Health Check: Is Growth Through Acquisition Making the Grade?
Evaluating the value behind goodwill and intangibles in the healthcare sector
A month ago, we touched on consumer staples stocks that have accumulated massive goodwill and intangibles balances via their growth through acquisition strategies in our report Are You Flying to Quality Quality? We followed that up with Flying to Quality- Part 2 where we took our analytical framework presented in the first report and applied it to three major consumer staples companies.
Today we will continue our look at the risks related to large goodwill and intangibles balances, but this time we will focus on the healthcare sector. We started with the healthcare stocks in our universe and applied the following steps:
We screened for companies with goodwill and intangible balances that were more than 50% of total assets.
Next, we looked at the trend in goodwill and intangibles over the last five years for each company to find the ones making regular acquisitions. This weeds out the companies with intangible balances resulting from one major acquisition made many years ago.
From there, we selected companies that cannot pay for acquisitions with free cash flow after dividends and buybacks.
We then looked for impairments to goodwill and intangibles as well as regular restructuring charges and aggressive non-GAAP adjustments.
Today, we will examine five companies that we flagged during the above process, and we will look at several others in a later report. We constructed tables for each company with the following sections:
Goodwill and intangibles as a percentage of total assets- In our mind, any company that exceeds 50% deserves closer inspection from investors.
History of impairments?- Many of these companies have already shown a series of significant write-downs. While these write-downs are always added back to non-GAAP results and often ignored by investors, they represent instances where shareholders' capital was spent on investments that did not live up to expectations.
Do they have the cash to keep acquiring?- This section looks back over the last five years at cash flow minus capex, dividends, buybacks, and cash spending on acquisitions. All of these companies regularly experienced cash shortfalls in years in which a significant acquisition was made.
Are the acquisitions accretive? This section looks at pretax return on invested capital over the last three years using the company’s adjusted operating income figures. We then add back the non-GAAP adjustments we consider unrealistic and present an ROIC figure based on those numbers. In many cases, these companies have single-digit ROIs which calls into question how much real value is being created by integrating the acquired operations.
Never-ending restructuring charges? Regular acquisitions almost always come with regular restructuring and integration charges, much of which are paid in cash. These amounts are typically added back to non-GAAP earnings and are ignored by investors. However, as we will see in the tables below, these companies incur these charges every year, so are they truly one-time expenses, or should they be viewed as an ongoing cost of the company’s business strategy?
What is the real cost of the company’s acquisitions? GAAP no longer requires companies to amortize their goodwill and all of these companies add the amortization of acquired intangibles back to their non-GAAP earnings. Thus earnings do not reflect any of the costs of the deals. If these companies had developed the acquired technology in-house, they would have spent extensively on personnel and R&D infrastructure which would have been expensed on the income statement. This section of the tables below illustrates what EPS would be if goodwill was amortized over 40 years and intangible amortization was not ignored. We could argue that given the high-tech nature of the heart valves and software underpinning the value of the goodwill for these companies, 20-25 years might be a more realistic amortization period which would double the goodwill impacts in the tables below.
This report will examine five companies that we believe warrant attention on all of these fronts. These include major medical device companies that are mainstays in many large-cap portfolios. Their inclusion on this list does not mean we consider them to be automatic short ideas by any means. However, investors should be aware of the risk inherent in their acquisition strategy and make sure they understand how much value the acquisitions are actually adding for shareholders.