How Good Is Good Will?

Richard Kramer: Welcome to the Bubble Trouble, conversations between the economist and author Will Page and me, independent analyst Richard Kramer, where we lay out some inconvenient truths about how financial markets really work. Today we go back to basics where we get to grips with some of those fuzzy terms and intangible concepts that too easily pass you by when following markets, picking stocks or reading about acquisitions. This week we get to the good, the bad and the ugly of goodwill, how it's supposed to be used and how it can often be abused in bubble trouble. More in a moment.

Will Page: Welcome back to Bubble Trouble where we reveal some inconvenient truths about how those financial markets really work. And this week we're gonna get back to basics, back to those foundations that we've been building all along, where we get to grips with some of the fuzzy terms and tangible concepts that too easily pass us by when we're following markets, picking stocks or reading about mergers and acquisitions. This week we get to the good, the bad and the ugly of something called goodwill, how it's supposed to be used and how it can often be abused in creating bubble trouble. Welcome back to the show, Richard.

Richard Kramer: Thanks, Will.

Will Page: So this week it's goodwill. How good is goodwill? How bad is goodwill? How ugly is goodwill? And I gotta say, this show's been helpful for me personally because I understand there's market imperfections. We discussed on our podcast about the SAC, the subscriber acquisition cost. You know, it's discretion that's applied. There seems to be a lot of discretion applied to goodwill. So I'm, I'm interested in tackling this one first. What, where, how. What is goodwill? Where do you see it in your accounts? And how is it calculated?

Richard Kramer: So there's a lot to unpack there. But at the most basic level, goodwill is what's called an intangible asset. So it's defined in a, a negative sense by what it's not. It's not property or buildings or land. It's not hard goods or stuff that you can sell. But instead it's things that require discretion to see and value in financial terms. Companies will have level three assets on their books which are those defined as things where they lack observable inputs, for example, a stake in a private company. It's very hard to value.

But goodwill itself depends on the judgment the management alongside their auditors to say, "This is the value of our brand. This is the value of our customer relationships," or this is the value of that intangible asset of the warm and fuzzy and feeling that we have about our company that makes us believe there's some intangible value to it, not something we can package up and sell as a commodity in the market.

Will Page: So I love that description, Richard. Now you described warm and fuzzy as a feeling of goodwill. Who is it exactly that decides how warm and how fuzzy that goodwill is? Is it the management team or some independent auditors?

Richard Kramer: So it is indeed the auditors in conjunction with the management team that would say, for example, how many customers bought your product last year and did they buy it because of the brand, or did they buy it because you produced it at a very low price?

Will Page: Is there a survey that's done to determine that, or...

Richard Kramer: Well, you could have a lot of inputs to that. But let's not get caught up too much in the details. It's about the value of something intangible over time. You would normally expect that value to degrade over time, but there have been some fantastic examples of brands that had to write down their value because tastes changed. And typically goodwill is most often seen when you have one company acquiring another. So, for example, when Kraft Heinz was bought by private equity, they had to put a value on all the brands of the Velveeta Cheese and, and, and tomato ketchup that were being that were being acquired. And if tastes changed because people are moving away from buying processed cheese or think there's too much sugar in ketchup and don't wanna eat it anymore, then the value, the goodwill value of those brands goes down. The fallout that happens when a company pays too much money to acquire another company thinking that their brand is gonna last into perpetuity.

Will Page: This is very trend dependent. It's very much fashion-based almost in terms of fashion cycles here. Let's move into a little bit of arithmetic here. So my understanding is, if Richard Kramer's company's underlying assets are worth 100 and I was to acquire you for 150, presumably that delta, that 50, is a portion that you'd put to goodwill, correct?

Richard Kramer: Yes.

Will Page: But there are examples where goodwill can be worth more than the company itself. Could you just kinda walk me through how this asymmetrical or even symmetrically works in terms of if that company has some skeletons in its closet, some liabilities which need to be factored in as well.

