Write-offs are a slightly more complicated beast for companies than they are for individuals.
In this week's episode of Industry Focus: Tech, Motley Fool analysts Sean O'Reilly and Dylan Lewis explain what investors should know about corporate write-offs and writedowns. Tune in to find out the major types of write-offs and when they come up in the news, what a writedown is and how it ties in to acquisitions and goodwill, how to look at investing in a company that has a large amount of goodwill on their balance sheets, and more.
A full transcript follows the video.
This podcast was recorded on May 13, 2016.
Sean O'Reilly: This episode of The Motley Fool's Industry Focus podcast is brought to you by Audible.com. Audible.com is a leading provider of audio books, with more than 250,000 downloadable titles across all types of literature, including fiction, nonfiction, and periodicals. Listeners looking for a free 30-day trial can go to audible.com/fool.
Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Friday the 13th, so we're talking tech write-offs and yadda yadda yadda. I'm joined today by Dylan Lewis, but before we dive in, we're going to play a short clip.
Cosmo Kramer: Hey, you got it!
Jerry Seinfeld: Hey! What happened to my stereo? It's all smashed up!
Kramer: That's right. Now, it looks like it was broken during shipping, and I ensured it for $400.
Seinfeld: But you were supposed to get me a refund!
Kramer: You can't get a refund, your warranty expired two years ago.
Seinfeld: So we're gonna make the post office pay for my new stereo now?
Kramer: It's a write-off for them.
Seinfeld: How is it a write-off?
Kramer: They just write it off.
Seinfeld: Write it off what?
Kramer: Jerry, all these big companies, they write off everything.
Seinfeld: You don't even know what a write-off is.
Kramer: Do you?
Seinfeld: No. I don't.
Kramer: But they do. And they're the ones writing it off.
O'Reilly: Dylan, you don't even know what a write-off is.
Dylan Lewis: I love that clip so much.
O'Reilly: That show ... I was so happy, because it's free on Hulu now. I was 12 and I would watch it with my dad, and wouldn't quite get it. But now it's gold. (laughs)
Lewis: It's the same thing for me. I remember being young, and my dad was just laughing on the couch, and I was like, "Wait, what's so funny?" (laughs) It was way over my head. I was downstairs in the gym running maybe two weeks ago, and that clip played, that episode, and I was just like, "We have to do a show about this."
O'Reilly: "We have to do a write-off episode!"
Lewis: Yeah, because I'm sure that's how the majority of people feel when I hear someone talking about a write-off.
O'Reilly: Right. So, what is the technical definition of a write-off to the IRS? How would you explain it to the layman?
Lewis: Most people, when they hear "write-off," they're thinking about a tax deduction, so, something that lowers your taxable income. Kramer, in this clip --
Lewis: I think he's talking about line items that are designated to account for shrinkage or damaged products? I don't think he knows what he's talking about. So, most people think about the tax side of it. There's more on the retail side. I'm sure Vince could talk about this on the show sometime. Most retailers have accounts set up to compensate for either shrinkage, so, stolen products, or damaged products, things that get lost somewhere or aren't sellable for whatever reason. Maybe they get returned out of season, and they just know they're going to take a loss on that item. There's some notion of a write-off there.
But today we're going to be talking about more corporate-side write-offs, less personal ones --
O'Reilly: (laughs) I can't stop laughing.
Lewis: -- and a couple really big ones that have hit the tech sector.
O'Reilly: Okay. So, Kramer is obviously a moron, doesn't know what a write-off is. We know it's basically just writing things off for corporations. Are there any major types we should know about? Because you obviously have the broader, "Oh, we took a loss." But what about accounts not being paid for something?
Lewis: Yeah, more on the investing side, and looking at companies, I think one of the big ones to be aware of is this idea of an uncollectible account. When you have companies working in a B2B setting, they'll have customers, and a lot of them will have available lines of credit. They'll have terms like 2/10 net 30, or something like that. You pay in a set amount of time, you get a discount; beyond that, you pay the full amount.
O'Reilly: Right. Oh, I remember doing that stupid stuff in accounting class ...
Lewis: (laughs) Does that ring true to your accounting classes in college? So, basically, the way that works is, they made the sale, but for accounting purposes, they record the transaction in the accounts receivable portion of the balance sheet. Accounts receivable is basically an asset line item that says, "We made this sale, it's there, but we don't have the cash yet." The idea is, once you get paid, you have that money in cash, so you would reduce the amount from accounts receivable, that money would go to cash, everyone's happy.
O'Reilly: For everybody listening, you'll find this on every balance sheet, basically. Everybody has accounts payable and accounts receivable.
Lewis: Right. It keeps business flowing. You don't always need to have the money on hand to pay whatever you're paying. If you have a long-standing relationship with a supplier, you've built up trust, they know you're going to pay. Of course, there's always the situations where people don't pay. That's where you run into issues. Most major companies have an estimate of bad receivables. It'll typically be on a time-frame basis. So, they know 95% of receivables that are still within the first month are going to be paid, 90% within the first six months, and then if something has been outstanding for more than a year --
O'Reilly: Probably not getting that sell.
