As we all know, the construction materials industry, which in part includes construction aggregates, ready-mixed concrete and concrete products, has been consolidating rapidly over the past three decades, and the pace of that consolidation shows no signs of abating anytime soon. So it is worth understanding how purchasers in our industry, usually large multi-nationals, treat a purchase of a smaller competitor … and how that treatment may soon change.
The Concept is Simple. On a seller’s balance sheet, there is the asset side: it consists of all the company’s property, plant, equipment and working capital, less accumulated depreciation. On the liability side, there is the current and long-term portions of all third-party bank debt (remember that accounts payables are reconciled through working capital).
Subtracting the bank debt from the assets, less depreciation, gives us the net asset value of the business. But almost all transactions sell for more than the net asset value, so the portion over and above the net asset value finds its way onto the purchaser’s balance sheet as goodwill. It is an important element of any transaction, as it is often the largest portion of the purchase price allocation.
But now, the entire concept and treatment of goodwill may wind up getting turned on its ear under new accounting rules being proposed, which could have a negative effect on purchasers’ balance sheets, and could negatively affect the value of companies thinking about selling.
An Illustration. Let me use an illustration outside our industry so as not to bring attention to any particular transaction that has occurred in construction materials. When Amazon bought Whole Foods Market for $13.7 billion in 2017, the e-commerce giant paid $9 billion more than the value of the supermarket’s stores and other net assets. That amount was added to Amazon’s books as goodwill.
And like every other company that carries a meaningful amount of goodwill on its balance sheet, Amazon is supposed to evaluate, or test, that $9 billion every year to see if its value still holds. If not, they must write down a portion of it in what is known as a “goodwill impairment charge,” a move that flows through the income statement as a loss and cuts the company’s profit in that given year.
For instance, Kraft Heinz Co. last year announced a $7.3 billion goodwill impairment that resulted partly from falling profitability expectations for its Kraft cheese and Oscar Mayer cold cuts businesses. And General Electric stunned investors in 2018 by writing off $22 billion of goodwill from its 2015 purchase of Alstom, a French power business, a move that added to GE’s long slide in shareholder value.
Whether to Continue. The Financial Accounting Standards Board, the accounting-rules maker, is now weighing whether to continue to assess goodwill by tests, or return to a similar approach to the guidelines of nearly 20 years ago, when companies wrote down a set portion of goodwill each year for up to 40 years.
The FASB has asked for comments on the possible change, and companies haven’t been shy about weighing in. Some argue the test approach is costly and subjective, but others say the old approach, the so-called amortization of goodwill year-by-year, allows companies to mask problems for a long period of time. And some fear that amortization might cause the write-off of a substantial portion of the assets and equity of U.S. public companies and would reduce profits to nearly zero for a significant number of them.
For all public companies trading in the U.S. markets, goodwill exceeds $5.5 trillion. Within the construction materials industry, the top 25 publicly traded companies are carrying significant goodwill on their balance sheets as a result of the hundreds of acquisitions that have taken place over the years.
A re-write of the goodwill rules that would require amortization could clearly affect the balance sheets of the multi-nationals, and likewise could have a negative effect on value for sellers of private companies in the future.
Pierre G. Villere serves as president and senior managing partner of Allen-Villere Partners, an investment banking firm with a national practice in the construction materials industry that specializes in mergers and acquisitions. He has a career spanning almost five decades, and volunteers his time to educate the industry as a regular columnist in publications and through presentations at numerous industry events. Contact Pierre via email at [email protected]. Follow him on Twitter @allenvillere.