Richard Kramer: Absolutely. So there was another very famous case where General Electric bought a European power generation company called Alstom and they paid about $10 billion for it. They ended up writing off $23 billion of goodwill because in that goodwill was all of the commitments that had been made to Alstom's customers that GE still had to fulfill, but those customers were fed up with Alstom and didn't wanna buy from them anymore. So in that case the write off of goodwill was actually larger than the purchase price because the balance sheet that GE bought included a bunch of liabilities which weren't assets, weren't reflected in the goodwill value of the intangible asset of literally the goodwill of the customers or those relationships that were based on selling power generation equipment to utilities. But they also included a bunch of liabilities that weren't properly reflected that said we're going to fix all the equipment that we sold you in the past, and that's added to the negative goodwill.

Will Page: So it's... I'm hearing it's imperfection in markets, goodwill. It's not a science. It's an art. It's a discretionary art form as well. But it's also distortionary. I mean, this whole podcast series is about bubble troubles, how they happen with a worrying amount of frequency. How the boy who cried wolf doesn't learn from past mistakes. What is the role of goodwill in creating bubbles and getting us into trouble?

Richard Kramer: At the fundamental value level, goodwill is typically brought together because one company buys another. And we've talked before in Bubble Trouble about all of the perverse incentives that lead companies to pay too much to acquire another company. You always want what you don't have and you always think the company that you're going to acquire is going to have the magic bullet solution to all of your problems and needs. And along the way you have a bunch of investment bankers who have a conflict of interest to see the deal get done, egging you on and saying, "Come on. You gotta take the plunge." And that's why you get deals like AOL buying Time Warner, or AT&T buying Direct TV.

Will Page: That was a classic.

Richard Kramer: All of these acquisitions that generate goodwill because you're paying so far above the actual asset value, and it's very hard to ascertain what that future goodwill value will really be because you're starting to deal with a lot of nested uncertainties. Now I wanted to bring up one very simple example of goodwill and how it's often used. It's very hard to test brand loyalty over the longterm. You know I do a lot of running, and I have been wearing for many years Adidas running shoes because they fit. Now when they changed the shoe shape, the, the last of the shoes with the ultra boost 2019 version, they didn't fit me anymore and I had to find another brand. What I ended up doing was buying old models of the same running shoes until they ran out. And had they not changed the last back so that it fits me again now, they would have lost my goodwill as a customer.

So that goodwill is dependent on having a consistent promise to the consumer. And if you're an Internet service or, or a consumer brand of any sort, or a food brand, tastes change, the quality of your content changes, and you can very easily lose that goodwill. But while that's getting depreciated or amortized on the balance sheets of these companies at a very steady rate, I think we all know that there's lots of examples where that goodwill can evaporate overnight. It just takes one rotten Chipotle burrito-

Will Page: [laughs]

Richard Kramer: ... or one [laughs] salmonella case to wipe out a huge portion of the goodwill that's built up by any sort of fast food chain brand.

Will Page: It, it really feels to me that much of what we discussed in the, the past 20-plus podcasts, you know, [inaudible 00:09:22] is talking your own book. It's almost like goodwill is a sewer which captures all of that stuff. You know, as you're preparing the value for a company you have all these distortionary mechanisms out there. And whatever it is, you can just pile it into goodwill and you'll book it down as that.

Wrapping up on part one here, what I think is interesting for me, from what I've learned from you, Richard, is in auction theory, we have this thing called a suckers curse. That is, if you win an ascending price auction, what does that mean? It means you won the value of the asset. But it also means you're a sucker 'cause nobody else is willing to pay that price. So if you overpay for a company then that delta in terms of how much you got overpaid, seems to get washed up in this sewer of goodwill. Fascinating topic. Part two I want to get to some case studies, some write downs and also some write ups. And also we'll get to our famous smoke signals to help our audience avoid mistakes that goodwill can bring. Back in a moment.

Back in part two of Bubble Trouble where we're discussing the good, the bad and the ugly of goodwill. And I wanna start part two with a famous Warren Buffett quote which goes [inaudible 00:10:39] speaking like this, "Only when the tide goes out do you discover who's been swimming naked." And, Richard, we've been reading a lot about goodwill write downs in the press as a result of the pandemic and many other reasons, too. So I think it's time to maybe bring this subject to life with some case studies. You know, studies of write downs, write ups where goodwill hit the headlines for all the wrong reasons.

