Last week, Microsoft took a $6.2 billion write-down that made numerous headlines, and I’m sure the idea of a number that large raised many eyebrows $6.2 billion.
On my radio show and in my columns, many times I will talk about intangible assets and the dangers that they can create. So, today, I thought it appropriate to go into more detail about intangible assets and goodwill.
Often companies and people will say, "who cares about asset write downs?" It’s not real cash, and it’s not like the company really lost money.
That is not exactly true and I’m going to use Microsoft as the example. Back in 2007, Microsoft bought a company called aQuantive for $6.3 billion. Now, unfortunately for Microsoft, this investment in aQuantive didn’t work out and the company is nearly worthless.
When one company buys another company, for any amount over the book value, it is considered goodwill — an intangible asset. It is also important to know that book value is shareholder equity, minus intangible assets such as goodwill, patents or anything else that can’t be touched, is an intangible asset. Shareholder equity is assets minus all liabilities.
For Microsoft, as of the third fiscal quarter ended March 31, 2012, the shareholder equity was $68.6 billion and the goodwill on the balance sheet was $19.7 billion. For the next quarter, assuming no other changes, Microsoft’s goodwill will decline by $6.2 billion to around $13.5 billion.
Also, assuming no other changes in equity, investors will see a decline in equity from the current $68.6 billion to $62.4 billion. While this is not great news, it is not as damaging as it seems, because 12 months ago Microsoft’s equity was $53.5 billion and in one year it climbed $15.1 billion — or 28.2 percent — which is a very nice increase.
Investors must back out of the $6.2 billion to the $62.4 billion, and the increase in equity is $8.9 billion — or 16.6 percent. While not as good as 28.2 percent, a 16.6 percent increase in equity beats out many other companies by a wide margin.
Another important part of the puzzle for investors that is affected by the write off is debt to equity.
As of March 31, 2012, Microsoft had total debt of $11.9 billion — or a debt to equity of 17.4 percent. With this $6.2 billion write-off and the equity decline of $6.2 billion to $62.4 billion, the debt to equity will now increase to 19.1 percent.
The debt stays the same at $11.9 billion, but with the decline in equity to $62.4 billion we now have a debt to equity of 19.1 percent ($11.9B/$62.4B = 19.1 percent).
For Microsoft, this is not a big deal. They have a lot of tangible equity and not that much debt.
But what if you hold a company in your portfolio that does not have a lot of equity — what can happen then?
First off, one could see the company equity go into the negative column, this is where the liabilities of the company exceed the assets. This is similar to where one owes more on the loan than the worth of the house, negative equity.
Another thing that could happen is, what if the company has too much debt on its balance sheet? Investors could see the debt to equity ratio rise from maybe a 50 or 60 percent to an 80 or 90 percent.
You might think that is OK, except companies often have what are called loan covenants. Loan covenants are conditions or certain ratios. such as a debt-to-equity ratio, placed on loans by the lenders or the bond issuer that must be met.
If these are not met the loan could be placed into default and penalties could be applied or, worse yet, the loan or bond could be called for full payment. Something like this would not hurt a company like Microsoft with $60 billion in cash, but what if the company you hold in your portfolio has a $10 billion loan and only $5 billion in cash? That stock would fall like a rock.
What investors need to be aware of is that back before 2008, many deals were done with the market at higher levels. You must check and understand what the companies you hold in your portfolio have when it comes to intangible assets and their debt levels.
If you don’t know and aren’t watching it on a regular basis, you could be surprised one day when the announcement comes out that your company had a goodwill impairment charge. If you can’t figure it out, ask your advisor and if he or she doesn’t know it’s time for you to find another advisor.
Have a question or a company you'd like me to take a look at? Email me at firstname.lastname@example.org.
Wilsey is president of Wilsey Asset Management and can be heard every Saturday at 8 a.m. on KFMB AM760. Information is provided by Reuters.