Healthcare Goodwill- Part 2
Continuing our look at healthcare companies whose accounting hides the huge cost of their deals
A few weeks ago, we began our annual process of screening for accounting weak points by industry. These weak points represent where companies’ reported revenues, profits, and/or asset values are heavily dependent on estimates made by management. Our first area of focus has been companies with high levels of goodwill and intangible assets. Last Friday, we published the first part of our look at the healthcare segment in Health Check: Is Growth Through Acquisition Making the Grade? Today, we will finish our look at healthcare companies whose accounting is hiding the true cost of their acquisition programs with a look at four more names.
For review, here is an explanation of our process:
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.
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.
Below are four more companies we believe investors should be aware of the real cost of their growth through acquisition strategies.