Mad Dog 21/21: Nerves Of Steel
January 12, 2015 Hesh Wiener
As 2014 drew to a close, the Wall Street Journal, which undoubtedly can recognize an outfit in decline, said IBM shares would be the year’s worst performing component of the Dow Jones Industrial Average. IBM was the biggest loser of the DJIA in 2013, too. The last company to do so poorly was Bethlehem Steel in 1995 and 1996; it was kicked off the DJIA in 1997. In 2001, Bethlehem went bankrupt, and two years after that it was dismembered. If IBM doesn’t change quickly and dramatically, it is a goner.
Goodwill impairment may be the ruin of IBM. So, perhaps it’s time for Big Blue’s customers to understand just what it means. When one company buys another for more than the market value of its net assets (meaning assets minus liabilities), the difference between the net value and the acquisition price is called goodwill. When both companies are publicly held and the acquiring company pays more to buy its target than the price the stock market had previously concluded was its worth, the difference is easy to discern as goodwill.
For instance, if IBM bought a publicly held company with a total market capitalization of $1 billion and paid $1.5 billion to clinch the deal, IBM would put on its books assets totaling $1 billion plus a half billion dollars denoted as goodwill. Things can get a bit more arbitrary if the acquired firm is privately held, but accountants will arrive at a figure they stipulate is the market value of the company and call the amount by which the purchase price exceeded that value goodwill.
In the past, the acquiring company would slowly write down the value of goodwill, taking as long as 40 years to complete the process, slowly digesting the acquisition the way a python digests a large meal. But accounting rules change and in the USA, since 2001, companies are not permitted to amortize goodwill. They are, however, required to review the goodwill on their books. If a company decides that one of its acquisitions is no longer worth its former value because it could not be sold for at least the original acquisition price, the acquirer is supposed to declare a diminution of the goodwill on its balance sheet. The result would bring the acquired company’s declared value in line with its actual or presumed market worth. The sum lopped off goodwill is called impairment.
In its third quarter 2014 report to shareholders, IBM said that among its assets was goodwill valued at more than $31 billion. This was more than twice the value of IBM’s shareholder’s equity of $14.3 billion. Shareholders’ equity is also called a company’s net worth. If IBM took an impairment charge of half its goodwill, all its net worth would be wiped out. IBM would be broke.
Of course this cannot possibly happen. We are talking about IBM here, Big Blue. If IBM says it pretty much got its money’s worth in all its acquisitions or if the companies it has acquired are now worth as much as IBM paid for them over and above their tangible assets plus intangible assets less liabilities, well, who could doubt the reckonings of IBM’s bean-counters? Not investors. Not yet, anyway.
Bethlehem Steel lasted 99 years, longer than IBM has been around, if one starts the clock when the company re-invented itself out of what had been the Computing Tabulating Recording Company (CTR); Big Blue took the name International Business Machines in 1924. (If one prefers to reckon IBM’s longevity from the date CTR was formed, then IBM turned 100 in 2011.) Bethlehem Steel began as a producer of steel track for railroads. In addition, from its earliest days, it took an interest in large ships, making armor for the U.S. naval fleet. Bethlehem Shipbuilding grew to enormous size by the 1940s. All told, its shipyards built more than 1,100 vessels, launching out more than one ship a day during World War II.
Steel girders by Bethlehem, the technological offspring of its steel rails, became the bones of the George Washington Bridge, the Golden Gate Bridge, and a vast number of other bridges between its coastal creations. It made the steel frame of the Chrysler Building, provided components for the Empire State Building, and created the skeleton of the Rockefeller Center complex. It provided the steel used to make the Hoover Dam, the Bonneville Dam, and the Grand Coulee Dam.
Yet when it tipped into decline, its accomplishments remained standing with much more permanence than the company that poured their steel, just as the institutions whose financial frameworks were once totally powered by IBM computing equipment may long outlast the IBM that no longer makes business machines.
IBM’s $31 billion in goodwill is the result of dozens of acquisitions. In 1995, IBM acquired Lotus Development, paying $3.5 billion for a publicly held firm whose market capitalization prior to the IBM offer was about half that. So that one deal added $1.75 billion to IBM’s goodwill. The following year IBM bought publicly held Tivoli for $745 million; about a quarter of that price was added to goodwill.
In 2001, IBM bought the database management products and services made by Informix. The next year IBM bought the consulting operations of PricewaterhouseCoopers for $3.5 billion. These were private deals that leave the value of goodwill, if any, up to IBM and its auditors. In 2003, IBM bought Rational Software for $2.1 billion, a roughly 20 percent premium to its market price; thus, about $400 million was added to goodwill. In 2005, IBM bought Ascential Software (the other half of Informix it did not buy) for $1.1 billion, slightly above its market value. In 2006, IBM acquired MRO Software, FileNet and Internet Security systems for a total in excess of $3.6 billion. In 2008, IBM bought Cognos for nearly $5 billion, about 9.5 percent or $450 million above its market value prior to the IBM takeover. The next year IBM bought SPSS for $1.2 billion, paying more than 40 percent more than its market price and thus adding close to half a billion dollars to its goodwill. Since then, IBM bought Sterling Commerce for $1.4 billion, Netezza for $1.7 billion, Kenexa for $1.4 billion, SoftLayer for $2 billion, and Trusteer for $1 billion.
Investment analysts haven’t taken a critical look at the way IBM has piled up goodwill and never taken an impairment charge. The event that might have triggered a new level of scrutiny was IBM’s disposition of its semiconductor business, which it accomplished by paying GlobalFoundries $1.5 billion and in addition wrote off the value of assets associated with its chip business for a total pre-tax charge of $4.7 billion.
This bold disposition shows that IBM management is willing to own up to its errors, at least in this one watershed incident. It suggests that IBM may yet turn a critical eye to its many acquisitions. Some may have panned out poorly, leading to a continuing drag on IBM’s performance and fostering an atmosphere of denial that is bound to demoralize the healthy parts of the company.
Bethlehem Steel fell into decline during the 1970s as its aging plants fell behind more efficient facilities outside the USA and later, as American companies built new steel factories called mini-mills domestically, too. The company shut down or sold off its least profitable operations, but it was unable to re-invent itself using the rival technologies that were killing it. By some accounts Bethlehem Steel’s management took the same sort of sour grapes stance that has become a characteristic of IBM’s official description of its failures and withdrawals.
It is impossible to say whether Bethlehem Steel might have somehow saved itself by taking a different course and a different attitude 60 or more years ago, before Europe and Japan fully recovered from World War II, before America entered a socially, politically and, now, financially corrosive era of self-doubt. But it does seem clear in retrospect that Bethlehem could have put up a better fight, if only it had management with more savvy and more nerve.
I suspect the same will someday be said about IBM, not so much that its management should have been smarter but that its management team, had it been more daring, might have kept it from expiring.