Nearly two years ago, the Wall Street Journal and S&PCapitalIQ did a study of firms in the S&P 500 with the highest goodwill as a percentage of their stock market capitalization, or market value. Six of these firms had goodwill balances that exceeded their stated market values, which is a potential red flag that they botched a major acquisition.
Goodwill on its own is not a bad thing. It simply represents the premium over the estimated market value of the assets acquired when buying another company. Many firms with minimal or negligible asset levels, such as service companies, are able to generate ample profits and high returns on assets. Significant cash flows could garner a significant buyout premium. Manufacturing firms and other asset-intensive industries might have significant assets on the balance sheet, but might not generate as much in terms of cash flows. As such, goodwill in a buyout would be less.
The Laggards Two Years Later
The study mentioned above was published on August 14, 2012. Since that time, seven of the 10 companies mentioned have outperformed the S&P 500. The three laggards are Frontier Communications (FTR), RRDonnelly (RRD) and Republic Services (RSG). The stock price performance of each of these underperformers has still been positive, but has lagged the market’s 40% return of this period.
A problematic acquisitions appears to be the culprit for the share price struggles of Frontier Communications. In 2010, telecom provider Frontier Communications acquired assets from Verizon (VZ) in rural territories it is alleged to have neglected, which adversely affected customer loyalty. This hasn’t stopped a long-term decline in reported profitability at Frontier, but it did serve to nearly triple goodwill from $2.6 billion in 2009 to $6.3 billion at the end of 2013.
Water provider Republic Services acquired rival Allied Waste in 2008 and has struggled since to boost profitability. Overpaying right before a recession hurt results and boosted goodwill on the balance sheet, which currently stands at $10.7 billion. Printing firm RRDonnelly made a smaller acquisition of Consolidated Graphics for $620 million, which accounts for a healthy proportion of recent goodwill of $1.4 billion. But its business appears to be struggling as media moves to digital mediums.
A Summary of the Winners
The firms that have outperformed since the article was published include Sealed Air (SEE), Nasdaq OMX (NDAQ), L-3 Communications (LLL), Hewlett-Packard (HPQ), Xerox (XRX), Fidelity National Information Services (FIS), and Gannett (GCI).
The strongest performers of the group are Sealed Air (up nearly 150%) and Gannett (up more than 100%). Package and container provider Sealed Air has benefitted from a “transformative” deal to diversify its business and buy cleaning and chemical firm Diversey. The purchase was made in 2011 and looks to have worked out well, though it also took a hefty write down in 2011 that lowered its goodwill balance. The same goes for Gannett, publisher of the USA Today and other periodicals. It recently acquired Below to diversify out of print and more into television and broadcast media. The other firms have benefitted from general improvements in their businesses, thanks either to an improving economy or smarter, smaller acquisitions.
The Bottom Line
The conclusion from the above is that looking at goodwill as a percentage of market value has its merits, but the important thing is to analyze the merits of an acquisition or what management is doing to improve its operations. Those that discovered Sealed Air and Gannett during their acquisitions made out well, but the laggards have underperformed due to a combination of bad M&A due diligence and struggling existing businesses.
At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.