With absolutely no malice aforethought (honest, it's just happened this way), Moneybox this week has been devoted to the thoroughly scintillating issues of double-parking and corporate accounting. I promise next week to return to our usual diet of sex and scandal. But in any case, class, today's topic is "write-off charges after acquisitions: good or evil?"
Hey, you in the back row, stop snoring! And you, put down that Game Boy!
Ahem. Actually, write-offs have been in the news all week. Intel reported its third-quarter results, which included a hefty write-off related to its acquisition of Level One Communications, upon which some commentators cast a jaundiced eye. Motorola, meanwhile, announced that it would be taking a $700 million write-off because of its investment in troubled satellite-phone company Iridium, and added that it might have to take an additional $350 million write-off in the next quarter. Those write-offs were generally described as sensible, since Iridium may very well turn out to be a complete bust, and Motorola needs to make sure it has enough money on hand to account for its losses from the investment.
The biggest write-off-related news, though, has to do with Tyco, which until this week has been one of the hottest companies and hottest stocks in America. This is Tyco International, not Tyco Toys. Along with GE, it's one of the few truly successful industrial conglomerates left in this country, with lines of business ranging from disposable medical products to underwater telecommunications. Tyco has turned itself into a $30 billion company through an aggressive program of acquisitions (a total of 110 in the last seven years), acquisitions that it has done a rather remarkable job of integrating into its broader management structure.
This week, though, David Tice, who runs the Prudent Bear Fund out of Dallas, issued a report calling into question "the quality of Tyco's earnings," which is a nice way of saying Tice is suggesting that Tyco's acquisition-driven strategy may be a way of masking slow growth in its underlying business. In particular, Tice pointed to Tyco's hefty write-offs of its acquisition costs, write-offs that have totaled something like $3.9 billion in the last four years.
Companies take one-time write-offs because they're better than having to write off a little bit each year. Investors and analysts tend to treat large write-offs as one-time events, and therefore disregard them. Skeptical investors, like Tice, don't like this, especially when--as in the case of Tyco--a company is taking large write-offs year after year. The write-off, in the minds of bears, can be a way for companies to hide the costs of acquisitions.
This critique of write-offs is completely wrongheaded. If the cost of acquisition is hidden by a write-off, it's hidden in plain sight, since the company announces it quite publicly. And while it's possible that there are investors who get tricked by write-offs into believing that an acquisition was free, it's also true that there are people who still believe their fates are governed by the stars. Companies are no more responsible for the former than the latter. The market as a whole cannot be systematically deluded by accounting gimmicks, as long as the gimmicks are publicly disclosed.
Here, though, we get into the other potential problem with write-offs. Essentially, when a company takes a write-off with regard to an acquisition, it's setting aside a reserve of money that it says it believes it will need to complete the acquisition. The danger is that an unscrupulous company will set aside too much money--since with a big write-off investors tend to disregard the hit to earnings--and then use the excess to make its bottom line look better in future years. In other words, I set aside $3 billion to pay for the acquisition of Company X, but in reality it only costs me $2.8 billion, giving me $200 million that I can feed back into my income statement in upcoming years. You need a couple of pennies of income to meet Wall Street estimates? You got 'em.
This, for instance, is exactly what Sunbeam did when Al Dunlap was CEO. (Dunlap denies knowing about the shenanigans that took place under his watch.) And although Tice hasn't come out and said it, this is what he's implying may (or could) be happening at Tyco. The charges have had a dramatic effect, driving the stock down 6 percent on Wednesday and another 10 percent on Thursday, even though the company's CEO denounced the charges as utterly baseless and just about every Wall Street firm reiterated "buy" ratings on the stock.
Looking at the numbers, I think Tice is completely off base about Tyco. And, in theory, feeding a write-off reserve back into operating income shouldn't even be possible. The reality, though, is that this kind of stuff still happens all the time (even though eventually everyone does seem to get caught). And Tice was onto Sunbeam before almost anyone else. But to a man with a hammer everything looks like a nail. Write-offs themselves are not the problem. It's the lack of transparency in the way that companies--like Sunbeam, and not like Tyco--use them that is.