It was January 10, 2000. America Online had just announced that it would acquire Time Warner to create the largest media company. The purchase price amounted to more than $160 billion, and the combined entity was estimated to have a market capitalization of ~$350 billion. The deal was the biggest corporate merger to that date and was expected to launch the next Internet revolution, according to then-CEO of AOL Steve Case. The transaction valued Time Warner at about $108 per share, a huge premium over its price of $64.75 per share the trading session before. AOL’s shares closed at $72 the day of the announcement.
Just a couple years later, things were quite different. When it reported full-year 2002 results, AOL posted a $98.7 billion net loss as a result of two massive goodwill write-downs. The yearly loss was made up of a $45.5 billion goodwill charge during the fourth quarter of 2002, which came on top of a $54 billion goodwill charge in the first quarter of the same year. The charges were related to–you guessed it–the merger (primarily tied to the America Online division). Synergies simply never materialized. The net loss was the biggest annual corporate loss in history, and on the day of the yearly earnings release, AOL’s shares fell below $13 per share in after-hours trading—a far cry from their bubble peak.
Goodwill is almost never a good thing in accounting. Accounting goodwill is only created during the merger and acquisition process (specifically through purchase accounting) when the fair value of the target’s assets does not equal the purchase price of the target’s assets. The difference between the purchase price and the fair value of the target’s assets is added as an intangible asset to the acquirer’s balance sheet as goodwill (once the transaction is completed). In the case of the AOL-Time Warner deal, there was a mountain of goodwill added to the combined entity’s balance sheet.
Goodwill used to be amortized, but ever since 2001, goodwill is now tested for impairment under US GAAP. If the fair value of a company’s asset (as measured by its future cash flows) is less than carrying value of the asset on the balance sheet (i.e. the asset is impaired), the goodwill value on the balance sheet is adjusted lower so the fair value is equal to the carrying value. The impairment loss/charge is reported as a loss on the income statement, and the reduced value of goodwill is updated on the balance sheet.
Generally speaking, when companies take huge charges (write-downs) on assets that they’ve recently acquired, it is almost always the case that management overpaid for those assets. In the case of AOL-Time Warner, management significantly overpaid. Many still call this transaction the “biggest mistake in corporate history.” This example, though extreme, really hits home the price versus value dynamic we hope to instill within readers: price is what you pay for an asset, but value is what you get.
Management teams—just like investors–can overpay for assets, and sometimes badly. This is why our fair value estimates are anchored to projections of free cash flows—not based on speculative merger-and-acquisition euphoria and/or irrational buyout multiple analyses. Each fair value estimate on our website is backed by extensive free cash flow analysis, not ‘castles in the air’ (1) justifying the next takeover price.
That said, synergies can justify a premium above a company’s standalone value, but in many cases, the acquirer has to pay so much for the target that most of the value of the transaction accrues to the target’s shareholders—not to the acquiring shareholders. Sometimes, as in the case of AOL-Time Warner, synergies don’t come to fruition.
More recently, we’ve been starting to see management teams get a little too comfortable with wheeling and dealing. In one particular example, we simply couldn’t believe the price Pfizer (PFE) was willing to pay for AstraZeneca (AZN). Pfizer’s willingness to put to use non-US-domiciled cash and re-incorporate in Britain, where it could pay lower taxes, pushed its offer price to nosebleed (and irrational) levels. It seems, however, that there may be no price high enough to please AstraZeneca’s board (Pfizer’s shareholders were relieved).
The recent surge in the number of tax-inversion deals is certainly starting to turn heads, and we believe management teams are looking. Such a trend could potentially put a premium on the assets of non-US based companies, especially if the political tensions that caused Walgreen’s (WAG) to scrap its plans to re-incorporate in Switzerland ease.
AbbVie (ABBV) and Shire, Medtronic (MDT) and Covidien (COV), and now today, Burger King (BKW) and Tim Hortons (THI), are three of the biggest tax-inversion deals that we’ve seen. Warren Buffett (BRK.A, BRK.B) is reported to be helping finance the Burger King-Tim Hortons transaction, perhaps adding more controversy to the political fire as Washington seeks to close loopholes in the tax code. If the Burger King-Tim Hortons transaction goes through, we would expect more tax-inversion deals to come to light. Many are probably being discussed right this minute in boardrooms across the US.
Absent the Pfizer-AstraZeneca deal that didn’t happen, bids have been relatively reasonable thus far, though we contend that most are at the high end of what we would consider a ‘reasonable’ range. Still, that doesn’t mean management teams can’t overpay, and the stark reminder of the AOL-Time Warner blunder is worth keeping top of mind as market valuations are bid ever higher. The S&P 500 (SPY) surpassed 2,000 during the trading session Monday, and by default, premiums paid to close deals should be lower, not higher. Today’s take-out prices almost speak to the type of premium paid by AOL to close its deal on Time Warner during the dot-com bubble peak.
Unless otherwise stated in a company’s 16-page report, the fair value estimates of firms in our coverage universe represent the respective firm’s standalone intrinsic value. The high end of the fair value range is a good estimate of what a strategic buyer may be willing to pay for that particular company (factoring in synergies), but in almost all cases, a price above the fair value range is simply difficult to justify. Management teams can certainly pay far above intrinsic value (and the value of synergies) to consummate a deal, but these cases almost always end badly, and we have AOL-Time Warner to remind us of this.
Just remember: price doesn’t always equal value, and management teams can overpay (badly) for assets. Picking which assets management will (badly) overpay for is not a game that we think is worth playing, especially near market highs (peaks). We’re happy when an underpriced gem in the Best Ideas portfolio and Dividend Growth portfolio is scooped up by an acquisitive management team at a premium, but we wouldn’t go rushing to add companies to the portfolio on a small probability they might get taken out at an irrational price. That’s a game for greater fools (2) and a sure way to get whipsawed in today’s market. We continue to prefer ideas in the Best Ideas portfolio and Dividend Growth portfolio.
(1) Castles in the air: “The theory postulates that the investors try to build a sort of castles in the air and think of the probable price rise in the future than estimating the intrinsic values of stocks. Once the investor has estimated this, he/she tries to beat the crowd by building positions in the preferred stocks before the crowds (read other investors) start buying those stocks and the price surges ahead.” – Finance Wikia
(2) Greater fool theory: “A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price. When acting in accordance with the greater fool theory, an investor buys questionable securities without any regard to their quality, but with the hope of quickly selling them off to another investor (the greater fool), who might also be hoping to flip them quickly. Unfortunately, speculative bubbles always burst eventually, leading to a rapid depreciation in share price due to the selloff.” – Investopedia
Note: The Valuentum process combines what has traditionally been known as the Firm Foundation theory and the Castles in the Air theory, requiring firms to have both a firm foundation on the basis of valuations and fundamentals and the prospects for price-to-fair value convergence via strong technical and momentum indicators. Said differently, Valuentum stocks are undervalued stocks that are going up (i.e. converging to their respective fair value estimates).
Related Firms: TIME, TWX, TWC, AOL, TAST