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ROC - how to adjust for "maintenance acquisitions"

by coffee1029 (/member/coffee1029/23676)

Chanos argued recently that some technology companies are really capitalizing view available tags (/tags)
R&D expense through acquisitions, which overly atters FCF and ROC metrics
(e.g. see eBay thread question). When you assess a company's quality based
on ROC metrics, how do such "maintenance acquisitions" get included in your
calculations? Print

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# AUTHOR
DATE
SUBJECT

coda516
5 12/05/13
thrive - a decade ago, Ebay had goodwill of $2B wh

thrive - a decade ago, Ebay had goodwill of $2B while today that number is $8.5B - so of the $9B in acquisitions they
made, $6.5B will never be expensed through operating income, and if it's ever impaired, you can be sure that the non-
GAAP numbers will ignore it. Similarly, the $2.5B in acquisitions that didn't end up in goodwill is a) small enough not to
matter when you consider that acquisitions are staggered over time and that the depreciation is further stagerred over
time and b) even when it does get GAAP-expensed, it's never counted by the analyst world that will look at capex as the
important cash ow number while totally ignoring D&A.
 
Another way to say this is that a good analysis that looks at cash ow pays more attention to the capex number than the
D&A number, and a company with lots of acquisitions should have its acquisitions considered in the capex number.

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thrive25
4 12/04/13
Good points, I guess my only objection is that sim

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Good points, I guess my only objection is that simply subtracting all acquisition out ows as maintenance expenses
seems to unfairly hurt the bottom line.  Shouldn't we think about the goodwill created from an acquisition as the
maintenance R&D?  Just the way we might compare capex to D&A to gure out what is growth and what is maintenance,
can't we trust that GAAP is expensing the intangible premium paid for assets not on the balance sheet?  This premmium
arguably could equate to the R&D spent by the target company.  Presumably all other assets acquired, other than
goodwill, have their own economic / accounting life and will also get expensed accordingly.  I guess my point is this:
whether you do it in house or acquire it, sooner or later (arguably later), it does get expensed by GAAP -- so cumulative
net income should be pretty close.  Or am I missing something?  I completely agree that if you look at a serial acquirer,
and judge its FCF by simply taking OCF plus D&A minus capex you are missing an important out ow that should be
equivalent to the A component of the D&A you added back.  Does that sound about right?  Thanks!

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coda516
3 11/28/13
Thrive - I think Chanos made the argument that it

Thrive - I think Chanos made the argument that it ater FCF metrics because he's talking about the "non-GAAP, adjusted"
metrics that companies present for themselves, as well as the ones that Street analysts use, and the ones that are used
by buy-side guys trying to gure out true owner earnings. For the latter group, they are trying legitimately to tease out
EBITDA minus maintenance capex, so when you do capex/R&D by acquisition, many less-experienced or naive analysts
will ignore the acquisition numbers. The sell side sure does.
 
Coffee - in terms of how to deal with the problem, there are two things I normally do:
If the company is a serial acquirer, then acquisitions very much matter. Ebay has done $9B in acquisition for the
trailing ten years, and $4.8B in capex (also $6.4B in D&A, and $24B in cumulative OCF). In this case, given the
amount spent on acquisitions relative to OCF and capex, I would simply count acquisitions as capex.
I would look at marginal ROIC including goodwill. One of the aforementioned "adjustements" to the analysis
process is often understanding how great a business is by looking at ROIC without intangibles. But if Intangibles
and Goodwill are a constant investment, you can't make that adjustment.

By the way, I've stayed away from IBM for the same reason - if you assume that acquisitions are an expense or capex,
then the valuation is not nearly as cheap as it looks. In many ways, these companies are worse than the CRMs of the
world - at least there, the "growth expense" number gets expensed...

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coffee1029
2 11/27/13
I posted this under general topics because I am tr

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I posted this under general topics because I am trying to understand how others tackle this problem, and I cannot
believe that the question only applies to ebay, (though I can believe that I am missing something obvious, so would really
appreciate any comments or criticsm).  For the sake of clarity let me use ebay as an example of how the judgement
about which part of its acquisitions cash ow are “maintenance” and which are “growth” can materially affect
measurement of FCF.  This example produces a FCF measure which is merely 52% of the company de ned one over the
past 7 years, if, in the extreme, all acquisitions in reality were "maintenance" in nature.
I will use the company de ned FCF (net cash provided by operating metrics, less purchases of property and equipment),
which though awed should simplify the comparison and focus on this speci c question.  Their method ignores all
acquisitions. 

Management is obviously continually faced with the choice between incurring immediate expenses (hiring, in-house
innovation and R&D) and acquiring companies.  Qualitatively, management might make various arguments as to why
they chose acquisition over in-house, organic development (e.g. speed of execution, competitive dynamics) but they
also frequently claim that one of the key things they achieve through acquisition is “talent.”  That sounds to me like
something that should be immediately expensed, maybe as a sign-on bonus, not put on a balance sheet since the
company would not be able to monetize it if the “talent” left.  So I think there should be some reasonable debate about
the extent to which the acquisition line of the cash ow statement should be left out, or included, in FCF.  A cynic would
say that all recent acquisitions for eBay could and should have been achieved in-house, and therefore remove 100% of
the acquisition cash ow from FCF.  Here are the numbers:

$ millions         Company de ned FCF         less 100% of acquisition cash ow      Cynical FCF

2006                   1,732                                  -1,036                                    696

2007                   2,187                                  -2,732                                   -545

2008                   2,316                                      -46                                  2,271

2009                   2,341                                     -864                                 1,477                                

2010                   2,022                                   -1,360                                   662

2011                   2,310                                   -1,209                                 1,101

2012                   2,581                                       -91                                 2,490

Cumulative          15,490                                                                                                    8,152

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thrive25
1 11/26/13
Not sure i agree it atters FCF metrics? unless y

Not sure i agree it atters FCF metrics? unless you analyze cash ow solely on years post-acquisition ignoring the
acquisition out ows.  In terms of its impact on accruals it can have a few distorting effects.  All things being equal, it will
overstate the balance sheet with assets and goodwill and in ate net income relative to the same business operating
with an internal R&D budget that would, under accounting rules, expense these investments.  The net impact on ROIC
depends on the amount of goodwill created and the amortization schedule; the higher IC that comes with capitalizing it
as an investment is accompanied with higher net income in future years.  Chanos is right that this understates the
actual ongoing expenses, but how else would you account for it?  

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