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August 8, 2001

Goodwill and The Big Bath

Recently, telephone equipment maker JDS Uniphase took the largest write-off of assets in corporate history, $44.8 billion. The amount is staggering. Far too large for our feeble imaginations to get a handle on. Most of the JDSU write-off is "goodwill," an ever-present and poorly understood accounting term.

When a company buys another company, it is required by accounting rules to assign a value to each asset acquired. When you add up the values of these assets, you get a number that is called the "tangible book value" of the assets acquired. The amount of the purchase price of the acquisition that is in excess of that total is called "goodwill." It is supposed to represent the value of the acquired company's reputation, business contacts, customer base, etc.

Overpay Now - Payback Later

Just last year, JDS Uniphase paid top dollar to acquire SDL, a competitor with valuable assets, especially in pump-laser fiber-optic technology. With the market for such equipment now growing much more slowly, it is clear that JDS overpaid for SDL. So, JDS will write-off a good deal of that purchase price as a bad investment. If you were to calculate the company's return on equity, or assets this year, you'd get a huge negative number.

But, sight unseen, (because I haven't looked at these financials yet) I'll bet JDS also wrote down the value of every other asset it possibly could, whether tangible or intangible, from inventory, to purchased research, to goodwill. The reason I'll make that bet is that companies do this all the time. (I'll bet Lucent has done it recently too.) In accounting circles it's called "The Big Bath."

A company takes the plunge of a big bath when it is going to have a terrible quarter anyway, and it knows its stock price is going to get smashed regardless. It then tries to find every possible thing that could go wrong in coming years, and it takes any write-offs relating to those problems. This way, they get two benefits when presenting their newly-washed company to the public.

A Cleaner Image

First, there will probably be no nasty surprises in coming quarters requiring more downward earnings estimates. Anything that could go wrong has already been reserved for in the earnings period that they hope Wall Street will forget soon. Moreover, if the company gets lucky, and things don't turn out as badly as it expected, it can actually reverse some of those charge-offs in a future period, boosting reported earnings, though it won't effect cash flow a whit.

The second accounting benefit is even more sneaky. By writing off so much in assets, future earnings show a higher rate of return on shareholder equity and assets. For example, if you had $100 million in shareholder equity, and you wrote off half of that, then next year a $5 million profit would be calculated as a 10% return on equity (5/50=10%). Without the write-off, the return would have been 5% (5/100=5%). The economic reality is the same in both instances, but the appearance is better after the write-off. Most investors will never notice the legerdemain.

If you want to see how a company has treated investors' capital over the years, it is necessary to go back and look at the financial statements with a gimlet eye. You must add back all the write-offs, and calculate what the return has been. That will help you to gauge whether management has done a good job shepherding shareholder value.

Companies like JDS Uniphase, who have taken a big bath, may be a good value at their greatly-reduced stock prices, but as part of your assessment of their prospects, you have to take into account the big mistakes they've made along the way, and see if you're confident that it won't happen again.

That way, you won't be the one taking the bath.

Jack




   
Copyright 2001 by Jack Adamo. All rights reserved.