Scotts Miracle-Gro (NYSE: SMG) carries $650.5 million of goodwill and other intangibles on its balance sheet. Goodwill, especially when it's excessive, can sometimes foreshadow problems down the road. Could this be the case with Scotts Miracle-Gro?
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, including $128 billion 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 Scotts Miracle-Gro 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 considers anything greater than 20% worrisome, "because management might be overpaying for the acquisition or acquisitions that gave rise to the goodwill."
Scotts Miracle-Gro has an intangible assets ratio of 21%. This is far enough past Heiserman's threshold 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 (also known as book value). 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."
Scotts Miracle-Gro's tangible book value is $138.1 million, so it passes this test.
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 and negative tangible book value. He said 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 Scotts Miracle-Gro's numbers, as well as a bonus look at a few other companies in its industry:
|
Company |
Intangible Assets Ratio |
Tangible Book Value (millions) |
|---|---|---|
| Scotts Miracle-Gro |
21% |
$138 |
| PotashCorp (NYSE: POT) |
1% |
$7,066 |
| Mosaic (NYSE: MOS) |
12% |
$9,812 |
| Sociedad Quimica y Minera (NYSE: SQM) |
1% |
$1,689 |
Source: Capital IQ, a division of Standard & Poor's.
If you own Scotts Miracle-Gro, 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.
