Melco Crown Entertainment
Before we answer that, let's look at what could go wrong.
AOL blows up
In early 2002, AOL Time Warner traded for $66.27 per share. It had $209 billion of assets on its balance sheet, including $128 billion in 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 -- being intangible, after all -- it can go away if the acquisition or merger doesn't create the expected amount of value. That's what happened in AOL Time Warner's case. It had to write off most of the goodwill over the next few months. One year later, that line item had shrunk to $37 billion. Investors punished the stock along the way, sending it down to $27.04 -- 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 such a potentially volatile company. Let's see how Melco Crown Entertainment holds up according to his criteria.
Intangible assets ratio
This ratio shows us the percentage of total assets made up of goodwill and other intangibles. Heiserman says he considers anything over 20% worrisome, "because management might be overpaying for the acquisition or acquisitions that gave rise to the goodwill."
Melco Crown Entertainment has an intangible assets ratio of 24%. This doesn't exceed Heiserman's threshold enough to make me manic, but I do 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 (also known as book value). If this value's negative, 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."
Melco Crown Entertainment's tangible book value is $1.4 billion, so no alarms sound here.
By the way, I asked Heiserman about the tendency for some large-cap blue chips -- names like Procter & Gamble, IBM, and Altria -- to have a high intangible assets ratio alongside 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.
Foolish bottom line
To recap, here are Melco Crown Entertainment's numbers, as well as a bonus look at a few other companies in its industry:
Intangible Assets Ratio
Tangible Book Value (millions)
|Melco Crown Entertainment||24%||$1,386|
Las Vegas Sands
MGM Resorts International
Data provided by Capital IQ.
If you own Melco Crown Entertainment, 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 in this case, I think Melco is sending up a yellow flag. 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 Procter & Gamble, but no other companies mentioned in this article. The Motley Fool owns shares of Altria Group and International Business Machines. Motley Fool newsletter services have recommended buying shares of Procter & Gamble. 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.