Is Vonage Hiding Weakness?

Vonage Holdings (NYSE: VG  ) carries $45.7 million of goodwill and other intangibles on its balance sheet. Sometimes goodwill, especially when it's excessive, can foreshadow problems down the road. Could this be the case with Vonage?

Before we answer that, let's look at what could go wrong.

AOL blows up
In early 2002, AOL Time Warner was trading for $66.27 per share.

It had $209 billion of assets on its balance sheet, and $128 billion of that was in the form of goodwill and other intangible assets. Goodwill is simply the difference between the price paid for a company during an acquisition and the net assets of the acquired company. The $128 billion of goodwill in this case was created when AOL and Time Warner merged in 2000.

The problem with inflating your net assets with goodwill is that it can -- being intangible after all -- go away if the acquisition or merger doesn't create the amount of value that was expected. That's what happened in AOL Time Warner's case. It had to write off most of the goodwill over the next few months, and one year later that line item had shrunk to $37 billion. Investors punished the stock along the way, sending it down to $27.04 -- or nearly a 60% loss.

In his fine book It's Earnings That Count, Hewitt Heiserman explains the AOL situation and how two simple metrics can help minimize your risk of owning a company that may blow up like this. Let's see how Vonage holds up using his two metrics.

Intangible assets ratio
This ratio shows us the percentage of total assets made up by goodwill and other intangibles. Heiserman says he views anything over 20% as worrisome, "because management might be overpaying for the acquisition or acquisitions that gave rise to the goodwill."

Vonage Holdings has an intangible assets ratio of 20%.

This is right at Heiserman's threshold, and you should keep a close eye on just how the company is trying to fuel growth. But we're not through; let's also take a look at tangible book value.

Tangible book value
Tangible book value is simply what remains after subtracting goodwill and other intangibles from shareholders' equity (also known as book value). If this is not a positive value, Heiserman advises you to avoid the company because it may "lack the balance sheet muscle to protect [itself] in a recession or from better-financed competitors."

Vonage's tangible book value is -$100.5 million, which obviously raises a yellow flag.

Foolish bottom line
To recap, here are Vonage's numbers, as well as a bonus look at a few other companies in its industry:

Company

Intangible Assets Ratio

Tangible Book Value (in millions)

Vonage Holdings 20% ($101)
Sprint Nextel 47% ($9,536)
Verizon Communications 45% ($63,608)

Source: S&P Capital IQ.

If you own Vonage, or any other company that fails one of these checks, make sure you understand the business model and management's objectives. You can never base an entire investment thesis on one or two metrics, but there is a yellow flag here. I'll help you keep a close eye on these ratios over the next few quarters by updating them soon after each earnings report.

Fool analyst Rex Moore owns no companies mentioned in this article.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 03, 2012, at 11:25 AM, Demokrat wrote:

    Here we go again! Another "pull out of the drawer and fill in the blanks" article. Low cost unprofessional, and lacking in honor type journalism.

    "Is this what I studied journalism for?"

    You people, or whoever runs the show at MotleyFool, are trying to reinvent journalism by assuming that your readers do not see that the same articles appear regularly with only the names of the companies and their respective numbers changing from one moment to another. God awful thing to do. I do hope for that one day of redemption when you folks change these cost-cutting bargain-basement ways. Like it or not, I will be there, not to applaud you, rather, to snicker at the fools that dared to dare.

  • Report this Comment On January 03, 2012, at 9:42 PM, TMFOrangeblood wrote:

    Demokrat,

    These articles are intentionally formulaic -- they are a way of applying the same lens (margins, cash flows, receivables, intangible assets) to a wide variety of companies, making suggestions for further research, and flagging potential issues along the way.

    The aim of these articles is to provide one specific way of looking at current or prospective investments, and as they are company-specific, we can use that same lens across a wide group of companies that are of interest to readers. The articles have limited aims: They make general points about key metrics and urge members to dig deeper should something not look right at first glance.

    We don’t hide at all that we produce these, and I state in the last paragraph that I’ll be updating the numbers quarterly. Nonetheless, I understand they’re not for everyone and I apologize if you don’t find them useful.

    Rex

  • Report this Comment On January 09, 2012, at 3:15 PM, bevo123 wrote:

    I worked at Vonage for a number of years. This article talks about fueling growth. They have had basically the same "customer count", or "line count" or "subscriber lines", however they choose to represent it this month, as they did 2 years ago. They are barely keeping up with churn and the business is getting more competitive by the day. It is about growth, but they are in a race to stay head of churn, let alone grow the business. The metrics speak for themselves, and as they reduce their marketing spend to remain profitable in the eyes of the investment community, they inhibit the ability to acquire new and retain existing customers, and this will eventually show up.

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