What are intangible assets? What role do they plan in fundamental analysis?
Intangibles. This is a cool sounding term (“How intangible!”) but it’s often confusing, and sometimes it hides things we should, as investors, look at closely. What follows is an explanation.
Intangible assets are assets that are not physical in nature. That is, they cannot be touched or seen, but still exist. Examples of Intangible assets include copyrights, trade marks, patents, software, government licenses and goodwill. Tangible assets on the other hand have physical substance and can be touched and seen – land, buildings, property, plant and equipment and fixed deposits, for instance.
Within intangibles, goodwill appears as a separate line item on the balance and the other intangible assets are clubbed together and shown as one line item on the asset side of the balance sheet. Why is this so?
The answer lies to the segregation of intangible assets. Intangible assets can be classified as
- Identifiable
- Un Identifiable
Identifiable (also called definite) intangibles are assets which have a definite life and are independent of the company, meaning a company can sell these assets off separately. For instance take the case of patents, pharma companies have patents on their drugs, these patents are for a definite period – meaning they will expire in 5-10 years. Government licenses is another example, companies in the mining industry may be granted government licenses, these licenses are for specific periods and there is also a possibility of transferring or selling these licenses before the expiry. Since these assets are definite in nature the amount paid to acquire these assets are amortized over the life of the asset. The amortized amount is charged against earnings every year.
Meaning, when you pay, say 100 cr. upfront for a 10 year mining lease, on your books there will be an intangible asset called a “mining lease” worth 100 cr. for year 1. This will become 90 cr. in year 2, 80 in year 3 etc. Each year, there’s an “amortization” of 10 cr. – similar to how a car depreciates every year.
Un Identifiable intangibles also known as indefinite intangibles. Goodwill falls into this category. But first let us understand what is goodwill. This happens typically in mergers and acquisitions.
Goodwill arises when the purchase price paid in an acquisition is higher than the net assets (assets – liabilities) of the acquired or target company. Goodwill is the difference between the purchase price and net assets and this is recorded as a separate line item on the balance sheet.
Consider Walmart’s $20 billion purchase of Flipkart. Flipkart surely doesn’t have physical assets (building, machinery, cash) worth $20 billion. It probably had about $2 billion of this, maximum. So when Walmart buys Flipkart, it will get $2 billion of physical assets, assuming there are no liabilities. The remaining $18 billion, which has been paid, is accounted for as an item called “goodwill”.
Companies pay in excess of the net assets of the target company for various reasons, some of the them may due to the large customer base and loyalty that the company enjoys or it may enjoy a very strong brand, thereby leading to pricing power that the company enjoys for its products. These assets are not independent of the company, these cannot be sold off separately and are perceived to have indefinite life till the company is in operation. It is because of this reason that Goodwill is shown separately on the balance sheet.
There is no amortization provided for goodwill and it is tested for impairment every year or frequency as per the accounting standards followed by the company. Losses if any are recorded on the profit and loss and value of goodwill is adjusted on the balance sheet.
In the context of Walmart-Flipkart, every year, they have to analyse if the Flipkart they own continues to be worth $18 billion at least (the intangible part). If it is worth only $15 billion they have to take a loss of $3 billion as “impairment of goodwill”. However, the judgement is left to the company and to its auditors.
So goodwill can stay on the balance sheet for a long time. In some cases, a company might choose to have it stay longer than required – which means it has something on the balance sheet that is apparently worth something, but in reality is not worth that much. This can be a danger sign – where goodwill is a big part of a balance sheet and it’s not been tested for impairment for a long time.
Impact on Earnings
Intangible assets that are created by the company internally do not appear on the balance sheet. For instance a company would be spending huge sums of money on research and development (R&D) expenses to develop products. R&D expenses in this case could be expensed on the profit & loss account, even though a company may be developing products which will give it pricing power, customer loyalty and build a brand for its products. In such a case the earnings of the company are understated.
In the case of acquired intangibles these are reflected on the balance sheet and they are either amortized or impaired.
