Advertisement

You will be redirected to the page you want to view in  seconds.

More Companies Expect Declines in Goodwill

Jan. 29, 2013 - 02:57PM   |  
By ZACHARY FRYER-BIGGS   |   Comments
  • Filed Under

At first glance, General Dynamics’ (GD) year-end earnings announcement the morning of Jan. 23 looked bad. The company reported a loss of $2.1 billion from continuing operations compared with revenue of $31.5 billion for 2012. The stock opened down about 4 percent, and dropped another percentage point quickly.

But by the end of the day, the stock had climbed and actually closed above the pre-announcement levels. Analysts said the climb was likely driven by a closer reading of the financials released by GD, which showed it hadn’t actually lost $2.1 billion in cash or expected revenue. The vast majority of that figure came from a valuation change that exists only on balance sheets and measures intangible assets.

It’s likely the first example in what is expected to be a trend of defense companies adjusting the reported values of their properties to reflect reductions to the defense market and declines in market opportunities. Those reductions won’t necessarily reflect any change to profitability, but will still show up as large “losses” in earnings reports.

“It’s hard to imagine that this is a one-off thing,” a defense analyst said. “Are they really that different than anybody else?”

The value drop for GD largely came from an adjustment to the company’s reported goodwill, an accounting term used to represent intangible assets a company has following acquisitions. The value of goodwill is meant to demonstrate the advantages a company gains in market position and reputation, among other things, when it acquires another company.

In the defense industry, where acquisition activity is common, goodwill can represent a large chunk of a company’s value on balance sheets.

For General Dynamics, goodwill represented 39 percent of the company’s assets at the end of 2011. For Lockheed Martin and Raytheon, goodwill accounted for 27 percent and 49 percent of their total assets at the end of 2011, respectively.

Each year, companies are required to test the value of the goodwill on their balance sheets, considering whether market factors have changed the value of individual units. The testing became a requirement after scandals at the beginning of the millennium, when several publicly traded companies, including Enron, lied about the value of goodwill on their balance sheets to artificially inflate their numbers.

In GD’s earnings call with investors, the company pointed to its Information Systems and Technology (IS&T) group as having been the driver of the new goodwill valuation, including $2 billion of the goodwill valuation reduction.

“IS&T has experienced continued top line pressure, resulting from slow defense spending in their markets and margin compression due to mix shift, and cost performance,” said company Chief Financial Officer L. Hugh Redd.

Those market trends aren’t specific to GD, and at some point, other companies will likely have to follow suit, analysts said.

“When do they have that moment when they come back and realize, oh crap, the outlook really isn’t that good?” a defense analyst said.

The sudden drop in GD’s stock price, followed by a rebound, demonstrates another fact of the modern market: automated trading systems.

Many news entities reported in bold headlines that GD had lost $2.1 billion in 2012, which while true, might mislead some into thinking the company had experienced a sharp decline in profit or sales. Trading algorithms probably saw those headlines and reacted quickly, said Byron Callan, a defense analyst with Capital Alpha Partners.

“There are now algorithms that will read the news feed and if they see certain words, act, and so there’s a part of this market that is robo-driven, so you can get those kinds of goofy initial responses,” Callan said.

By the time the company had its earnings call, and had provided greater detail on the drop in goodwill value, which is known as goodwill impairment, the stock had already declined. More careful reading, paired with confidence in new company head Phebe Novakovic’s response, pushed the stock back up.

At the close of the markets on Jan. 22, before the announcement, the stock was trading at $70.64. After a bit of yo-yoing following the drop and subsequent rise, the stock closed Jan. 24, the day after the announcement, at $70.64.

The leveling of the stock price also shows that goodwill isn’t a major factor in trading decisions for investors, Callan said.

“The whole goodwill part of this business, it used to be important, but we just stopped paying attention to book value because of that goodwill,” he said. “The more important thing is the cash flow.”

While other major defense companies haven’t yet reported significant adjustments to their goodwill values, if the current expectations for defense spending decline are met, goodwill will fall.

“You can probably look at the direct correlation between the U.S. defense decline and what someone’s goodwill will mean,” Callan said.

But even if trading algorithms are fooled by headlines, Callan said he expects traders won’t be. “I think most people correctly look through it.”

More In World News

Start your day with a roundup of top defense news.

Subscribe!

Subscribe!

Login to This Week's Digital Edition

Subscribe for Print or Digital delivery today!

Exclusive Events Coverage

In-depth news and multimedia coverage of industry trade shows and conferences.

TRADE SHOWS:

CONFERENCES:

Defensenews TV

  • Sign-up to receive weekly email updates about Vago's guests and the topics they will discuss.