Wednesday, November 21, 2012

Goodwill Hunting

Just shoot me
I try to maintain my equanimity, O Dearly Beloved. I really do.

I make every effort to exercise regularly, eat healthy food, and maintain my legendary composure by adhering to a strict drug and alcohol regimen sketched out on a bar napkin in 1962 by Hunter S. Thompson himself. But every so often, some ill-advised knucklehead will publish, under the aegis of a purportedly respected publication, such toxic, ridiculous, and misleading nonsense that I simply must respond with decisive and overwhelming force.

Today’s example hails from the eponymous financial newssite of Gotham City’s favorite sesquibillionaire mayor and short-man-about-town, Mike Bloomberg. In it, the award-winning [sic] financial journalist Jonathan Weil ventures the following thesis for the entertainment and edification of his hapless readers:
Here’s the problem with Hewlett-Packard Co.’s explanation today for why it took an $8.8 billion writedown related to its purchase of Autonomy Corp.: The numbers don’t make sense.
He then spends the next nine paragraphs making sure the numbers don’t make any sense and befuddling the naive and inexperienced among his audience into a state of utter confusion matched only by his own apparent cluelessness. Chief among his complaints seems to be that he doesn’t understand how HP can write down over $5 billion of value due to allegedly dodgy accounting associated with Autonomy when the latter had pre-acquisition assets totalling only $3.5 billion. He also seems very suspicious of the $6.6 (later $6.9) billion of goodwill Hewlett-Packard recorded when it purchased Autonomy, writing that
HP recorded the goodwill because it knew Autonomy’s identifiable assets were worth much less than it paid.
The implication being, of course, that HP actually knew it was “overpaying” for Autonomy at the time and that the current writedown is really just HP acknowledging the inevitable.

Call me crazy, but I have to believe there are some among you who might agree with me that it seems reasonable a journalist tasked with covering financial markets, stocks, and corporate finance should have at least some basic understanding of public accounting rules and merger math. Or at least the time, resources, and ambition to find out. Apparently we would be wrong.

So, in the interest of trying to rescue some of the well-meaning ignoramuses who have been happily educated into insensibility by Mr. Weil’s folly, I will try to provide a mini-primer on purchase accounting. In the course of this, I believe I can demonstrate that, indeed, Hewlett-Packard’s recent accounting writedowns make perfect sense.

* * *

Chief among the conceptual foundations of merger math which we must address is the distinction between enterprise value and book value, or true value and accounting. Most mergers and acquisitions are done to acquire operating businesses, not merely a laundry list of assets. Just like the real value of Apple Computer cannot be reduced to its Cupertino real estate, the inventory in its factories and stores, and the office supplies in its employees’ desks, the real value of an operating business lies in the way its management and employees use those assets, their knowledge, and their company’s brand and reputation to earn income. That is what a business acquirer will pay for.

How much an acquirer will pay for a business is determined in the course of merger negotiations by reference to comparable companies trading in the public markets, comparable M&A transactions, and the projected discounted future cash flows of the target business, overlaid by the competitive dynamic of the sale process. At the end of the day, the acquirer pays what it decides owning the target business and its associated cash flows would be worth to it, moderated by what it has to and can afford to pay. The book value of assets on the target company’s balance sheet has nothing to do with it.

Once the ink has dried on the purchase agreement and the checks have cleared, however, the accountants move in to memorialize (or embalm) the transaction in their own special way. They review the balance sheet assets and liabilities of the target company to determine their fair market value at the time, which more often than not is different from their recorded book values.1 Tangible assets like receivables, inventory, real estate, fixtures, and office supplies are valued at replacement cost or nearest appropriate market value and recorded in the opening balance sheet. Then the gnomes attempt to quantify the value of discrete and identifiable intangible assets like patents, customer lists, brands, and other intellectual property: all the assets you cannot put your finger on but you know are essential to generating the ongoing revenues and cash flows of the business. Add these together, and you have all the tangible and intangible assets which can show up on a balance sheet. Subtract that total (less the fair value of operating liabilities like accounts payable) from the amount of money you paid for the business and, presto, you get goodwill: the accountants’ remainder account where they memorialize the premium to the target’s net tangible and intangible assets the acquirer paid for the business. Goodwill can be seen as the difference between the full operating value of a business—as paid at one point in time by a third party buyer in a specific arms length transaction—and the fair value of the net operating assets its managers and employees use to run it.

