The Lemon Fool

Hi all,

In addition to thoroughly reading a company's ARs, figuring out it's business etc. I have probably spent too much focus on profitability and valuation measures.

I've just re-looked at Next (NXT) and Zytronic (ZYT) (we own shares in each) and I'm still reasonably content with these two.

I'm now looking at a possible addition - Halma (HLMA). I have had a very quick skim read of the first 30 or so pages of the 2014 AR, and periodically see the word "acquire" or "adding valuable sectors to our...by acquiring".

Now although I'm often a tad cynical re. acquistions, I guess when pursued diligently, then perhaps they can/do add value.

Then the thought occured to me - What ratios, can be derived from the assets part of my analysis spreadsheet with a view to assessing to balance sheet impact of several years of acquiring?

This is how the assets data entry section on my spread sheet is currently setup:

Non current assets         |      
Goodwill                   | 0.00 
Other intangibles          | 0.00 
Tax                        | 0.00 
Property,equipment etc.    | 0.00 
Receivables                | 0.00 
Investments                | 0.00 
Joint ventures, associates | 0.00 
Miscellaneous              | 0.00 
Pension surplus            | 0.00 
Total                      | 0.00 
Current assets             |      
Inventories/stock          | 0.00 
Tax                        | 0.00 
Work in progress/for sale  | 0.00 
Marketable investments     | 0.00 
Receivables                | 0.00 
Cash and equivalents       | 0.00 
Miscellaneous              | 0.00 
Total                      | 0.00 
Total Assets               | 0.00

(To the right of the sheet, a bunch of calculations are done and the sheet displays the OM, ROCE, gearing, interest coverage etc)

Regards the analysis of a company with a view to whether the acquistions over time are becoming weighty in the balance sheet, what do people think about the introduction of following ratios:

Goodwill/Total Assets

and

Intangibles/Total Assets

Clearly their values, impacts, etc. could be sector/company dependent. But any ideas about what sort of values may give rise to cause for concern? 20% ?

Anyway for now I'm going to add the above ratios to my sheet, and then see how their values change over the period 2014-2018.

All comments, other ideas, ruthless ridicule welcomed,
Matt

Slight addition to the OP. I guess the appearance of increasing goodwill ratio over time would imply that the firm is gradually acquiring more than it can consume/integrate? But, for example, for a tech company an increasing intangibles ratio could indicate a lot of R&D costs are being capitalised and this would perhaps imply the need for further enquiry to see whether the company's book value is being overstated?

Hmm....Just thinking perhaps the analysis would be better if instead of

Goodwill or Intangibles / total assets

perhaps this is better:

Goodwill or Intangibles / net assets

as it would highlight the company's potential vulnerability a little bit better?

Matt

Hmm...I realised that my spreadsheet already has P/Book and P/Tangible Book. Here's what I got for Halma (HLMA) so far just for 2014, before I escape for a breath of fresh air in my workshop

Goodwill/Net Assets    | 68.99%
Intangibles/Net Assets | 23.20%
                      
P/Book                 | 4.51x  | Market capitalisation / NAV                                
P/Tangible Book        | 57.75x | Market capitalisation / (NAV less intangibles and goodwill)

Look iffy?

The analysis of goodwill and intangibles VS ROCE and PE, and comparing against two other FTSE 100 companies, lend me to view that I'll won't be touching Halma with a barge pole:



Indeed the contribution of Goodwill and Intangibles to the Balance Sheet is so profound that for Halma, removal of these as assets and applying the equity equation results in HLMA being in negative equity.

TheMotorcycleBoy wrote:
Indeed the contribution of Goodwill and Intangibles to the Balance Sheet is so profound that for Halma, removal of these as assets and applying the equity equation results in HLMA being in negative equity.

And yet during the same period as your data, for the years 2014 to 2018, the share price of HALMA has almost trebled, from around 580p in 2014 to 1341p today -

https://yhoo.it/2TwWld4

For the avoidance of doubt Matt, is this a sell-signal that you're investigating here, or a buy signal....

:O)

Cheers,

Itsallaguess

Hi Itsallaguess,

Itsallaguess wrote:For the avoidance of doubt Matt, is this a sell-signal that you're investigating here, or a buy signal....

I was investigating the share with a view to potentially buying it, as I alluded in my OP:

TheMotorcycleBoy wrote:I'm now looking at a possible addition - Halma (HLMA).

But to be honest, perhaps your question is a little irrelevant since I raised it mainly to see if the value of described ratios may serve as useful clues as to a company's worthiness as an investment.

Matt

BTW I created another thread in share ideas

viewtopic.php?f=33&t=15556

to present more of a "to buy or to not buy" case for Halma - a firm which I have referred to in the above analysis.

Matt

This is slightly finger-in-the-air, but in my experience, intangibles, especially goodwill is a form of leverage for a company. If things are going well these items accrue to the balance sheet and the company grows fast. When hard times arrive, goodwill is reassessed and written off the balance sheet, producing eye-watering losses.

Obviously if there is low goodwill/intangibles, a company may be at a certain phase of its evolution...


