions that serve a single investor's interests. The company would have difficulty doing anything other than serve Coke's interests even if other investors wanted it to, because Coke owns about 40 percent of CCE's stock and has considerable influence over its board. But because of the current accounting rules for consolidating minority interests, none of CCE's goodwill appears on Coke's balance sheet. That could change under a proposal by the Financial Accounting Standards Board. But at the moment, investors evidently don't take into account CCE's goodwill, or the fact that at least some of it could eventually become Coke's.

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