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Saturday, 5 March 2011

Watch out for the Intangibles!


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.


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.



Blogger wee said...

hi market uncle,

on a unrelated topic - I noticed that you have bought back food empire recently despite previous concerns about its receivables and cash flow. which is what I had done as well. I have thought that the recovery of the receivables during the Crisis is a proof that there is nothing seriously wrong.. perhaps maybe just very unfavourable trade terms that is inherent in Russia.

Now that the sales has recovered, the company has gone back to its poor cashflow ways. Granted a company growing rapidly will always have more and more cash tied in receivables, I doubt that is the full story here.

care to do an update or give your take on Food Empire's latest full year?


7 March 2011 at 10:53  
Blogger Market Uncle said...

During the last economic bull run, food empire was almost reporting record profit quarter after quarter, and its receivables charge up even faster. I'm just afraid its using too lose a credit terms to boost sales ad risk having huge bad debts, assuming the sales are indeed genuine. Now that it survived a recession without much bad debts could mean its just the way the managment choose to handle the payments, thus I'm now not too worried.

9 March 2011 at 22:41  
Anonymous cif5000 said...

A note on IPCO. Their tangibles may not be as tangible as they should be.

13 March 2011 at 15:20  
Blogger Market Uncle said...

Hi cif5000,
Thanks for pointing out. Out of 7cts of NAV:

PPE + inventories: 2.6cts;
Financial Assets: 3.0cts.

Thus financial assets and intangibles already made up significant portion of their assets.

20 March 2011 at 14:59  
Blogger donmihaihai said...

Hi market uncle,

For IPCO, I count differently.

NAV = 7 cents.

Intangible = 3 cents

Tangible = 4 cents

Inventories, cash & receivables < total liabilities.

So that 4 cents come from PPE plus some financial assets or financial assets plus some PPE.


Are you pointing out on those distribution rights?

Base on current accounting rule, the premium about NBV is will become either Goodwill, intangible assets or both.

Last time almost everyone lump it at Goodwill so be careful when trying to take those intangible other than goodwill as something 'special'.

Lot of intangibles are 'force' out by accounting rule and not many know how to count them.

27 March 2011 at 18:23  
Anonymous cif5000 said...

Take the latest 3Q statement.

Total equity: 151,225
Intangible: 64,473
Financial asset: 54,190 + 7,807

The financial asset is "not as tangible as they should be".

They are part of this.

28 March 2011 at 18:19  
Blogger Market Uncle said...

Hi cif5000,
yes, precisely these financial assets made up 3 cts per share (based on outstanding no. of shares before further dilution). Even if you price these to NIL, the other PPE + inventories already made up about 2.6 cts per share, already much higher than current share price of 1.5/2 cts.

28 March 2011 at 21:50  
Blogger donmihaihai said...

Interesting and is tangibles not intangibles.

Now if financial asset and intangible are nil then NTA = 1 cent

A 7 cents NBV can easily 'cut' to 1 cent

28 March 2011 at 23:46  
Anonymous cif5000 said...


What denominator did you use to calculate per share values? There are now more than 2bn shares issued.

Actually, valuing the intangibles as zero is as conservative as one can get. I would lump Management Character as "intangible" as well. The problem is that some managements carry a negative score. Multiply anything by a negative number and that upsets the whole valuation process. IMO, the best thing to do is to avoid such a stock altogether.

29 March 2011 at 15:06  
Blogger Market Uncle said...

based on 3Q results:

a) current financial assets: $54,190,000
b) non current available for sale financial assets: $7,807,000

c) no of outstanding shares as of 31/1/2011: 2,048,599,986

(a + b)/c = $0.0302 or about 3cts.

29 March 2011 at 22:53  
Blogger donmihaihai said...

What about liabilities?

30 March 2011 at 00:31  
Blogger Market Uncle said...

i'm merely showing how much 'non-tangible' 'tangibles' they declare on their balance sheet.

30 March 2011 at 21:38  
Anonymous Anonymous said...

Hi, just sharing some thoughts.

If there is an impairment of the goodwill on the income sheet, the conclusion we get is probably the previous acquistion is too high based on the expected returns. After tehe impairment, the ROE,ROA etc will look better, and the company will still generate the same economic benefits to the owners.

I read somewhere- If 2 identical companies produced the same economic benefits, but one is thru acquisition and one is thru organic growth - the one that grows organically will expense its expenses, but the one that grows by acquisition will have that capitalised as goodwill on his balance sheet, through the acquisition. But they both generate the same economic benefits to the owners.


15 April 2011 at 11:09  

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