GS

GoSeigen wrote:This is slightly finger-in-the-air, but in my experience, intangibles, especially goodwill is a form of leverage for a company. If things are going well these items accrue to the balance sheet and the company grows fast. When hard times arrive, goodwill is reassessed and written off the balance sheet, producing eye-watering losses.

Obviously if there is low goodwill/intangibles, a company may be at a certain phase of its evolution...


GS

Thanks GS,

Forgive my ignorance, but what is it that means a company decides to (suddenly) reassess it's goodwill (that is, after the g/w has been sat there for many years) and then decides to write it off? Or is it something that just happens when the administrator (if that's the correct terminology) gets called in ?

Matt

TheMotorcycleBoy wrote:
Forgive my ignorance, but what is it that means a company decides to (suddenly) reassess it's goodwill (that is, after the g/w has been sat there for many years) and then decides to write it off? Or is it something that just happens when the administrator (if that's the correct terminology) gets called in ?

Matt

Kitchen-sinking...

The goodwill represents some intangible advantage the company has which allows it to generate profit (or is perceived as such). If profits dry up, there must be a strong suspicion that the advantage has disappeared or was not there in the first place. So you see a kitchen-sink approach when these companies hit a cyclical downturn and they write off huge chunks of their goodwill along with their profit warnings.

However this is not my area of competence so hope others will wade in...

GS

GoSeigen wrote:

TheMotorcycleBoy wrote:
Forgive my ignorance, but what is it that means a company decides to (suddenly) reassess it's goodwill (that is, after the g/w has been sat there for many years) and then decides to write it off? Or is it something that just happens when the administrator (if that's the correct terminology) gets called in ?

Matt

Kitchen-sinking...

The goodwill represents some intangible advantage the company has which allows it to generate profit (or is perceived as such). If profits dry up, there must be a strong suspicion that the advantage has disappeared or was not there in the first place. So you see a kitchen-sink approach when these companies hit a cyclical downturn and they write off huge chunks of their goodwill along with their profit warnings.

However this is not my area of competence so hope others will wade in...

GS

I think I get it.....such firms will see their ROE and ROCE numbers fall, and shaving off their G/W and Intangibles will reduce the size of their capital base, hence push the return on numbers back up........but they need to do this late at night so that no-one can see what they are up to..

Matt

TheMotorcycleBoy wrote:.but they need to do this late at night so that no-one can see what they are up to..

It usually seems to follow a change in management, particularly if restructuring and disposal is in the air. The idea is to pin the blame for all the losses on the departing team, so the new team is always announcing positive news for shareholders.

That's when there's something of value to sell or borrow against of course. The more spectacular crashes come when there isn't anything of any value on the balance sheet.

Hi Matt,

“Then the thought occured to me - What ratios, can be derived from the assets part of my analysis spreadsheet with a view to assessing to balance sheet impact of several years of acquiring?”

Incremental return on equity is a good place to start. A quick Google check finds a reproduction of an article I wrote 17 years ago:

(I am not allowed to post links, but try this boards.fool.com/incremental-roe-29006788.aspx)

“Indeed the contribution of Goodwill and Intangibles to the Balance Sheet is so profound that for Halma, removal of these as assets and applying the equity equation results in HLMA being in negative equity.”

True, but the goodwill represents companies acquired by HLMA that presumably generate cash on a regular basis.

Strip out goodwill etc, and you do have negative assets — which are not a problem if liabilities can be serviced through regular and sturdy cash flows.

Tobacco companies have operated on negative net tangible assets for decades, as their tangible assets are minimal compared to the cash flows generated and debts taken on. Tobacco companies have taken on large debts because their predictable (or at least historically predictable) cash flows could easily pay off the interest and leave room to pay dividends, buy back shares and acquire other tobacco firms.

Negative net assets are only a problem if cash flow dries up and money has to be found to pay off debts and other liabilities.

Back to HLMA.

As a rough guide to the incremental ROE, for 2008 HLMA produced earnings of £53,627k and had net assets of £239,104k. By 2018, earnings had grown to £171,534k and net assets had grown to £828,397k.

So the incremental ROE would be (£171,534k less £53,628k) divided by (£828,397k less £239,104k) = 20.00%.

In other words, for every £1 HLMA retained during those 10 years, an extra 20p of earnings was produced. So the acquisition spend seems to have been worth it. Which perhaps explains why the share price has done so well.

Note that I have not looked closely at HLMA’s figures. That 20% IROE could have been ’juiced’ by taking on irresponsible levels of debt. Or HLMA’s earnings could have been plagued by write-offs or other ‘non-core’ charges, which would lower the net asset figure and inflate the 20% ratio (you could add all these write-offs and non-core charges back on to the net asset denominator to recalculate IROE).

Maynard

MaynardPaton wrote:(I am not allowed to post links, but try this boards.fool.com/incremental-roe-29006788.aspx)

Thank you - I'm reading it now...

Back to HLMA.

Note that I have not looked closely at HLMA’s figures. That 20% IROE could have been ’juiced’ by taking on irresponsible levels of debt. Or HLMA’s earnings could have been plagued by write-offs or other ‘non-core’ charges, which would lower the net asset figure and inflate the 20% ratio (you could add all these write-offs and non-core charges back on to the net asset denominator to recalculate IROE).

I did also find lots of capitalised R&D in fairly significant quantities.