Lewis: -- there's probably a 50% chance or 30% chance of getting paid. So, that number is built in that way. One of the ways this also manifests itself, and this is something that investors might want to be aware of, is when you have a company filing for bankruptcy.
O'Reilly: Oh, man. (laughs)
Lewis: A very high-profile example of this that applies to tech is Circuit City's bankruptcy in 2008. At the time, they'd had debts around, I think, $2.3 billion. You look at their major creditors at the time, not surprisingly, a lot of major tech companies. That's what they were selling.
O'Reilly: Right. Dell, HP, Microsoft (NASDAQ:MSFT), all those guys.
Lewis: Yeah, the biggest one was Hewlett-Packard, who was owed just under $120 million.
O'Reilly: Wow. That's a lot of printers they gave them.
Lewis: (laughs) Right? Samsung (NASDAQOTH:SSNLF) was like $116 million. Sony (NYSE:SNE) was about $60 million. The thing to be aware of here is, if you see a major retailer or a major distribution outlet for hardware manufacturing or whatever going out of business, those companies probably aren't going to be collecting 100% of that money they're owed. If they're lucky, they're probably going to get about half. But realistically, there's some times where you're getting pennies on the dollar in this situations, with these bankruptcy settlements.
For a company like HP, Samsung, and Sony, these are huge companies. It's not going to have a meaningful impact on them. But, there was another creditor on that list, Garmin (NASDAQ:GRMN).
O'Reilly: They needed the money.
Lewis: Yeah. They were only owed about $15.4 million, but analysts at the time expected that it could impact them on a $0.06 per share basis if they weren't able to collect on any of that balance.
O'Reilly: That's meaningful.
Lewis: Yeah. And Circuit City at the time was a little bit under 2% of Garmin's sales. Depending on the size of the company and the relationship they have, it's something you definitely need to be aware of.
O'Reilly: Yeah, and not only that, but when that retailer goes away, that's a 2% swing in your revenues. That definitely happens. It's always funny to me, it doesn't happen a lot, but, in another retailer situation, not a tech one, but J. C. Penney two years ago, when the word bankruptcy was being thrown around, even though they didn't, holiday season ran around, and they actually did a share sale just so they would have the cash on hand so people would send them clothes to sell at Christmastime. Everybody was like, "No, we're not going to send you clothes unless ... " Like, Ralph Lauren wanted to make sure they were going to get paid, and they were kind of withholding.
Lewis: Yeah, another example of that going on right now outside of the tech space, if you look at Sports Authority, two of the largest creditors in the publicly traded sphere for Sports Authority are Nike and Under Armour. The idea is, they've given them supplies, and they're waiting to get paid for them. So, that's a story to watch if you want to see how this topic develops and get a better sense of it. Watch the news items as they relate to that bankruptcy. I think they'll do a really good job of illustrating that.
O'Reilly: Awesome! Before we move on, here at The Motley Fool, we talk a lot about investing. Every now and then, we recommend books, services and other great ways to educate yourselves. A great way to do that, of course, is audiobooks, which is why we're so excited to be partnering with audible.com. As I mentioned before, they have over 250,000 fiction and nonfiction titles, one of which is a book I've recommended to Dylan numerous times, which is Adventure Capitalist by Jim Rogers.
Lewis: Yeah, you've really sold it, I have to be honest. I haven't not tried it because of my own reluctance. I've been listening to podcasts and stuff. But I've gotten through that backlog, and I'm excited to give it a shot. Can you give us a two-sentence description on this?
O'Reilly: Two sentences ... Jim Rogers was a hedge fund manager in the 60s and the 70s. He was actually the first business partner of George Soros, the hedge fund manager who lives and works in New York. Jim Rogers retired in like 1980, he has like $100 million and just hangs out now. And he writes books and all this stuff. But, he went around the world twice. 130, 140 countries. The first time was in the early 90s, and he did it on a motorcycle with his wife. And he writes about his journeys, what he learns about investing in each of these countries. It's awesome, because he did it again, in a car this time, in the book "Adventure Capitalist." And he starts in Ireland and he zigzags all through Africa, Europe. They put the car on the Trans-Siberian railroad. It is awesome. And he talks about investing insights and insights about people in his travels.
Lewis: It sounds like I'm going to have a pretty riveting metro commute for the next week or two.
O'Reilly: Cannot recommend it enough. Moving back into talking about write-offs, talk to me about writedowns. People do need to estimate, especially in tech, they're like, "OK, we're going to spend $1 billion making this new computer chip, oh no, it doesn't actually work ... " How does that happen?
Lewis: In the previous example, with accounts receivable, you thought you were getting X amount, and you actually wound up getting Y amount, and you had to write down for that. It's a similar idea with writedowns. Most of the time, you see this with acquisitions or in the goodwill space, where what you thought was worth X was actually worth Y. That's the best way I can explain it for you.
