When a company makes an acquisition, the premium it pays over the acquired company's book value is called goodwill, and counts toward the acquirer's total assets. In times of duress, however, goodwill can suffer dramatic writedowns as the acquired businesses suffer material declines in their cash flows to lose their business values.
Let's take a look at two companies that arguably closed acquisitions with poor timing due to the effects of the coronavirus, and why it's best to avoid their stocks.
A leveraged nutrition company
Last March, Tivity Health (NASDAQ:HWAY), a leading provider of fitness, nutrition, and social connection solutions, completed a leveraged acquisition of nutrition giant Nutrisystem for over $1.3 billion in cash and stock. In hindsight, the timing of the deal could not be worse, as a looming recession has caused Tivity to write down more than $199.5 million worth of goodwill from all nutrition brands operating under its umbrella. Unfortunately, the worst may be yet to come.
In the final year before the acquisition took place, Nutrisystem recognized $691 million in revenue at the cost of spending $203 million in marketing alone (without accounting for sales, general, and administrative expenses). The considerable marketing cost here implies the consumer bounce rate for the product is rather high, and the business must rely heavily on sales and marketing for new customer acquisition, which poses a significant problem. When one in five Americans is unemployed, it is hard to argue that the convenience of home delivery will outweigh that of families and individuals cutting off discretionary spending to save cash.
During the last recession, Nutrisystem's revenue declined by $400 million, or more than 50% over six years starting from 2007. It was not until 2014 that the company's revenue begin to tick up again, illustrating the severe risk of doing business in the nutritional weight loss sector.
Meanwhile, Nutrisystem's book value accounts for a vast majority of Tivity Health's $535 million in goodwill, which accounts for a significant portion of the company's $1.468 billion in assets. When evaluated against Tivity's $1.087 billion in long term debt (from the Nutrisystem acquisition), and other liabilities, what's left of equity for shareholders only amounts to about $7.642 million. If we were to take away the goodwill amount, Tivity would see a massive shareholder deficit.
To make matters worse, the company only has about $83 million in cash on its balance sheet to offset all its liabilities. Tivity also recently announced it would seek strategic alternatives for its nutrition business, which saw a 7% decline in revenue year over year. Also, COVID-19 has caused gym closures across the nation and has negatively affected the company's core Prime segment.
More goodwill writedowns may be on the table for Tivity, and it's hazardous to know the company's liabilities will far outweigh its assets. At a minimum, healthcare investors should wait until the company gives its guidance for 2020 (which was pulled during the first quarter) before buying the stock.
Next up is a company which went heavily into debt to acquire assets a few years back, but is feeling the ripples of what happens when the deal goes wrong.
A previous pharmaceutical titan
Since 2012, Valeant Pharmaceuticals, now Bausch Health Companies (NYSE:BHC) made a series of leveraged acquisitions amounting to well over $22.2 billion. These acquisitions include $8.6 billion for eye care company Bausch and Lomb, $11 billion for gastrointestinal healthcare company Saliq, $2.6 billion for Medicis Pharmaceuticals' dermatology portfolio, and many more.
To say the company overpaid for some of these companies is an understatement. Currently, Bausch Health has about $24.4 billion in long-term debt on its balance sheet, compared to only $790 million worth of shareholder's equity. However, if we were to take away the $13.034 billion in goodwill away from its total assets, then Bausch Health would be operating at a considerable shareholder's deficit.
Goodwill items are not real assets like a manufacturing plant or the value of a brand, per se. Instead, the value of goodwill (in case you forgot) represents the premium an acquiring company paid over an acquisition target's net book value, and can face massive writedowns if the underlying business goes bad.
Recently, Bausch Health's vision care segment saw its revenue go flat year over year as COVID-19 placed countries around the world into lockdowns, forcing many retail stores carrying its products (such as contact lenses) to close. It was hit hard in Asia, which accounted for nearly 50% of the segment's sales.
Also, both its diversified portfolios as well as its derm and dentistry segments witnessed 9% and 4% revenue declines, respectively, compared to last year. Salix was the only segment that grew its sales, which amounted to 7% year over year.
In all, Bausch Health reinvests a tiny fraction -- just over 6% -- of its revenue into research and development expenses, which is far below that of its peers. Meanwhile, almost 20% of the company's sales goes to paying back its interest expenses alone (never mind its debt principal).
Unfortunately, there isn't anything to protect what's left of shareholders' equity in the event of more material business consequences due to COVID-19. I would highly recommend investors stay away from the stock due to the company's crippling debt situation.