Richard Kramer: Will, you're right to point out that there had been a record level of goodwill write downs in some part prompted by the pandemic, but also because we've seen this vast boom in M&A. And if you wanna go back to the granddaddy of all terrible acquisitions, Time Warner buying AOL, you saw shortly thereafter when the tech bubble burst just after the turn of the millennium, a huge goodwill write down. I think in one quarter they wrote off $45 billion worth of goodwill because they realized that all those AOL subscribers were simply never going to turn into paying customers they way they'd hoped for when Time Warner paid $100 billion to jump on this crazy train at the time called the Internet.

Will Page: $45 billion. Just to contextualize that, I think that's about the value of the Scottish economy around that time as well. So-

Richard Kramer: It probably was. And the point was that goodwill was that price paid over hard assets, that future commitment, and one can imagine if someone had acquired Myspace just before Facebook launched, they would have paid a huge premium for the expectation that everybody would keep dumping their personal content on Myspace. And again, all that would have evaporated in a goodwill write down.

And the reality is, that goodwill is very poor at capturing changes in consumer behavior or one-off events because it gets amortized on a straight line basis over a period time. How long does a brand last? 20 years. So let's amortize 5% of our goodwill every year for the next 20 years. Well, brands don't work like that. They get quickly supplanted by something new and exciting that consumers turn their attention to, and then that goodwill evaporates and gets written down.

Now the scary thing about how it's treated in the financial markets is when you pay for a company, when you buy a company, you're paying real money. But when you then write off the goodwill, you say, "Oh, well. It's a non-cash charge."

Will Page: Right.

Richard Kramer: What it really reflects is that you overpaid for the asset in the first place and destroyed shareholder value, but the way it's treated, especially going back to our previous shows about gap and non-gap accounting and minding the gap, is they say, "Well, you know, that's something we did in the past. We can't do anything about it now. Let's just write it off."

Will Page: So it's not my money I'm writing off, it's your shareholder value that I'm writing off?

Richard Kramer: Yes.

Will Page: I wanna tackle the rules for a second. There's so much we could discuss here, but I'll break it down into two parts. I'm interested in firstly a retrospective angle in the rules around goodwill. You know, is it different in the UK from the US? Was it different in Internet bubble 1.0 versus Internet bubble 2.0? And then secondly, looking forward, how could you make those rules better? Let's look backwards. Initially you were talking about Time Warner/AOL. That was a long time ago, two decades ago. Have the rules changed since then? Were the rules different which created that issue?

Richard Kramer: I mean, yes, some of the rules have changed, but equally the abuse of the rules in excluding things from adjusted non-gap earnings like goodwill, like restructuring, they haven't changed. And remember, as we said with restructuring, you don't take a charge when you hire a management consultant to get you a new CFO. But you do take a charge when you fire that guy-

Will Page: [laughs]

Richard Kramer: ... and you have to pay him out a big severance package. The rules are always going to be used by managements to favor the way they treat their own accounts and exclude as much stuff as they can as one-offs as opposed to accepting that it was normal course of business for them to make dumb acquisitions and end up seeing them go poof.

Will Page: What I'm hearing is that in the past we've just kind of papered over the cracks here. If we were to appoint Richard Kramer as the chief executive of the SEC in, in Washington D.C. how would you rewrite rules around goodwill? What, what tweaks, nuances, adjustments could you make to the term goodwill that makes it better?

Richard Kramer: I think the, the first thing that you would do would be require greater disclosure of the value judgements behind the goodwill. What ensures that that brand is going to stay healthy? What is the basis of believing that those customer relationships are rock solid and will last for 20 years? Some of that could be made more public. You could also have different treatment of the impairment of goodwill and make managements more liable for the risk of overpaying shareholders funds for assets.

Now clearly shareholders could do that themselves by punishing the companies that overpay for assets and often times they do. When you look at, uh, Bayer buying Monsanto with the liability of RoundUp weedkiller, and then it goes awfully wrong with the liabilities that they have, and of course, uh, Bayer knew those liabilities were there, but they chose to ignore them. And if their stock under performs for five years until they get on top of it and pay for it, well, that's their punishment.

But one of the things the SEC could certainly do is end the use of all of these adjusted non-gap earnings metrics and say, "Right. Let's have all companies report and treat all of their accounts in the same way and not allow them to cherry pick the metrics which most favor their equity story."

Will Page: Reducing the discretion, reducing imperfections?

