Something to Watch With IBM

International Business Machines (NYSE: IBM  ) carries $31.4 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 IBM?

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 IBM 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."

IBM has an intangible assets ratio of 28%.

This is not so far over Heiserman's threshold as to cause panic, but you'll want to keep an eye on this number over the next few quarters. 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. If this is not a positive value, Heiserman advises you to run away because such companies may "lack the balance sheet muscle to protect themselves in a recession or from better-financed competitors."

IBM' tangible book value is -$10.9 billion, which obviously raises a yellow flag.

I asked Heiserman about the tendency for some large-cap blue chips to have a high intangible assets ratio and negative tangible book value. He says this can be OK, provided the company has (1) modest or no net debt, (2) persistent and rising levels of free cash flow, and (3) stock buybacks at a discount to intrinsic value.

Because of this -- and research I've done indicating negative book value may not be detrimental to large caps -- I give this company the benefit of the doubt here.

Foolish bottom line
If you own IBM, 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.

Keep up with IBM, including news and analysis as it's published, by adding the company to your free, personalized watchlist.

Rex Moore owns none of the companies mentioned in this article. Motley Fool newsletter services have recommended creating a synthetic long position in IBM. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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 August 27, 2012, at 4:57 PM, SaraW946 wrote:

    I have a question: what continues to attract Warren Buffett to IBM? I mean, surely he knows all that, yet he keeps adding to his position. Any ideas? I a really asking out of curiosity.

  • Report this Comment On August 28, 2012, at 1:07 AM, Camacam wrote:

    These numbers have actually deteriorated since the last quarter. And IBM just made another cash acquisition. Did it overpay?

  • Report this Comment On August 29, 2012, at 11:27 AM, TMFOrangeblood wrote:

    Again, it's only one metric... and if Buffett is confident with management's acquisition abilities, then goodwill is probably not a problem for him.

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