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Thursday, October 22, 1998

An Investment Opinion
by Alex Schay

Jump In the Pool

Despite the fact that cash flow is completely unaffected by the business combination accounting decision, a great deal of controversy has swirled around "pooling of interest" transactions. This is largely a reflection of investors' obsession with accrual earnings and management's willingness to play to its audience. The Financial Accounting Standards Board (FASB) has vowed to shoulder the Herculean task of overhauling the way American businesses account for combinations, and in July of this year it initiated a study to determine whether or not there is even a need to have two methods (purchase and pooling). I hope you've got your Snickers -- because we're not going anywhere for a while. Suffice it to say, an outcome is not immediately forthcoming.

Ironically, pooling accounting gained currency as a result of abuses that were occurring under the purchase method. According to Tony Cope of FASB, back in the days when utility companies could pretty much receive a steady, guaranteed return on their asset bases -- thanks to sympathetic regulators who would help hike rates if returns were not growing with assets -- there was a strong incentive to boost assets by means of acquisition (and the subsequent goodwill that was created in the purchase). Rate boards began to catch on to the abuse, hence the pooling methodology began to wend its way through corporate America -- resulting in the skein that we see today. In February 1997, CFO Magazine reported that the dollar value of poolings as a percentage of all acquisitions had increased from 14.4% in 1991 to 22.9% in 1996, and as a percentage of overall mergers they increased from 4% in 1991 to 9.1% in 1996.

Since the FASB announced, way back in 1996, that it would take a closer look at the combinations, companies have been feverishly jumping into "the pool." Perhaps this is better than facing the possibility down the road of joining the chorus singing, "Good thing� Where have you gone?" In 1996, the total number of announced poolings came in at 381 and grew to 528 in 1997 -- an increase of almost 40%. As of July 24, 1998, there have been 330 announced pooling transactions, which is well on track for another record-breaking year.

At least one more pooling announcement has been made since then, as housewares concern Newell Co. (NYSE: NWL) reported yesterday that it had agreed to buy consumer and commercial products maker Rubbermaid Inc. (NYSE: RBD). Over the last 30 years, Newell has grown through a heady pace of acquisitions, tallying 75 at last count. Goodwill has not skyrocketed at the company, thanks to its preference -- and ability -- to engage in pooling-style accounting. Interestingly enough, accounting rules dictate that combinations must be conducted via the pooling method unless a company can't satisfy the 12-criteria test outlined by APB No. 16. As can be seen, purchases are perceived to be the default method, due to the stringency of the standards (outlined very briefly below).

1. Each firm is autonomous and has not been a subsidiary or division of another enterprise within two years before the plan of combination is initiated.

2. Each of the combining enterprises is independent of the other combining enterprises (no more than 10% intercompany investment in outstanding voting common stock).

3. The combination is effected in a single transaction or is completed in accordance with a specific plan of combination within one year after the plan is initiated.

4. An enterprise offers and issues only common stock with rights identical to those of the majority of its outstanding voting common stock in exchange for substantially all of the voting common stock interest of another enterprise at the date the plan of combination is consummated.

5. None of the combining enterprises changes the equity interest of the voting common stock in contemplation of effecting the combination either within two years before the plan of combination is initiated or between the dates the combination is initiated and consummated.

6. Each of the combining firms reacquires shares of voting common stock only for purposes other than business combinations, and no enterprise reacquires more than a normal number of shares between the dates the plan of combination is initiated and consummated.

7. A stockholder's interest in the combining enterprise relative to other stockholders is unchanged as a result of exchanging stock. No common stockholder is denied or surrenders its potential share of a voting common stock interest in a combined enterprise.

8. Voting rights in the resulting combined enterprise are exercisable to the shareholders; there can be no period in which voting rights are restricted or denied.

9. The combination is resolved at the date the plan is consummated and no provisions of the plan relating to the issue of securities or other consideration are pending.

10. The combined enterprise does not agree directly or indirectly to retire or reacquire all or part of the common stock issued to effect the combination.

11. The combined enterprise does not agree to enter into other financial arrangements for the benefit of the former stockholders of a combining enterprise.