As a refresher, we've actually talked about goodwill a little bit. I think we did the show, "Everything you wanted to know about tech but were afraid to ask." We talked about Facebook's (NASDAQ: FB) goodwill with the WhatsApp acquisition. But goodwill, basically, when one company acquires another company, there's the book value for that business, and then there's what the acquirer actually wound up paying. There's usually a premium with any acquisition, it just happens. But they attribute that premium to the intangible assets like brand, established customer base, the employee culture there, things that seem to add value to the business, but you can't tie a direct dollar amount to. That premium is what goes on the balance sheet as goodwill.
Of course, you either wind up realizing that value or you don't. Sometimes you have to pay the piper and say, "OK, turns out it didn't really work out," or, maybe in the case of Facebook and Instagram, "This has been gangbusters for us, and it's incredible."
O'Reilly: This is actually funny to me, WhatsApp keeps adding users, and I'm starting to wonder, will they get about $20 billion in value out of them? That'd be cool. Anyway, do you have any bad examples for us?
Lewis: Yes. In the case of Microsoft's acquisition of Nokia --
O'Reilly: What's Nokia?
O'Reilly: I'm kidding. (laughs)
Lewis: Yeah, right? Oof. So, in April of 2014, Microsoft acquires Nokia's phone unit. They bought it for about $9.5 billion--
O'Reilly: (laughs) I didn't know it was that high!
Lewis: That does include $1.5 billion in acquired cash.
O'Reilly: Whatever. (laughs)
Lewis: Depending on how you see it stated, it might be closer to $8 billion, as reported by some outlets. This was, of course, a deal in the Steve Ballmer regime --
O'Reilly: He bought Skype for $8 billion, too, do you remember that?
Lewis: Yeah ... He was Satya Nadella's predecessor. This was obviously a flop. Microsoft's smartphone business has not done well. It has not gained market share or traction, and it's just kind of floundered and lost money. So, in July of 2015, the company announced that they were going to take an impairment charge of $7.5 billion related to the phone hardware business, which is the Nokia acquisition. That was their phone hardware presence. This writedown actually caused Microsoft to incur its largest-ever quarterly net loss.
Lewis: It's incredible. So, you see these things on the balance sheet, something like goodwill, and it's kind of like kicking-a-can-down-the-road type of approach to accounting things. But at the end of the day, the companies have to come to terms with what they own and what it's worth. And that's where you see these large impairment charges coming in. This is a write down as it relates to an acquisition.
O'Reilly: Taking a step back as investors and philosophically, how does Dylan Lewis treat a loss like that from Microsoft? What do you think when you see that?
Lewis: This was telegraphed. Investors knew what to expect, so when they had their conference call, it was not a huge shock, which is good. That's what you want to do with a company, you want to message it and make it clear. My personal thoughts? If you see a company carrying a ton of goodwill, you need to be aware that this is the downside of something like that. There's a big difference between actual value and unrealized value. And I think that's just something to be aware of. If you're looking for a teachable moment here, you're not always going to be able to see or really easily project how an acquisition might pan out. But, if you see a company has a ton of goodwill on their balance sheet, maybe you need to pump the brakes a little bit.
O'Reilly: Cool. Thanks for your thoughts.
Lewis: I'm going to plug our Twitter feed briefly, Sean, just because I have to.
O'Reilly: Oh, man. You've been doing this all week. (laughs)
Lewis: I have a special trivia question for listeners. We have a little trivia tidbit that we came across on the show, and we thought it'd be more fun to ask you guys and see if you could find it. What is the largest goodwill writedown in history? If you know, or you can find the answer, tweet it at us @MFIndustryFocus. We'll probably just retweet the first person to find it.
Also, I want to give a special shout-out to Nagarjuna S., who correctly guessed the break-even number of burritos at Chipotle's first location. That was something that we tweeted out earlier that week. That was 114 burritos.
O'Reilly: Oh my gosh.
Lewis: Crazy, right?
O'Reilly: What do they cost? $8 each?
Lewis: It was a long time ago. I think his monthly rent was like $850 or something.
O'Reilly: So, just to specify, the question of the day today is corporate America history, not other writedowns, too?
Lewis: Yes, I'm not accepting sovereign debt writedowns.
O'Reilly: Well, I was going to be like, "The British Monarchy probably had to write-off the 13 colonies, that would be pretty big ... " (laughs)
Lewis: No. This has happened, let's say in the last 30 years.
O'Reilly: Hint: it's a rather large number. (laughs)
Lewis: Yeah, it's huge. It makes the Microsoft Nokia acquisition look like peanuts.
O'Reilly: Yeah. Thanks again, Dylan.
Lewis: Always a pleasure, Sean.
O'Reilly: See you later. That's it for us, folks. If you're a loyal listener and have questions or comments, we would love to hear from you, just email us at IndustryFocus@Fool.com. Again, that's IndustryFocus@Fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell stocks based solely on what you hear. For Dylan Lewis, I am Sean O'Reilly, thanks for listening and yadda yadda yadda.
Dylan Lewis owns shares of Under Armour (A Shares) and Under Armour (C Shares). Sean O'Reilly has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Facebook and Under Armour (A Shares). The Motley Fool owns shares of Microsoft and Under Armour (C Shares). Try any of our Foolish newsletter services free for 30 days. 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.