October 4, 2018

Jeff Sprague Quoted in Financial Times on General Electric

Source: Financial Times
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GE’s $23bn writedown is a case of goodwill gone badEd Crooks in New York OCTOBER 4, 2018

Company raised eyebrows by taking big accounting charge over its $10bn Alstom deal

Ed Crooks in New York OCTOBER 4, 2018

When General Electric replaced its chief executive this week, it also said it would write off $23bn from the value of one of its core divisions, the business supplying equipment to the power industry.

Most of the charge relates to its 2015 purchase of the energy businesses of Alstom of France for $10.1bn, and it raised a question that has been widely asked in the days since: How is it possible to take a writedown that is greater than the cost of the acquisition?

The Alstom deal is not the sole reason for the writedown — the rest of GE’s power division is also sinking fast— but the accounting for the purchase reveals how GE was so keen to get the deal done that it paid too much.

After taking control of Alstom in November 2015, GE spent about another year working out exactly what it had bought. It gave a final reckoning in its annual 10-K report for 2016 — and the numbers were startling.

The Alstom businesses had gross assets of $21.3bn, including $2.8bn of property, plant and equipment, and $4.4bn of intangible assets, principally in customer relationships, patents and technology, and capitalised software. But they also had liabilities of $23.2bn, including $10.7bn of expected costs to fulfil contracts with customers.

Taking into account minority interests that were left in some of the operations, that meant the businesses acquired by GE had a negative book value of $7.2bn. Under standard acquisition accounting, the difference between that figure and the purchase price of $10.1bn was added to the balance sheet as goodwill.

The company justified that hefty difference as reflecting “estimated GE-specific synergies”, including “additional revenue from cross-selling complementary product lines”.

Paul Chaney, a professor of accounting at Vanderbilt University, has a sceptical view of that kind of claim. “A lot of analysts view goodwill as the size of the amount that you overpaid for the acquisition,” he said.

Jeffrey Sprague, an analyst at Vertical Research Partners, called attention to the issue in a note this week, describing the Alstom acquisition as “the most unusual deal we have ever seen”. In similar industrial sector acquisitions over the past five years, goodwill was on average 65 per cent of the price paid. Accruing more goodwill than the price paid for the deal, as GE did with Alstom, is rare.

Accrued goodwill does not have to be written down on a regular basis — a process called amortisation — but it does need to be tested at least once a year to see if its value on the balance sheet is fair and whether the assumptions about future benefits from the business are still justified.

GE tests its goodwill every third quarter, and that exercise last year, after a revision in the fourth quarter, concluded that only a modest downward revision of about $1.2bn was necessary in the power division. An “interim revision” in the second quarter prompted a further paring of goodwill by $2.1bn.

Only three months later, a repeat of that test has apparently shown that almost all the remaining $23.2bn of accrued goodwill on the power division’s balance sheet is actually worthless. The implication is that as the outlook for the fossil fuel power equipment supplied by GE darkens, the future benefits projected when the Alstom deal was done have vanished.

“It amounts to an admission that the acquisition that gave rise to the goodwill was ill-conceived and the business so acquired does not have the earning power you initially envisioned for it,” said Robert Willens, an accounting analyst and professor at Columbia Business School.

The ousted chief executive, John Flannery, admitted as much. “If we can go back in a time machine today, we would pay a substantially lower price than we paid,” he told CNBC last year.

But although the writedown reflected a gloomier view of the outlook for the power business, it was more an acknowledgment of present reality than a revelation about the future, in the view of Jack Ciesielski of Analyst’s Accounting Observer.

“When you take a write-off of goodwill, it means things have turned out very badly. But we already knew that,” he said. “You made a mess. This is part of the clean-up.”

Indeed, for new chief executive Larry Culp, taking a large writedown is a good way to start his tenure, removing the need to take regular smaller hits for years to come.

“Culp has a great opportunity here,” said Mr Chaney. “If he writes off as much as he can now, then it will benefit earnings in the future. I think that might be an excellent strategy.”