So when Hewlett-Packard decided to write down the value of its investment in Autonomy, it did not inventory paper clips. It revalued the remaining intangible assets on its balance sheet acquired from Autonomy, based on their newly-determined earning power, and it revalued the goodwill of the total business based on its revised understanding of its overall cash generating capability. If Autonomy did indeed misrepresent the earning power of its business as HP alleges, goodwill would be the exact account where you would expect to see writedowns.

Autonomy misrepresented its gross profit margin and also falsely created or miscategorized more than $200 million in revenue over a two-year period starting in 2009, John Schultz, Hewlett-Packard’s general counsel, said in an interview. Autonomy was reselling Dell Inc. computers and counting those sales as software revenue, he said. Some sales were also fabricated through resellers.
When your view of the value of a business or collection of assets changes, accounting rules compel you to revise any associated goodwill account to reflect this new information. This is not that difficult a concept to grasp or convey.2

I just wish our financial press corps was better at educating the public about such things, rather than muddying the water because they’re too lazy to figure it out beforehand.

* * *

UPDATE November 21, 2012: Ugh. Apparently Jonathan Weil has not heard of the Law of Holes:

When you find yourself in a hole with a shovel in your hand, stop digging.
He has released another post today in which he throws about random balance sheet, income statement, and market value numbers from Hewlett-Packard’s accounts without the least apparent understanding of what any of them mean or their most basic interrelationships. He is trying to make the argument that HP massively overpaid for Autonomy in the first place, and that the admittedly skimpy numbers which the former has released in connection with its writedown announcement do not seem to disprove his thesis. He may be right, for all I know. I do not know and I do not care.

But when he spews forth idiotic, misleading dreck like this, my ears begin to smoke:
HP finished the fiscal third quarter with $32 billion of shareholder equity. Its balance sheet showed $36.8 billion of goodwill (which isn’t a saleable asset) and $8 billion of other intangible assets. By comparison, HP finished the fiscal fourth quarter on Oct. 31 with a stock-market value of $27.2 billion.

In other words, on paper, HP’s goodwill supposedly was worth more than the company as a whole
[emphasis mine]. The market knew big writedowns were necessary. Investors saw that Autonomy was a disaster. They were just quicker to acknowledge the reality than HP was.
No, no, no, no, NO. No, you numbnuts. Goodwill is a balance sheet account, based on historic book value with periodic testing to check that it is still valid. It bears no direct relation to what the company is worth at all.

And the worth of the company is not equal to the market value of its common equity, except in the most trivial of cases. The company’s worth, or value—known among people who actually work with this concept for a living, like me and, oh, a billion other non-idiots as total enterprise value—consists of the market value of common equity plus the market (or book) value of debt and other capital liabilities less cash on hand. In HP’s case, at the end of its 2012 fiscal third quarter, this was $27.2 billion + $29.7 billion – $9.5 billion, or $47.4 billion. At July 31, 2012, Hewlett-Packard as a whole was worth $47.4 billion. This, just to help Mr. Weil in case he runs out of fingers, is clearly more than $36.8 billion in goodwill. Which, by the way, doesn’t mean anything, just in case you were wondering.

You might argue that with my carping I am overreacting to Mr. Weil’s sloppy writing and thinking and missing his larger, potentially valid point about the poor rationale for HP’s purchase of Autonomy. But I am traditional enough to believe that a person who puts himself out there as a financial journalist who writes about M&A and corporate accounting issues for an international financial publication should fucking know a little about goddamn basic accounting.

Go ahead, call me cranky and unreasonable. I’ve been called worse by worse people.

And someone, please, buy Jonathan Weil a basic accounting textbook and make him read it before he writes again. My blood pressure will thank you.

1 Goodwill already on the target company’s balance sheet from prior acquisitions of its own, like the $1.5 billion in Autonomy’s pre-deal accounts, is written off at once. Of the remaining $1.9 billion of Autonomy’s pre-deal assets, over $700 million was cash and $600 million was other intangibles. Hewlett-Packard acquired very few tangible operating assets of any kind when it bought Autonomy.
2 I don’t have an opinion, by the way, as to whether HP’s allegation of accounting shenanigans is true or not. Autonomy’s former management disputes it. All I will say is valuation of intangible assets either in a sale transaction or on an interim basis and valuation of the long-term earnings power of a business where there is no concrete, objective reference point like a deal value to point to can be awfully squishy, subjective stuff. This, naturally, raises the question as to whether HP might be sandbagging its goodwill writedown to make future results look better. I have no special insight here, other than to note such an occurrence has happened many times before.

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