Shares of 3D Systems (NYSE:DDD) fell 46% between the end of 2013 and the end of last month. The company's a recommendation of Motley Fool Stock Advisor, and as the senior analyst for that service, I'm taking a closer look in this series of articles at whether investors should be worried.
In this part of our deep dive into 3D Systems, we'll look at how the company's accounted for its string of recent buyouts, and whether management might be using this to play games with its net income. Let's see whether 3D Systems' use of goodwill should leave investors like you in a bad mood.
What is goodwill?
When one company buys another company, it and the management (and board) of the target company negotiate a purchase price; everyone who needs to agree to the deal does so; the purchaser cuts a check or issues stock to pay for everything; and everybody is (presumably) happy. Here's how that total purchase price breaks down.
All identifiable assets and liabilities are assigned a fair market value, or FMV. Hopefully, there are more assets than liabilities.
Fixed assets like plant, property, and equipment are marked to FMV by looking at comparable items elsewhere (e.g., if a widget is on the books at $25, and it's selling for an average of $30 at other widget sellers, then it's marked up to $30), by getting an appraisal (e.g., land and buildings), or by estimating how much it'd cost to replace any specialized equipment (pretty difficult, actually, especially for some of the more esoteric stuff).
All of these items (except land) are depreciated on the income statement based on an estimate of useful life, just like any other capital expenditure. Example: A machine costs $100,000 and can be used for 10 years; at the end, it'll be worth $10,000. On a straight-line depreciation schedule, the depreciation expense would be $9,000 per year, and that's charged against revenue, or "expensed."
Intangible assets like patents, brand names, trademarks, customer lists, and so on are assigned a value as well, such as legal expenses made to obtain the patents, advertising to build a brand name, and the like. These are amortized (expensed on the income statement) over time based on an estimate of useful life. Example: A customer list has a value of $18,000 and will provide useful sales leads for three years, with no value after that. It would be amortized at $6,000 per year.
Once the net assets are assigned a value, anything left over between that and the purchase price is goodwill. For example, in a $20 million deal, $15 million is for identifiable assets at FMV (divided between fixed and intangible assets) and $3 million is assigned to identifiable liabilities at FMV. The buyer is therefore paying $12 million for net identifiable assets at FMV, and the remaining $8 million is goodwill. (For those of you who are accounting wonks, I'm ignoring the nuances between full and partial goodwill.)
Why is this important?
Until several years ago, goodwill was amortized as an expense on the income statement like any other intangible asset. You buy it, and you expense it over as many as 40 years. However, FASB, the governing body for U.S. GAAP, the accounting rules that public U.S. companies follow, changed this in 2001. Now, companies keep all the goodwill on the balance sheet and are required to test goodwill for impairment each year. That means they look at the value of the acquired assets and make a call on whether the cash flows those assets can likely generate are enough to justify holding the goodwill on the balance sheet.
If the answer is "yes," nothing else happens. If the answer is "no," however, then goodwill has to be written down. That's a hit to earnings in the period this is determined -- and it can be drastic, easily turning a profitable year into an unprofitable one.
If the acquirer has done a reasonably good job at not overpaying at a particular purchase price and identifying FMVs for assets and liabilities, then the chances that goodwill will be impaired are relatively low. If, on the other hand, the acquirer has paid way too much to buy the assets, or the market where those assets are used craters (so that the expected cash flows dry up), then an impairment and writedown are much more likely.
What are the concerns?
First, by growing its goodwill balance a lot over the past several years, 3D Systems is possibly making its balance sheet less healthy and increasing the risk of future impairments, which could hurt its stock price in the future.
Second, by assigning a large percentage of the purchase price to goodwill, 3D Systems is assigning lower percentages to fixed and intangible assets. That means they'll cost the company less in depreciation and amortization in the future. And those lower costs will make net income higher. If 3D Systems were to underestimate those assets' fair market value, it could use that lowball guess to artificially pump up its earnings.
But is that what's really going on?
What I discovered
I looked in the footnotes of 3D Systems and similar companies' 10-K annual filings with the SEC (or the equivalent 20-F filings for foreign companies), noting how much they paid for each disclosed acquisition, and how they divided that price among fixed assets, intangible assets, goodwill, and assumed liabilities.
My sample set included Arcam, 3D Systems, Stratasys (NASDAQ:SSYS), ExOne (NASDAQ:XONE), and voxeljet (NYSE:VJET) -- all in the 3-D printer industry -- and Cisco Systems, Facebook, Groupon, and Nuance Communications -- all acquisitive, (mostly) high-growth tech companies. Of this set, I could not read the (very short) annual reports of Arcam (they're in Swedish and did not appear to have extensive footnotes), and ExOne and voxeljet reported no acquisitions.
I then calculated the average percentage of each year's total acquisitions and of total assets that goodwill represented. Here are the results for each year for six companies:
To my surprise, 3D Systems falls in the middle of what comparable companies are assigning to goodwill when they make purchases, roughly in the 60%-75% range (with some outliers). 3D Systems actually started quite low but then assigned more to goodwill as time went on, leveling off more recently.
Goodwill as a percentage of assets currently sits at 33.7% for 3D Systems. That's higher than in the past, but not excessively so. It's also a little higher than others, especially Cisco, but again not excessively. Facebook started off low but is coming up, and with the recent WhatsApp and Oculus acquisitions, that is likely to continue. Stratasys unsurprisingly jumped dramatically after acquiring Objet in 2012 and MakerBot in 2013. Nuance, however, has listed more than half of its assets in goodwill over the period studied, and it looks more worrisome to me than 3D Systems does.
I'm retracting the yellow flag I'd raised on this point. 3D Systems' goodwill situation is not as bad as I had originally feared, although it sits at a higher level of total assets than I'd really like. I do think it's excessive to assign 70% of an acquisition's price to goodwill, but for the types of companies being purchased -- mostly asset-light -- that seems to be in line with similar acquisitions made by comparable companies. Also, given this, I don't see evidence that 3D Systems is using this to manipulate earnings.
Next, we'll spend some time looking at the financial situation of 3D Systems and how it compares with similar companies -- starting with the capital expenditure issue I raised as another yellow flag in this series' introduction.
Readers can find each article in the series by clicking here.