Goodwill hunting

If merger and acquisition activity slows any more, investment bankers might have to be placed in cryogenic chambers and awoken in the next decade.

And if things couldn't get any worse, the Financial Accounting Standards Board, the agency responsible for promulgating changes in accounting guidelines, is close to issuing a final standard that eliminates “pooling of interests” accounting, the financial reporting method that stoked much of the high-tech M&A frenzy of the past few years.

Pooling of interests was popular because it didn't create “goodwill” — an intangible asset that represents the difference between the book value (hard assets) of an acquired company and the price the acquiring company paid. Goodwill usually consists of the acquired company's reputation and market presence. Other intangible assets include brands, patents and intellectual property.

Under pooling-of-interests accounting, no goodwill is created because the two companies in effect simply combine balance sheets. But under the new, not-yet-official rule by the FASB, the pooling-of-interests option would no longer be available, and acquirers would have to use a revised form of purchase accounting.

Goodwill would not have to be amortized, which results in continuous one-time charges to the bottom line, but it would be written down against earnings in the periods in which the “recorded” value of goodwill is more than its fair value. That would be required, for example, if among other instances a goodwill asset exceeds the company's total market capitalization and the decline is more than temporary, or if a product or service is introduced by a competitor that causes or is expected to cause a significant reduction in a reporting unit's market share.

This “impaired value” approach is superior to the old method of writing off goodwill in equal amounts over a five- or 10-year period, said Robert Abbe, managing director of BroadView International.

“It should more accurately reflect the inherent value of those assets on the balance sheet,” he said. “It will be easier for analysts and shareholders to understand the quarter-over-quarter performance of a company. You won't have the fluctuations based on the price [acquirers] are paying for companies. It brings us closer to a cash-flow model of performance.”

In contrast to the old doom-and-gloom proclamations about the new FASB rule slowing down M&A activity, Abbe suggested there will be no negative impact on dealmaking or transaction activity.

“The change is very healthy,” Abbe said. “Most companies, especially in telecom, are focused on cash [earnings per share] anyway.”

If impairment works to keep the value of goodwill accurate on a more timely basis, it may also prevent asset writedowns like the $12.3 billion in intangibles Nortel Networks wrote off for its June quarter. The writedown was the result of Nortel's acquisition spree last year, funded by its high stock price.

“Because companies have been so highly valued, any transaction executed as a purchase resulted in big goodwill numbers,” Abbe said. Nortel was forced to use purchase accounting because Canadian law prohibits pooling.

The issue of the value of goodwill could actually be a flashpoint between investors and companies during the latter half of this year as more companies are forced to clean up their balance sheets.

On the carrier side, balance sheets are heavy with goodwill. WorldCom, for example, has $36.4 billion of goodwill and other intangible assets on its books. That's almost half its total assets of $86.9 billion.

“The goodwill is bogus — they said it's from the MCI [acquisition] — it's probably stuff that was on [MCI's] books for 10 years and they never depreciated it,” said Susan Kalla, senior analyst at Friedman Billings Ramsey. “It really has no value.”

WorldCom is not alone. McLeodUSA, which already uses the purchase accounting method to account for mergers, added $2.3 billion in goodwill and other intangibles from last year's acquisitions of Split-rock Services and CapRock Communications.

Verizon Communications had less intangible assets relative to total assets but still had $44.1 billion in intangibles at the end of the March quarter. Both the Bell Atlantic/GTE and the Bell Atlantic/Nynex mergers were accounted for as poolings of interests, meaning there was no goodwill impact, said David Frail, executive director of financial and strategic media relations for Verizon Communications. However, Verizon accounted for its 1999 wireless joint venture with Vodafone under purchase accounting, resulting in an undetermined amount of goodwill being added to its balance sheet.

Although equity holders might not care as much about the value of goodwill, debt holders do because it “changes a company's capital structure radically,” Kalla said. Goodwill props up a company's asset value and makes the company look less leveraged, she said.

Numerous signs point to more large writedowns in telecom, according to Kalla. Bankrupt companies are selling their property, plant and equipment at 30¢ on the dollar, but existing operations often value their equipment at 100% and often sometimes even capitalize labor costs.

“Prices for [property, plant and equipment] should probably be 20% to 30% down from where they are now,” Kalla said. “The depreciation schedules [being used] for PPE are anachronisms.”

Not everyone thinks the amount of goodwill on a company's balance sheet is that important, however. “I value companies for [their] ability to generate cash flow — goodwill and amortization and depreciation are non-cash charges,” said Glenn Waldorf, equity analyst at UBS Warburg, pointing out that competitive local exchange carriers (CLECs) such as McLeodUSA are typically valued on that earnings metric.

“There are a number of factors [to look at] before you look at goodwill,” Waldorf said. “There are companies that can't generate revenue, can't generate cash flow, and have large fixed interest payments — all those issues are a greater priority in tough economic times.”

Of course, the new impairment method to valuing goodwill will not be easy to adopt, said Brian Borders, president of the Association of Publicly Traded Companies. “The impairment model is far superior, but it's a great deal more complex than pooling or the old purchase method. It's more complex and will take more resources — outside accountants and valuation experts.”

If the value of a company's goodwill undergoes rapid change after an acquisition, writedowns still will happen, just less often and maybe not as drastically.

“I wouldn't expect there to be material events every quarter that affect goodwill,” Abbe said. “But [the new rule] forces companies on a quarterly basis to review the value of that goodwill.”

VC watch

Company	Description	Amount	Lead investor(s)	Purpose
WaveSmith Networks	Multiservice switch developer	$31 million	Fidelity Ventures	Product development and production
InterSymbol Communications	Integrated circuit technology developer	$2 million	CID Equity Partners	Product development
BrightLink Networks	Optical switching system	$36 million	Draper Fisher Jurvetson ePlanet	Customer trials and product shipment
Luminous Networks	Optical equipment vendor	$80 million	Pyramid Technology Ventures	Product development, manufacturing, sales and customer service
Ikano Communications	IP infrastructure developer	$15 million	Insight Capital Partners	Expand product offering and staff; marketing, sales and client services support; product development
Florida Digital Network	Facilities-based ICP	$50 million	WallerSutton 2000	Network and product expansion
TollBridge Technologies	Voice-over-broadband equipment vendor	$25 million	Matrix Partners, Meritech Capital Partners, Sutter Hill Ventures, TeleSoft Partners, WorldView Technology Partners	Product development and increased presence in cable and international markets
Compiled by Toby Weber