What Lies Beneath

Keen-eyed investors can expect to see more exceptional items this reporting season.

As companies report generally awful annual results, investors have been scouring financial statements in unusually close detail. Gluttons for punishment, perhaps, but more likely they are seeking the non-operating items that surface during downturns. (See “Ominous Matters.”)

The most notable of these is goodwill impairment. Writedowns on acquisitions have hobbled earnings this reporting season. “While these may not be cash items, they have not been warmly received in an environment of broad balance-sheet scrutiny,” commented Credit Suisse in a January report. But the writedowns are not merely abstract accounting exercises either. For example, after revealing a €1 billion impairment in December, German car supplier Continental announced shortly after that it was mulling a similarly sized capital increase. Credit Suisse noted that the ratio of intangible assets to market capitalisation at Continental was 373%, with a “market implied goodwill impairment” of more than €3 billion. Many other companies had similarly large, potentially overvalued goodwill assessments lurking on their balance sheets. 

With debt covenants in mind, market watchers are “delving into the notes” of financial statements with increased zeal, says Michael West, a managing director at Moody’s. The agency is preparing a series of reports about accounting arcana — contingent liabilities, inventory valuation and the like — that are less emphasised in happier times.

In a similar vein, analysts at Citigroup have issued reports on pensions and taxes. On pensions, they make projections for firms that reported large net financing credits in 2007. British transport firm First Group, for example, is expected to see a 28% credit in 2007 turn into a 22% charge in 2009.

Citi is also worried about deferred tax assets. Mainly derived from losses carried forward, stock options and pension deficits, these assets may be written down as economies deteriorate and share prices fall. This will affect distributable reserves and asset-based covenants, in addition to serving as a “useful lead indicator of future profitability concerns,” as these assets are recognised only if there are profits to offset.

Trawling through the minutiae tucked deep within annual reports is trying at the best of times. But these days, “there are nuggets in the notes,” says West of Moody’s. Unfortunately, it isn’t the kind of treasure that investors will be happy to find.

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