Watch out for the Intangibles!

Motivation

A friend recently approached me to help him take a look at Healthway Medical. Once of the most glaring thing that struck me when I thumbed through its latest financial statement was the huge intangibles on its balance sheet. After I explained to him my concerns, I thought I might as well highlight it on my blog too.

Risk of high intangibles

Intangibles on the balance sheet arose primarily from when a firm acquires another business and pay a price higher than its the net tangible assets. This translates into goodwill that the acquiring company reports. Another common intangibles can be copyrights or patents that royalties can be collected. Whichever it is, intangibles have to be revalued periodically and amortized (write down) accordingly if necessary. Basically, intangibles are valued by how much revenue it can generate, forecast into the future, and discounted to present value. Thus should any estimated variables (forecast revenue) change, the value of the intangibles need to be readjusted. Thus, it is always easier to value licence, copyright etc, than pure good will.

What happens when an intangible asset is marked down? The same amount has to be reported on the income statement as a deduction against the revenue. If the amount is huge, a 'loss' is reported even though the company is actually profitable. On the surface, this might not seems to be a serious concern since the impairment does not even impact the cash flow. But the fact that a huge amount of intangibles got wrote off either meant the business acquired earlier on was worth much less (goodwill) or the copyright or licence couldn't bring in as much revenue as forecasted. Either way, the drop in net asset value following the amortization meant the price-to-book ratio will jump, a simple litmus test to indicate overvaluation.

Case study 1 - Healthway Medical

A look at Healthway Medical's latest financial statement shows that it carry $177.6m of intangibles out of total assets of $242.2m as of 31st December 2010, i.e. about 9.5cts out of 10.48 cts of NAV is intangibles! A check on Healthway Medical's Annual Report reveals that the intangibles are mostly made up of goodwill which comprises of discounted future cash flows from various clinics under its management. The anticipated growth rate of the revenue was 2-4% for 2010 to 2013 and 4% infinitely. Discount rate was 7%. Thus if these clinics failed to performed as targetted, significant amortization, and hence net loss, could occur. Against the NAV of 10.48 cts, the company's share price was trading at around 13.5 cts.


Case study 2 - IPCO

IPCO has $66.4m of intangibles out of total assets of $195.3m as of 31 Oct 2010, i.e. about 3.7cts out of 7 cts of NAV is intangibles. The intangibles also arose from goodwill contributed by the valuation of future earnings of its subsidiary, Excellent Empire, which holds a 90% equity interest in three companies supplying natural gas under 30-year exclusive contracts in the cities of Anlu, Dawu, and Xiaochang in Hubei Province, China. However, due to past aggressive (possibly unsustainable) growth rate in revenue, chances of future earnings unable to hit projections become very likely. Anyway, against the NAV of 7 cts, the current share price of 2 cts continue to seem attractive to me.


Case study 3 - Armarda

Let's now look at what happens when the intangibles got amortized. Armarda had a string of acquisitions since IPO and as of 31 Dec 2009, had amassed HK $98.8m of intangibles against 229.2m of total assets. The intangibles also arose from goodwill contributed by various businesses. Unfortunately, most of their revenue failed to meet targets used to value them. Thus Armarda amortized these intangibles every quarter (resulting in net loss of each quarter). As of 31st Dec 2010, only about HK $11m of intangibles remain on its balance sheet. Its NAV is now 2.3 cts and the company is trading at 7.5 cts. I discarded the remainder my Armarda.

Conclusion

Not all cash generating assets are tangibles and ignoring these is a gross error in valuating a company. However, one must be cautious and mindful of their presense in the balance sheet, especially if the intangibles form a very significant portion.