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Amortization of Intangible Assets


Guest notorious546
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Guest notorious546

Hello,

 

I have been spending a bit of time trying to get more familiar with intangible asset amortization for different businesses.

 

There have been a few examples where I have come across where the largest contributor to total amortization charges is something like “customer relationships” for example if you look at Cognizant or Sherwin Williams – in what cases do you think it is appropriate to exclude this as a go forward economic cost? I don't really see it as an ongoing cash cost for either business but it does seem to weight on near term profitability. Any related reference pieces or comments on this from a broader perspective would be appreciated as well.

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It really depends on what is being amortized, a good portion of SHW intangibles come from the acquisition of Valspar, when you add back the amortization related to the acquisition you're including the benefit of the acquisition but turning a blind eye to the cost that allowed you to get that extra revenue, earnings, etc. 

 

This is a little different of an example than what you asked but it kind of proves the point:

 

Imagine a rollup, they acquire other shops to grow, instead of all those cash outlays hitting the actual capex account it hits the acquisitions account in the investments section of the cash flow statement. Now all of the amortizations related to the acquisitions get added back the operating cash flow. Now imagine your trying to calculate the company's historical FCF over the last 5-10 years, and you just subtract capex from operating cash flow ignoring the cash outlays for all acquisitions but still including amortization of those assets related to those acquisitions that allowed you to generate that operating cash flow

 

Hope this helps somewhat.

 

 

 

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Hello,

 

I have been spending a bit of time trying to get more familiar with intangible asset amortization for different businesses.

 

There have been a few examples where I have come across where the largest contributor to total amortization charges is something like “customer relationships” for example if you look at Cognizant or Sherwin Williams – in what cases do you think it is appropriate to exclude this as a go forward economic cost? I don't really see it as an ongoing cash cost for either business but it does seem to weight on near term profitability. Any related reference pieces or comments on this from a broader perspective would be appreciated as well.

 

It depends on what you're trying to do.  If you want to look at the economics of the existing business going forward, then amortization related to "customer relationships" and similar intangibles arising from purchase accounting should likely be excluded, because the costs associated replacing old customer relationships with new ones is already being accounted for in SG&A.  The issue that can be difficult to determine in real time is whether the company is spending enough to maintain steady state  (or grow) or is instead using acquisitions to mask declines in the legacy business.  But I believe it is better to try to answer that question directly, rather than try to account for it vaguely and indirectly by declining to exclude some or all of purchase accounting related amortization in your go-forward operating earnings calculation. 

 

On the other hand, if you want to see how well management allocates capital over long periods of time or how what the actual returns have been on acquisitions, then I would continue to subtract amortization from your operating earnings calculation, but I would also add all amortized amounts back onto the balance sheet, which will give you a better sense of the actual amount of capital invested in the business than book equity, which will be reduced over time via purchase accounting amortization.

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Short answer: I've found it very hard to follow this item over time, in the process of a specific acquisition and for specific company, because, after the acquisition, results of the acquired entity morph into the corporate numbers.

 

Internally developed 'customer relationships' and other intangibles such as human capital, organisation etc have costs associated with their creation and maintenance and these costs are simply expensed so it makes sense to somehow expense acquired 'customer relationships' but the reported expense may under- or over-estimate the 'true' expense. I wonder if the best way to assess this, over the long term, is to maintain the link between the income statement and the balance sheet and see if integration of an acquired entity results in maintained or higher profitability or return on capital overall. My humble conclusion is that the best indicator of 'success' for an acquisition is the previous history of acquisitions for a specific company or a specific top management team.

