Staples' Growth May Not Be What It Seems

Staples (Nasdaq: SPLS  ) carries $4.6 billion 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 Staples?

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 Staples 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."

Staples has an intangible assets ratio of 34%.

This is above Heiserman's threshold, and you should keep a close eye on just how the company is fueling its growth. It's also useful to compare it to tangible book value, which I explain below.

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."

Staples's tangible book value is $2.6 billion, which passes Heiserman's test.

Foolish bottom line
If you own Staples, 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 shares of no companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Staples. 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 (9) | Recommend This Article (7)

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 06, 2012, at 1:41 PM, Schmengee wrote:

    I think I read this same article for Nuance earlier today. How odd.

  • Report this Comment On January 06, 2012, at 3:31 PM, cjaym wrote:

    Interesting that you guys ran another article on Jan 3 "1 Stock to Buy in January" talking up Staples. I tend to agree that intangibles are make believe plug numbers and Staples is a dog of stock.

  • Report this Comment On January 06, 2012, at 4:32 PM, Polyguy wrote:

    I totally agree with cjaym that this seriously undermines MFs recommendations. How can they legitimately say, "Here is the one stock you need to own" and on the very same day print warnings about excessive goodwill?

    Have these fools simply become part of the broken machine that is he securities industry? I guess it is time to cancel the subscriptions.

  • Report this Comment On January 06, 2012, at 10:09 PM, Bradenn wrote:

    I couldn't agree more with the comments above with regards, to sending an article out regarding No 1 Stock to buy now, then later putting out a cautionary warning.

    Whilst it is appreciated that the communication is there and people just haven't buried their heads in the sands, it does seriously discredited the Motley Fool that they have don't their fundamentals.

    This is the reason why I subscribe, so I can get a lead in for further analysis, so please get your screening right and save us all time! Quality not Quantity

    Cheers

  • Report this Comment On January 07, 2012, at 12:40 AM, SirGalahad71 wrote:

    I, like the others who commented earlier, noticed that on one hand we were being told that Staples was a good buy and on then other hand told to be weary. To those people and myself I submit the following:

    "Motley Fool newsletter services have recommended buying shares of (Insert relivant stock here). 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."

    It maybe that MF is providing 2 opposing views on this, but I think it's a good thing to see that not everyone is drinking the same cool aid.

    It reminded me that not everyone will see something the same way.

    At the end of the day I now have more information to help me make a more informed choice and that is what this is, at least partly, about. Otherwise we would all have stock brokers doing our thinking for us, making our stock picks and playing with OUR money.

  • Report this Comment On January 07, 2012, at 1:05 PM, TimbitandMuffin wrote:

    SirGalahad71 made a good point. At the time, I agree with other comments that MF did not mention the apparently important goodwill to asset ratio in the analysis and final recomendation of SPLS as the No. 2 stock to buy in 2012. It makes you question the quality of MF's recommendations.

  • Report this Comment On January 07, 2012, at 1:21 PM, MikeeMike7 wrote:

    I agree with SirGalahad71, I appreciate the various points of view.

  • Report this Comment On January 07, 2012, at 5:44 PM, HillbillyBill wrote:

    Good info. I can make my own decisions.,

  • Report this Comment On January 09, 2012, at 11:31 AM, TMFOrangeblood wrote:

    Good conversation going on here, and I’ll add a couple of thoughts. Most important is that this series of articles is designed to make a quick sweep of many companies every quarter after earnings, and highlight the state of a couple of metrics. This is a formulaic process, and I think it brings some lesser-known metrics into view.

    However, failing one of the tests is just a call to dig in and make sure you’re comfortable with the reasons – in this case, if you’re comfortable with management’s acquisition strategy and abilities. Whatever your answer, at least the metrics have been brought to your attention and you have greater insight into this and other investments.

    Because we employ dozens of writers and produce hundreds of articles per week, you will definitely see stocks examined from many different angles – and since no stock is perfect, you’ll be able to find something negative about any one of them.

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