Let us look at the below balance sheets of Microsoft and Apple for 2018
Microsoft
Apple
One can see from the above balance sheets that Microsoft has Goodwill of $ 35,683 Mn plus $8,053 Mn of intangible assets on its books. Apple on the other hand has no goodwill neither any intangibles on its books. Microsoft in addition to developing assets internally has taken the acquisition route to grow the company.
Below is the Profit and Loss of both the companies for 2018
Microsoft
Microsoft has R&D and sales and marketing expenses of $ 32,195 Mn, 29% of its revenues. Microsoft is spending on R&D and sales and marketing to develop new products and generate higher sales. Spends under these heads are expensed as and when they occur as the company is acquiring assets externally. However as these expenses also lead to generating higher sales and value for the company, it would not be a bad idea to amortize these over period of time.
Apple also spends on R&D and selling and administrative expenses – $ 30,941 Mn, 12% of revenues. If these were to be treated like assets and amortized, earnings reported by these companies would be higher. Investors need to take note of this while valuing these companies.
In fact, one of the biggest winners for Amazon was that it built a new asset (AWS) while expensing salaries for many years in full. Then, when the asset grew to scale, the real explosion in earnings happened, and the earnings spiked up – because there were no amortized costs to bear in the earnings.
The positive of Amortization: When It Gets Over!
Where intangibles can positively impact earnings is when the amortization has run its course! Say intangibles form a large part of the assets and there lower amortization (due to writing down of the assets) year on year or if the assets is nearing its useful life, we can see something interest. You will see a boost in earnings, provided there is no more addition to intangibles and business conditions are not impacted adversely.
Let us take explain this with the help of an example, below is the consolidated balance sheet of Emami Limited,
Intangibles on the balance sheet are Rs 998 Cr, 36% of the total assets. The company incurred amortization expenses of Rs 244 Cr as compared to Rs 262 Cr in FY18. (This is the difference between the intangible assets last year and this year)
What was this? Emami acquired a brand of hair oil called Kesh King for 1651 cr. in 2015 It has decided to amortize this over a period of 5-10 years.
Below is the details of the companies intangible assets and schedule showing the useful life of the assets
Majority of the intangibles are in Brands and Trade Marks which have a useful life of 5-10 years. The company has made no addition to this in the year and the amortization expenses is Rs 198 Cr for the year. The carrying amount of this Rs 900 Cr and this should be written down over the next 5 years.
Which means – after 2023, Emami doesn’t need to amortize about Rs. 200 cr. a year cost on the Kesh King brand acquisition anymore. However, Kesh King – the product – will continue to give Emami its sales, and therefore profits. Emami currently posts a pre-tax profit of 400 cr. – which means that if everything remains the same, profits will jump by 50% in 2023!
This is however assuming that the company does not acquire any further intangible assets and the acquisition is actually working for the company – by working we mean the company is able to generate higher sales and profitability from the acquisition that it has made.
But it’s a point to watch – when the intangibles are bloated in a balance sheet and it’s not goodwill, then the company might have depressed profits due to amortization. And when that amortization is close to an end, it’s an opportunity.
Final Thoughts
Large number of companies have goodwill and intangibles on their balance sheets, it is very important to give consideration to these while evaluating investments in companies. For instance Tata Motors had written off goodwill in the recent past and this lead to recording losses on the profit and loss. It decided that the JLR acquisition is now impaired by about 44,000 cr.
On the other hand, if a company which has made the acquisition is able to generate higher sales, ROIC and ROE consistently after the acquisition it has made the right capital allocation decision. However, the accounting may be such that the profits appear lower as they amortize the purchase price, through intangibles, over a small period – after that, profits suddenly start to go up.
A close analysis of a company should pay attention to intangibles as well. Because sometimes value lies in what cannot be seen or touched.
NOTE: Please do not consider this article as a recommendation, It is purely for informative purpose only. Authors may have positions in the stocks mentioned, so consider our analysis biased. There is no commercial relationship between Capitalmind and the companies mentioned in this analysis.
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