When Kraft Heinz stock plummeted 27% on Feb. 22, a key culprit was an entry on its balance sheet called goodwill. Kraft wrote off $7.3 billion of goodwill tied to the declining value of its U.S. refrigerated-foods and Canadian retail businesses, resulting in a fourth-quarter loss of $12.6 billion.
Goodwill stems from acquisitions, which were critical to the creation of Kraft Heinz (ticker: KHC). When one company buys another, the purchase price often exceeds the sum of tangible and intangible assets and liabilities. The difference, recorded as an asset that reflects corporate reputation, customer loyalty, and other strengths, is called goodwill.
Sometimes, however, goodwill becomes impaired due to changes in the nature of a business, legal issues, or other factors. When that happens, its value needs to be written down. Companies recognize goodwill write-offs in their income statements, generating reported losses as a result. Wall Street tends to overlook these one-time losses, although that didn’t happen in Kraft’s case.
Accounting rules require companies to evaluate goodwill once a year, although they can choose when to do so during the year.
S&P 500 companies had $3.3 trillion of goodwill at year end, equal to roughly 10% of assets. Although Kraft’s impairment surprised Wall Street, it is sometimes possible to spot trouble before it occurs. That could be the case with companies such as Bayer (BAYRY) and Cigna (CI). More about that in a moment.
Large mergers and acquisitions typically generate the most goodwill, and are the biggest destroyers of it as buyers overpay. Kailash Concepts, a quantitative analysis firm, found that companies in the Russell 1000 index that make large acquisitions underperform the market by as much as eight percentage points in the following 12 months. What’s more, the companies doing the largest deals tend to be in the top quintile of firms based on a ratio of goodwill to total assets. “Historically, high goodwill-to-assets has been detrimental to forward 12 month returns” says Bill Roddy, a partner at the firm.
Heinz bought Kraft Foods in 2015 for $55 billion in a deal backed by Heinz owners Berkshire Hathaway (BRK.A) and Brazil’s 3G Capital. In addition to the asset write-down, Heinz also announced in February that it is cutting its quarterly dividend by 36% and being probed by the Securities and Exchange Commission in connection with its accounting practices.
Kraft is hardly alone in misjudging the value of acquisitions. General Electric(GE) wrote off $22 billion in 2018, although it paid only $17 billion for theAlstom ’s power assets it revalued. GE’s remaining $60 billion of goodwill totals 19% of assets.
Is there any way to identify whether goodwill is at risk of impairment? Robert Willens, a tax-accounting consultant and veteran Wall Street tax analyst, recommends focusing on companies’ return on assets, or ROA. Rising ROA could indicate that a buyer is squeezing more profit out of an acquisition. But declining ROA could signal a write-off is in the offing. GE returned 2.3% on its assets in 2014, the year before it acquired Alstom; ROA was negative 2.3% in 2017.
Germany’s Bayer bought Monsanto in 2018 for $57 billion, upping its bet on the future of agriculture. The deal boosted goodwill by about $26 billion, bringing the total to $43 billion, or 30% of assets. In the past year, however, Bayer has lost two lawsuits alleging that Monsanto’s Roundup weedkiller caused plaintiffs’ cancer. If juries continue to rule against the company, which faces thousands of Roundup-related suits, the price paid for Monsanto could be called into question.
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Bayer stock dropped nearly 10% in a single session in March when a jury found the company liable. The move cost the company $6 billion in market value, or about 10% of its Monsanto purchase price. Bayer didn’t respond to a request for comment about potential goodwill impairment.
Cigna also made a big purchase last year, buying pharmacy-benefits manager Express Scripts for $68 billion. The deal generated $38 billion in goodwill. Activist investor Carl Icahn opposed the deal and criticized the business model of PBMs, which negotiate drug prices for health-insurance clients. Regulators are also examining the industry’s drug-pricing practices, and Amazon.com (AMZN), which bought online pharmacy PillPack last year for $1 billion, poses a potential competitive threat. If PBM profit margins get squeezed, Cigna’s purchase price could look rich. A 25% hit to the goodwill generated by the Express Scripts deal would amount to $9.5 billion, or 15% of Cigna’s current market value. Cigna says it completed its annual goodwill impairment test before the Express Scripts deal closed and wouldn’t comment further.
Not all deals destroy value. Walt Disney (DIS) has $31 billion of goodwill, much of it generated by the purchase of Lucasfilm, Pixar, and Marvel Entertainment. These deals have been highly successful, contributing to Disney’s 16.3% average annual earnings growth over the past 10 years.
Willens describes goodwill as “the proclivity of customers to return to the same place.” Customers have returned to theaters for Disney’s hits, but whether they keep coming back to Kraft’s Oscar Mayer brand or Bayer’s Roundup remains to be seen.
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