Letter number 66 of March 2012


News : Cleaning up goodwill

During this period when a lot of companies close their accounts, many are confronted, as they are every year, with the issue of whether or not to record goodwill impairment. This issue is becoming increasingly complex since both internal (business plans) and external valuation parameters (risk free rates, risk premiums) have undergone major changes.

In a few months, the growth prospects and short-term margins of firms have been reduced. This anticipated downgrading is impacting on many geographical areas (including emerging countries over at least a few quarters) and a large number of sectors. Business plans (in particularly those of companies acquired over recent years), will logically also have been impacted. 

Additionally, even though the risk free rate has dropped marginally (the bund rate has fallen from 3% in December 2010 to 1.80% today), the risk premium has, for its part, increased substantially – from around 6.5% in the first half of 2011 to around 9.5% in the second half of 2011 according to Associés en Finance (1). Although we wouldn’t take a spot premium (over 9%), reflecting tension on the part of investors that is not likely to last, it does not seem reasonable to us to expect that the risk premium can, even in the medium term, recover its average level from the 1990s (3.9%).  Accordingly, the cost of equity has definitely increased substantially over the long term.

Spreads on loans are not about to return to their 2005 levels – 10 or 20 base points for the best groups (Pinch yourself! Yes, it’s true (2)). Since the level of groups’ debt is not going to increase in the future, the opposite is true in this new era of generalised deleveraging, we have to conclude that the average cost of capital has increased, rising from a European average of around 8% to at least 9%. This is consistent with the forecasts of McKinsey Global Institute (3) which anticipate a rise in the cost of capital of around 1.5% given a shortage of savings in the world in view of the amount of investments to be made.   

The combination of a high cost of capital and business plans that have been revised downwards, at least in terms of earnings for the closest years (4), inevitably results in lower valuations. The halving of stock market values in five years is just a reflection of this.

In this context, it seems to us that it would be difficult to justify keeping all goodwill intact!  A small part of the impairment work has already started, but the real work still lies ahead. For most groups, goodwill stands at around 20% of their total assets (5). This is a global observation and a close analysis of each group would show different results from group to group, and within each of them, impairments impacting on some divisions but not on others.

In terms of verification, it should be noted around 50% of European listed groups (6) currently have after tax return on capital employed (ROCE) that are lower than their cost of capital. Now, the basic purpose of goodwill is its capacity to generate ROCE that are higher than the cost of capital (7). If this doesn't happen on a long-lasting basis, we would be justified in questioning the value of goodwill. 

We cannot directly deduce that the ROCE of each of the divisions of these groups that is recording goodwill is lower than the cost of capital, nor that, if this is the case today, it will remain so over the medium term (since margins are close to their historic highs, gains in ROCE are going to be hard to achieve!) But this is another reason for concluding that logically, we should observe the goodwill impairment of these groups.

Having said that, even though impairment of goodwill under IFRS seems to us to be fully justified, reasoning as financiers, we find that this should be a non-event for investors. The general decline in values is common knowledge and can be seen in declining share prices. Investors who have read the Vernimmen (8) will know that goodwill impairment is both a non-recurring and non cash expense, which means that they it should be adjusted in any financial analysis. 
The impact in political terms is a different issue which we won’t spend a lot of time discussing, but while a lot of firms are restructuring, laying off staff or have a freeze on hiring, a year of poor results will certainly not harm their image. 
It is our view, that not to impair – four-and-a-half years after the beginning of the crisis – goodwill that is increasingly difficult to justify in any reasonable way, is a management error. This would give credence to the idea that accounting documents presented are not reliable.  We even believe that the impairment of goodwill will be seen as a sign of good management in the present (9) rather than a late admission of bad decisions in the past (nobody predicted the crisis that we’re currently experiencing, investors even less so than others!).

Is it just chance that the groups that are the most concerned, which combine high levels of goodwill and ROCE that is lower than the cost of capital over several years, have seen their share prices fall a lot more sharply than the market over the last few quarters?   Obviously not!

So, the thing to do is to get working on goodwill impairment.  
(1) The most reliable source for Europe, in our point of view.
(2) For more details see Vernimmen.com Newsletter n° 10, October 2005.
(3) Farewell to cheap capital December 2010
(4) Which are those that count the most in value because the inexorable mechanics of discounting has not yet made its impact
(5) Percentage excluding financials
(6) Excluding financials. 
(7) For more information, see chapter 6 of the Vernimmen.
(8) Page 83 in the 2011 edition.
(9) Crises are prolonged when players defer recording their negative impacts in their accounts.  The Japanese situation is clearly an illustration of this.

Statistics : Dividends and share buy backs in Europe

The top 50 listed groups in the Eurozone have returned to their shareholders  €94.4bn in 2011 versus €75bn in 2010, a clear testimony of their better health. The figure for 2008 was €139.5bn. Still a long way to go to fully recover.

Dividends paid (€84.5bn) are up 6% compared to 2010, but still much lower than those paid in 2008: €99bn. Only one group has not paid a dividend due to the need to prop up its balance sheet: ING. They are likely to be more numerous in 2012 as some banks are suspending their dividend payments to prop up their solvency ratios.

