2020 kitchen sinking, think big

The Heidelbergcement write-down of goodwill generated in 2007 on the Hanson acquisition brings about the usual suspicion that the 2020 macro disaster will be a good opportunity to write down assets which were poor performers well before the crisis. Nobody will take the time to comb through acquisitions which took place more than 10 years ago. The previous management will not be made to pay for ubris-led external growth while the management that does the kitchen sinking will post mechanically bright performances in 2021 including in terms of ROE and ROCEs on which (may be) variable pay is based. Ergo, management wins, shareholders weep.  Shareholders’ qualms on this lopsided accounting act could not be expressed in closed door AGMs if they have been held at all. 

Very big numbers indeed

Expect more and expect very big adjustments as the COVID-19-led recession is (hopefully) a one-off opportunity. To get an order of magnitude, the AlphaValue European coverage (452 issuers, €9tn market cap) has shareholders funds of €5,700bn (€4,400bn ex Banks) and a total goodwill of €1,830bn (€1,700bn ex Banks). This converts into a goodwill/equity ratio of 32% (39% ex Banks).

With a magic wand cancelling that goodwill in 2020, the ex Banks 2021 ROE would jump from 9.7% to 12.6%. For ROCEs, the ex Banks ex Insurance 2021 ROCE would jump from 7.1% to 9.2%. 

In short, slashing old layers of goodwill is tempting. 

There are 151 firms out of 452 with a goodwill/equity ratio at 50% or above and another 70 with a ratio between 25% and 50%. The issue is broad-based and not sector-specific even though it is a fair guess that the 2020 blow to business is bound to be huge for capacity-based industries (say Airlines) which will have a stronger case to clean up their asset base. 

Looking at the goodwill/equity ratio is unlikely to be a catch-all net, though. Consider the case of Big Oils, cleaning up their balance sheets precipitously as crude prices' expectations are being cut rapidly. Their goodwill/equity ratio is below 20%.

In the same line of thought, many businesses such as Pharmas or Food & Beverage that will navigate the COVID crisis without problem are acquisition-driven businesses with huge piles of goodwill, in absolute and relative terms. 

This is what the following table will highlight. Five companies in this bracket would be left with no shareholders funds if all goodwill had to be impaired. Starting with ABI. 

Mega goodwills (above €20bn)

Looking at the stocks with a goodwill/equity ratio above 90% (arbitrary threshold) will catch an impressive list of 67 names, most very respectable, including those such as IHG (Add, UK) which post negative equity. 

It is not practical to list all the names so that we provide a summary view and the list on request. The point is that these firms are riskier on average and that a number of covenants will be broken the day goodwill is impaired and equity deflates in proportion. But managers do know how to speak to their lenders about non-cash impacts. Interestingly as well, being goodwill-heavy was not a performance driver (see last chart). In a nutshell, shareholders could do with less external growth.

Summary view of high goodwill issuers

Goodwill heavy stocks underperform the Stoxx600