Richard Kramer: Yeah. And, and it's, it's very much like asking in your history, looking at government departments and saying, well, hang on a second. You've got to be able to produce consistent statistics instead of just picking the numbers that flatter your case when you want to praise your achievements or picking the most denigrating numbers when you're trying to call your opponent out for something they have or haven't done.

Will Page: Yeah. Thanks for picking up on that my [inaudible 00:17:11] government statistics. So you can see right there where I think, you know, what you're proposing for the SEC I think could apply to government bodies as well. Reduce the discretion, close down the imperfections.

So let's, let's move to our, our closing segment of every, every podcast that we do which is smoke signals. Again, the purpose here is for the listener. You know, we're gonna take up 20, 25 minutes of your time to introduce a concept to you, but we gotta give you something to take away, and the smoke signal is, the purpose here is so you can spot goodwill being used and abused in the future. Let me ask for two, Richard. What would be the first one? We're gonna go back to, uh, web bubble 1.0 for this one.

Richard Kramer: Sure. And I, I think one way to look at companies is to exclude the goodwill from the book value, if you will, the, the core asset base. And of course that's not gonna work for every sort of company. A software company or a consumer brand is going to be very heavily dependent on goodwill. But you have to realize if you're looking at those companies as investments, that things can change and that goodwill doesn't have the lasting value of the property plant and equipment, or land and buildings on the balance sheet of most normal companies. And so a company that's very heavily dependent on goodwill should have higher risk and you should be getting higher rewards. They should be earning higher returns because they're generating those returns out of intangible assets not out of tangible ones.

Will Page: Now the last thing I wanna do is generalize something as complex as financial markets. But is there a ratio our listeners could take such as if company A buys company B and goodwill is three times the value of the underlying assets of the company, that's too much or that's a comfortable figure? Is there any sort of ratio guidance you could give our listeners?

Richard Kramer: There isn't because, as I said, each sector is different. Whether you're looking at the property sector or chemicals, or, or tech companies, they'll all have different metrics and be willing to pay for different aspects of customer relationships, or brand loyalty, or intangible assets like, like patents or, or software development features. So you cannot generalize that way. But you really ought to pay close attention to the reliance on intangible assets and the risk that you need to attach to them potentially disappearing.

Will Page: Now smoke signal number two. I guess, it, I'd like to probe you a little bit further in terms how you can make the world a better place, to use that Silicon Valley expression. But, you know, what can we do here in terms of making sure that goodwill in the future stays good and doesn't go bad?

Richard Kramer: Yeah. The, well the deck has been stacked against investors for a very long time in terms of disclosure. And on intangible assets in particular, there ought to be more disclosure required. Anytime the major asset of a company is goodwill, you should be able to query some of the assumptions. How long do you expect that brand to last? And what sort of sales and marketing do you need to provide to ensure that brand stays fresh in consumer's minds? If it's an Internet service providing content, how much content do you need to fund every year? What's the assumption in terms of new shows or, or music or what have you that you need to deliver to make sure people keep subscribing to your service? And so all of those key assumptions are between the auditors and the management, but they need to be brought out into the open a little bit more for companies to prove that we are really well liked by our customers. We can sustain our goodwill value over time. We're not just a flash in the pan.

Will Page: Fantastic. Thank you so much. Well, that brings part two to a close. Part one made me think about the buyer and, you know, the suckers curse. If you win an auction you're a sucker 'cause nobody was willing to pay quite as much as yourself. And that, that delta between you and the next person could be called goodwill. Part two made me think about the regulator role, the retrospective after the event effect. When you have a write down, goodwill serves a purpose because goodwill is a way of adjusting that write down to make sure we clean up the mess that you've made from it. Nevertheless, it's a cause of bubbles and we are always blowing bubbles on this show, and just like the markets do [inaudible 00:21:32]. We'll be back next week with even more bubble troubles to discuss. My thanks to Richard Kramer and you've been with Will Page, and this is Bubble Trouble.

Richard Kramer: If you're new to Bubble Trouble, we hope you'll follow the show wherever you listen to podcasts. Bubble Trouble is produced by Eric Newsome, Jesse Baker and Julia [Nat 00:21:54] at the Magnificent Noise. You can learn more at bubbletroublepodcast.com. Will Page and I will see you next time.