Sunday, August 12, 2012

Another Acquisition Goes Sour--We Shouldn't Be Surprised

The evidence is clear that the vast majority of corporate acquisitions are mistakes for the acquiring company.  Acquisitions are usually made at large premiums to the current price of the acquired company's stock, which of course is a windfall for the acquired company's shareholders.  But so often the premium paid for an acquisition (which goes on the acquiring company's books as an intangible asset) is later written down significantly, if not completely, by the acquirer.

The latest example is Hewlett-Packard's 2008 acquisition of Electronic Data Systems for $13.8 billion.  Hewlett announced on Wednesday that it will take an accounting charge of $8 billion, which is a 58% writedown only four years after the acquisition.  That charge (along with an additional charge of $1.6 billion for layoffs) will cause Hewlett to report a loss of $4.31 to $4.49 per share when it announces its quarterly results on Aug. 22.

Since the $8 billion writedown is an "extraordinary" development, the company and the analysts that cover it will focus on "operating" earnings from ordinary business operations.  Yet, the $8 billion writedown is indeed a reduction in the accounting net worth of the company (assets minus liabilities).  

That is why when I analyze a company's financial position, I not only consider the net debt relative to shareholders' equity, but I also consider the amount of intangible assets on the books relative to shareholders' equity.  For as we saw recently with grocery retailer SuperValu, when a company with substantial debt and large intangible assets ("goodwill" and other intangible assets) has to write down the intangible assets to reflect an impairment in their value, the reduction in assets (and net worth) causes the debt ratios to soar--and perhaps imperil the company's existence as a going concern.

The lack of acknowledgement of huge mistakes by emphasizing "operating" earnings rather than net income is a primary reason for the overestimation of corporate earnings and a corresponding underreporting of the price/earnings ratio of the stock market.  The use of "forecasted operating earnings" for the next twelve months rather than the actual net income of companies over the last twelve months almost always makes the stock market look cheaper than it really is.

So while it is good that new CEO Meg Whitman is recognizing the huge mistakes of her (perviously lionized) predecessor Mark Hurd and is more accurately reporting the financial state of Hewlett-Packard, it remains that the bias on Wall Street is one of a rosy hue.

Steve Lehman

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