To start the New Year on a cheery note, I would like to extend my post-festive greetings to all finance directors and chief executives in the UK. This act of goodwill comes at a cost, however, because in return I would like the leaders of UK plc to try to win back the faith of the investing public. And to get the ball rolling, what better place to start than the treatment of goodwill itself.
The simple fact is that many companies, carried by the tide of optimism, have vastly overpaid for assets in the past few years. Now, I am not going to berate business leaders just for that as we all make mistakes and, as a stock-picker in a bear market, I am all to aware of the downside to the job. We, too, have overpaid for assets by giving ill-timed advice on firms that are now languishing in the special offer section of the stock market. Hindsight is a great thing, but at least we come clean and admit our mistakes. Sadly, not all companies share that candour.
First on my New Year wish list I would ask directors and their advisers to use a modicum of common sense when addressing shareholders, rather than trying to fob them off with some accounting jargon. Who cares whether or not writing off goodwill is a non-cash accounting item? This smokescreen doesn’t hide the fact that hefty goodwill impairment charges diminish the net assets of the business, and with it shareholders’ funds. It also highlights a reduced earning power which must be reflected in a more realistic valuation of those assets. This is an important point, as acquisitive firms are likely to have given their lenders net worth covenants on the debt financing these deals. And keeping within those covenants is just as important as adhering to the more normal lending criteria, such as interest cover.
The other bugbear I have is with the presentation of financial reports. Groups routinely manipulate results statements to try to put a gloss on performance – not surprisingly, given they generally have something to hide. Fine, strip out exceptionals and goodwill – amortisation and impairment charges – but don’t try to kid anyone that this is the same thing as making plain old unadulterated pre-tax profits. And let’s not forget that the need to write-off, not just routinely amortise, chunks of goodwill on one acquisition, and take associated restructuring charges, must raise a question over the need to do so again on other ill-timed purchases. In any case, why beat about the bush and try to dress up what is, when all is said and done, bad news? Shareholders, unhappy as they are, will undoubtedly appreciate a degree of honesty rather than accounting trickery.
On that subject, the recent interim results statement from computer services group Fayrewood really takes some beating. Under the title”Corporate developments”, chairman Pierce Casey noted:”In accordance with accounting standards, Computerlinks [51 per cent owned by Fayrewood and a major part of the group] will be reviewing the carrying value of its subsidiaries and associated goodwill to ensure that they reflect current market conditions.”
Unless I am mistaken, that is what a company is supposed to do as a matter of course. Given that Fayrewood bleated on about the continued weakness in the European IT market, this hardly inspires confidence in what the forthcoming review is likely to throw up.
If businesses truly want to improve the degree of transparency in corporate reports, they should concentrate on what investors want to know, rather than what management wants to hear. How often do finance directors boast about the conversion rate of operating profits to free cash flow? True, many have jumped on the ‘cash is king’ bandwagon and are at pains to stress the importance of cash flow nowadays. But investors should not confuse firms that consistently generate both strong operating and free cash flows with those that manipulate statements with a bit of jiggery pokery.
Just like the magician’s three-card trick, those illusory inflows can quickly disappear with a slight of hand – a point many more hard-pressed companies will be finding out in the months ahead.
Fortunes favours the brave, or at least I would like to think so. Having chosen the listed-Lloyd’s insurance sector as one of my picks of 2003 (Hot Properties For Re-rating, 1 November 2002), I am glad to report that the four insurers selected – Goshawk, Cox, Amlin and Brit – have risen by 44 per cent, 25 per cent, 29 per cent and 22 per cent, respectively, in only 10 weeks. Although I would not dissuade any investors – sitting on an average 30 per cent gain – from some profit taking, I still expect further outperformance in the year ahead.
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