 

For Cognizant (a company I don't know well and an industry I don't really understand), it is possible that acquiring "customer relationships" may result in an under-reported expense if, for them versus the previous owner, they can offer additional and complimentary services to the same customers. But one has to be skeptical about these potential 'synergies' especially if the acquisition appears expensive. Not related to Cognizant specifically, but it is often disappointing when management teams realize that synergies do not really materialize and have to take massive write-downs on goodwill and intangibles. Then, it's always amusing to read how they underline that the write-down has no operational cashflow impact in the present period, forgetting to mention (sometimes timidly noted when the acquisition was devised by the previous team) that the investing cashflows were very real when they were made. The icing on the take is when it appears that it will be easier to achieve a higher return on equity with a much lower denominator.

 

For Sherwin Williams, the Valspar acquisition was significant and one has to wonder if increasing market share to that extent does not result in a lower requirement for operational cashflows that would have been normally required (marketing etc) to build and/or maintain their moat, a conclusion that may warrant relatively high amortization expense from the acquired custome relationships.

 

If you're interested in this area from an investigative or scuttlebutt standpoint, you may want to look at it from the forensic point of view and try to communicate with the CFO (you need to dig details in financial statements and dissect purchase accounting documention) and ask for instance why there is a discrepancy between the duration of the customer contracts vs the estimated useful life and why the company uses a straight-line method when common sense would suggest that an accelerated method would make more sense. There are good reasons for discrepancies and it could be interesting to hear it from the horse's mouth.

 

Here's a nice summary related to valuation of customer relationships if want to focus on the forensic side and here's an example of an SEC communication with a company questioning underlying assumptions.

http://www.willamette.com/insights_journal/16/spring_2016_10.pdf

https://www.sec.gov/Archives/edgar/data/1123360/000119312506252464/filename1.htm

 

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I am not sure so maybe others can confirm. Amortization of intangibles occurs only by acquisition. After all, accounting standards usually don't allow you to add an entry for your own start from scratch business about the value of intangibles. I don't know what US GAAP says vs International GAAP. Upon sale, it may be above tangible book but that would be on realizing the gain on sale, so it is the new owner that adds intangibles.

Intangibles represent to me the volatility and durability of cash flows. They are inputs into what makes the output (free cash flows over time and their magnitude). Amortizing the purchase price of such assets is pure accounting fiction unless it is actually true that they degrade over time. Look to the moat of the business. The moat - if there is one and it isn't being eroded should determine whether you consider this deduction as fully true in any given year or you can ignore it to increase the annual cash flow. Amortization of intangibles seems conservative. It reduces current earnings - but not cash flow to protect against possible future reduction in earning power. If that does not come to pass, then you can ignore it...although you must make a judgement ahead of time what you think of the business itself!

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I am not sure so maybe others can confirm. Amortization of intangibles occurs only by acquisition. After all, accounting standards usually don't allow you to add an entry for your own start from scratch business about the value of intangibles. I don't know what US GAAP says vs International GAAP. Upon sale, it may be above tangible book but that would be on realizing the gain on sale, so it is the new owner that adds intangibles.

Intangibles represent to me the volatility and durability of cash flows. They are inputs into what makes the output (free cash flows over time and their magnitude). Amortizing the purchase price of such assets is pure accounting fiction unless it is actually true that they degrade over time. Look to the moat of the business. The moat - if there is one and it isn't being eroded should determine whether you consider this deduction as fully true in any given year or you can ignore it to increase the annual cash flow. Amortization of intangibles seems conservative. It reduces current earnings - but not cash flow to protect against possible future reduction in earning power. If that does not come to pass, then you can ignore it...although you must make a judgement ahead of time what you think of the business itself!

 

Under IFRS, intangibles have to be 'means tested' every year, with the difference in valuation written off as an immediate expense. Start from scratch businesses generate intangibles every time they capitalize something (IT projects, deferred sales commission, etc). In mutual fund holding companies , DSC's (commissions paid > client income received) may even be the largest ongoing asset.

GAAP allows straight line depreciation, and is wide open to manipulation.

 

Ultimately you're really trying to put a value on 'reputation', the asset that is NOT on the Balance Sheet. Intangibles are the proxy for it.

Obviously not great, but better than nothing.

 

SD

 

 

 

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