12. The combined enterprise does not intend or plan to dispose of a significant part of the of the assets of the combining enterprises within two years after the combination, other than disposals in the ordinary course of business or to eliminate duplicate facilities or excess capacity.

(Courtesy of the Analyst's Accounting Observer)

Taking a look at yesterday's transaction, it can be seen that it's a pretty sizable merger. Indeed, Newell -- known for its ability to acquire mid-tier brands and squeeze costs out of the system -- acknowledged that the combination holds the possibility of being the largest in its history. Here's what Newell is paying for Rubbermaid:

Fully Diluted Rubbermaid Shares (mil)  149.968
Exchange Ratio .7883
New Newell Shares 118.220
Newell Price (Tuesday close)* $48.875
Value of Rubbermaid Equity $5,778.002
Debt $586.935
Total Merger Value $6,364.937

(There are no caps or collars, and Newell sank 10% on Wednesday.)

Squashing together all the like account items at their book value is all that's required when looking at a pooling merger. Worthy of note, however, is the fact that in this instance Newell will be issuing stock valued at $5.778 billion for net assets with a book value of $1.056 billion. So, right off the bat, $4.772 billion worth of transaction value is just spirited away (over the fence, to finish off the mixed metaphor) -- because the book value is the only thing that will be recorded in the combined entity. This outcome is by far the chief criticism of the pooling methodology; that is, no trail of management's acquisition activity is left on the balance sheet. Now, let's assume for a moment that Newell is found to be in violation of one of the twelve APB commandments and must pursue a purchase transaction.

Purchase accounting doesn't have to be that bad. In fact, if a firm can persuade the SEC to allow it the full 40-year amortization period, it can do something like simultaneously try and lower the value of long-term assets that have useful lives shorter than 40 years (shaving depreciation expenditures). This practice, as well as attempts at writing down inventory in hopes of bringing total fair value closer to book value and getting the maximum amortization period, can definitely make management look like merger and acquisition geniuses if successful. Taking an unrealistic scenario and assuming that all of the premium over book value in the Newell case is attributable to goodwill (normally the investment bankers get to wrangle over the fair value of balance sheet items), we end up with about $119.3 million in goodwill expenditures per year -- on the maximum 40-year period -- that must be subtracted from earnings every year.

Under purchase accounting Newell would end up, well� a tad pudgier, with total assets about 57% greater than under the pooling arrangement ($11.2 billion vs. $6.4 billion). In turn, popular metrics like long-term debt to equity get distorted -- under the pooling method debt is 32% of equity, while under purchase accounting long-term debt becomes 12% of equity. As can be deduced, other metrics like return on equity will look a lot better under pooling than under purchase unless the effects of goodwill are netted out in the calculations. Here are the earnings per share effects for 1998:

                     Combined   Newell   Rubbermaid
1998 Estimates (Zacks) $2.07 $1.17
Fully Diluted Shares 173.3 149.9
Earnings (pooling) $534.11 $358.73 $175.38
Goodwill amortization $119.30
Earnings (purchase) $414.81

Taking the fully diluted share count after the acquisition (173.3 plus 118.2), EPS on a pooling basis comes to $1.83 and on the purchase it comes in at $1.42 -- a 22% drop. On Wednesday, the Chief Financial Officer of Newell, Bill Alldredge, gave his earnings forecast for the combined entity over the next couple of years. "Taking Newell's expected earnings per share� $2.35 in 1999 and $2.65 in 2000, and using that as the benchmark, we would expect some modest dilution� in 1999 as we are ramping up these improvements, and that modest dilution is probably going to be in the $0.10 to $0.20 range. By 2000, we are expecting accretion� in the $0.05 to $0.15 per share range, with the possibility that it could be greater than that."

Even though the cash economics of the deal are exactly the same under pooling and purchase, it's interesting to note the disparity in the earnings effects and the changes in the balance sheet. Again, this is not an indictment of Newell; in fact, management is just pursuing the best accounting policy that it has deemed available to it (although tying management's hands with respect to share repurchases is never wise). However, the market's reaction Wednesday is an indication that investors might be taking a good look at the cash economics as well.

[Background for this report was provided by AA Observer, Volume 6, No. 9, "What's Wrong with Business Combination Accounting"]