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Accounting techniques that enhance one part of a balance sheet will likely dent another

06/10/2016

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

Back in 2004 – just in case it passed you by – the UK’s accounting rules were altered to bring the treatment of goodwill into line with US practice. No longer would goodwill be subject to the annual process of amortisation – effectively the intangible-asset equivalent of depreciation – but instead the decision as to whether its value should be written down in any given year would be left to the company itself. What could possibly go wrong?

Suddenly companies found themselves with significant leeway on the accounting assumptions they could come up with – in tandem of course with their professional advisers – in order to justify their latest decisions on goodwill. And it did not take some companies – or, more likely, those professional advisers – very long to work out that buying a company could now be treated differently from buying an asset.

Say, for example, a company bought a power station – yes, that would presumably serve to boost its revenues but, equally, the accounts would have to record the asset was depreciating in value over time. When the amortisation rules were changed, however, it meant a company could not only buy another company and enjoy the boost in revenues, it did not automatically have to write off the acquired goodwill over time. And, even when a company did have to impair goodwill, it could just claim it as an ‘exceptional’ cost, which could be excluded from ‘normal’ activities.

Clearly, therefore, the 2004 rule change was potentially very beneficial for the profit and loss (P&L) account of a certain sort of company. And such companies – let us call them serial acquirers – received a second boost just a few years later as the current environment of historically low interest rates began. After all, what this would mean for both the cost of debt and for the interest on the cash on a company’s balance sheet would again flatter its P&L.

So not one but two developments have occurred over the last 12 years that have meant, were you disposed to buy lots of businesses yet still minded to have a good-looking P&L, the UK has been a pretty good place to be. It is particularly helpful if you are a manager with remuneration based on earnings per share (EPS) growth and, as we noted earlier, it did not take some companies long to identify all this – particularly in certain industries, such as media and, the focus of the rest of this piece, support services.

There are few things businesses in that sector love more than an acquisition and, here on The Value Perspective we would be happy to name half a dozen – if only we were not about to be quite rude about one of them. Casting a veil of anonymity over the culprit, then, we will move swiftly on to outlining a game that it and a number of its peers have been playing over the last decade or so.

Take a look at the chart below, which consists of just two lines. One of these is a line any company would be proud of – moving upwards in a beautifully straight fashion from left to right, it shows the business’s EPS number has been growing very nicely indeed since 2005. Company X – given how the chart looks, it seemed an appropriate choice of name – is never shy of showing investors this line.

 

 Source: Schroders 2016

 

That may be understandable enough but it is rare in business to get something for nothing and of course Company X’s beautiful line comes at a cost. Obviously its cashflow is dented – when one company is bought by another, the sellers tend to expect to receive some sort of payment – but it is when you focus on the returns made from such acquisitions that this strategy really starts to fall down.

As we have discussed in articles such as Merger mystery, it is in the nature of serial acquirers to do their deals at relatively high multiples, meaning the more businesses they buy and the more cash they spend, the more their overall group return on capital falls. In Company X’s case that of course leads to the other line you can see lurching down the above chart from left to right.

In this, Company X – and well done if you have worked out its identity – is not alone. We have been seeing a growing number of such instances – as yet, not a whole alphabet’s worth but certainly moving in that direction – and this has only served to increase our wariness about serial acquirers, merger and acquisition deals in general and, indeed, businesses that rush to embrace accounting rule changes which can flatter their EPS growth.

Author

Andrew Evans

Andrew Evans

Fund Manager, Equity Value

I joined Schroders in 2015 as a member of the Value Investment team. Prior to joining Schroders I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst. 

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