Share buy-backs amounted to €9.9bn compared to –€0.4bn last year. It is still a far cry from the figures for 2007 (€47bn) and 2008 (€41bn), which illustrates that share-buy backs are a discretionary tool to give back to shareholders transitory free cash-flows.

All in all, 53% of the recurring net income generated in 2010 has been paid out to shareholders, the balance been ploughed back in the business. As in 2010, the two largest groups by their size of cash returns are Telefonica and Total.

The funny case this year is Sanofi which paid 58% of its €3.3bn dividend in shares only to buy back €1.1bn of the same shares 6 months after.

For more on dividends and share buy-backs, see chapter 38 of the Vernimmen.

Research : The influence of employees on company boards

Several studies have examined the optimal composition of company boards – size, proportion of independent directors or financially savvy directors, presence of foreign or women directors. This article provides evidence on the impact of the presence of employee directors on boards on the financial performance and decisions of French companies. 

What are the arguments for and against? Detractors from the idea of employees on boards claim that introducing representatives of stakeholders complicates the board’s decision making process and weakens it, blurs the objectives, and in certain cases, promotes CEO entrenchment. They argue that employees are not a homogenous group of people and that their interests are too diverse for their representation on the board to be effective. Finally, they maintain that contractual mechanisms are preferable to direct involvement in decision-making via the board. 

Defenders of employees on boards argue that employees bring internal, relevant information to the board, help it to make more enlightened decisions and participate in internal corporate governance of managers. Additionally, the fact that employees have seats on the board reinforces the positive effect for the company of employee shareholding. 

The article presented this month(1) attempts to reach a conclusion as to which of these two positions is the best. A few previous studies have examined the German model, which is very different from that in France, since employee directors can occupy up to 50% of seats on boards, depending on the size of the company. Accordingly, Gorton and Schmid (2004) draw attention to the fact that German firms, with equal numbers of shareholders and employees on their boards, perform less well financially than those on which only one-third of directors are employees.

Fauver and Fuerst (2006) document that employees who sit on the boards of listed German firms improve the performance of these firms, but only those firms operating in sectors that require the co-ordination and special skills of employees, such as trade, transportation and industry. 

France is the only country that allows the presence of two types of employee directors - directors elected by employees and directors who represent the employee shareholders. Over the 1998-2010 period, 10.2% of SBF 120 companies had directors elected by employees, 11.6% had directors representing employee shareholders and 3.4% of companies had both types of directors on their boards. 

The article concludes that the presence of directors representing employee shareholders improves the operating and stock market performance of a firm, but does not have a substantial impact on the dividend policy or on the number of board meetings. As for directors elected by employees, they significantly reduce the amounts paid to shareholders in the form of dividends and share buybacks. Their presence tends to increase the number of meetings, but only has a limited impact on the value of the firms and on their profitability. These results are robust to several definitions of performance and dividend payments and to endogeneity concerns. 

(1) Edith GINGLINGER, William MEGGINSON, Timothée WAXIN, Employee ownership, board representation and corporate financial policies, Journal of Corporate Finance 17(4), September 2011, pp. 868-887.

Q&A : Are changes in taxation a threat to LBOs?

The tightening up of tax restrictions on the deductibility of interest on operations involving leverage in some countries, or plans for tax convergence with Germany where interest is only deductible for up to 30% of EBITDA, have occasionally solicited claims that LBOs are under threat.
In our view, this is a serious error of judgment.

The basic function of an LBO is not the quest for tax savings but the introduction of an ad hoc governance that will lead to the substantial improvement in the economic performances of the company being bought (1).

Studies carried out by LBO researchers have shown that they most often create value, thanks to the development of the activity (through organic and external growth), to better management that leads to improved margins, to a greater selectivity of investments (which doesn’t mean that fewer investments are made, but that they are better), and better control over working capital (2). The tax saving made on interest on the acquisition debt only makes a marginal contribution to the creation of value.  

An LBO is based firstly on a very strong motivation on the part of the managing team, guaranteed on the one hand by their direct or indirect involvement in the capital, and thus in the creation of value, and on the other hand by the high level of debt which forces them to focus on the generation of cash flows.  In short, it’s the carrot-and-stick approach!

Notwithstanding their sometimes negative image in certain quarters, LBOs are, more often than not, an efficient tool for improving the competitiveness of firms (especially SMEs).  Various studies have even shown their positive impact on employment.

Without the tax advantage on debt, prices that LBO funds could offer would certainly be slightly reduced, as would their competitiveness in the sale process. All the more so since they are often the only bidders for certain assets, without having to face competition from industrial players which are not really interested or are hampered by anti-trust regulations or the fact that the sellers are not keen to sell to their traditional competitors.  This is yet more proof of their usefulness.

If interest on the acquisition debt is not tax deductible, the expected rate of return falls by 1.5% to 2%, or the price paid must fall by around 7% in order to maintain the same returns.  So no reason here for calling LBOs into question. Let’s not confuse lobbying and intellectual rigour…

(1) For more information, see chapter 45 of the Vernimmen 2012.
(2) See for example the Vernimmen.com Newsletter n° 51, dated June 2010.