Heard off the street

Investors' goodwill gone up in smoke

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When U.S. Steel reports its third-quarter results this week, the Pittsburgh steel maker's bottom line will be reduced by $12.39 per share because of a $1.8 billion noncash goodwill impairment charge the company disclosed this month.

For those struggling to grasp the significance of this 10-digit accounting adjustment, consider the case of the investor who purchases 100 shares of stock at a price of $20 per share, an investment of $2,000. The investor thinks that's a great price given the company's prospects and eagerly anticipates selling the shares down the road for a profit.

Unfortunately, good intentions were not enough to nudge the stock's price higher. In fact, they could not prevent it from sliding all the way to $6 per share. All of a sudden, the investor's $2,000 investment is only worth $600.

Think of the $1,400 difference as the investor's goodwill gone up in smoke. Accountants wouldn't think of it that way. They'd call it a $1,400 impairment.

Companies in the business of growing through acquisitions typically pay above-market prices to purchase companies. Whatever premium they pay over the current market price is carried on their books as goodwill. If they can justify that goodwill by realizing the synergies and higher profits they anticipated from the acquisition, that book entry does not pose a problem.

However, accounting rules require companies to periodically compare the book value of the acquired company with its fair value, which is supposed to be an estimate of the actual market value. Like the victimized investor, the exercise oftentimes leads a company to the uncomfortable conclusion that it paid too much. Or to paraphrase the prison warden in "Cool Hand Luke": What we have here is a failure to synergize.

When that happens, the company has to reduce the amount of goodwill carried on its books.

That's what U.S. Steel admitted Oct. 18 when it disclosed the $1.8 billion noncash charge. The goodwill adjustment relates to two acquisitions the Pittsburgh steel maker made in 2007: Canadian steel producer Stelco and Lone Star Technologies, a Texas company that makes tubular products used in the energy industry. Because the lackluster recovery has chronically crimped demand -- because steel producers keep oversupplying the market, and because foreign producers keep shipping steel to U.S. shores -- Stelco and Lone Star aren't worth what they used to be, U.S. Steel said.

Compare the $3.1 billion U.S. Steel paid for the two companies to the $1.8 billion write-off and you get an idea of how much less their fair value is.

U.S. Steel emphasized that the noncash charge will not affect its liquidity or cause it to violate any of its debt agreements.

While characterizing such write-offs as noncash items is technically correct, it "is a game in wordplay," according to Ed Ketz, Penn State University accounting professor. He said there is upfront cash involved when a company overpays for an acquisition, just like there was cash involved when the investor paid $20 per share.

"The cash came when he first paid $20. If he sells the stock today, he's only going to get $6," Mr. Ketz explained.

Wayne Shaw, Southern Methodist University accounting professor, agrees.

"It's a $1.8 billion loss of value, and they paid for it," he said.

"The part that bothers me is not the write-off. It's the decision-making that you were willing to pay that price and missed so badly," Mr. Shaw said. "We ought to think about what caused them not to understand the benefit they were going to get out of this acquisition."

Mr. Shaw said the timing of U.S. Steel's announcement is typical of how companies carrying too much goodwill write it off. Frequently, the announcements are made: in the fourth quarter; late on a Friday afternoon; by a recently installed CEO; and long after most investors have come to the conclusion the acquisition has not panned out.

Because investors had already factored the problems with the Canadian and Texas operations into the price of its flagging stock, U.S. Steel's shares barely budged last week following the announcement.

U.S. Steel is not the first -- nor will it be the last -- company to pay too much for an acquisition. Examples are a dime a dozen.

Duff & Phelps, a financial advisory and investment banking firm, said U.S. companies wrote off $29.1 billion in goodwill in 2011, the latest period it analyzed. That compares with $29.7 billion in 2010 and $188.4 billion in 2008, when the market collapse caused many companies to remove goodwill from their books.

Impairment charges are common in industries facing tough times, and the steel industry fits that description.

In February, ArcelorMittal, the world's largest steel producer, took a $4.3 billion charge related to the value of its European businesses. Indian steel maker Tata Steel followed three months later with a $1.6 billion charge related to its 2006 acquisition of Corus, a European steel producer.

Duff & Phelps found that companies that write off goodwill underperform the S&P 500 in the six months after the announcement by 1.2 percent.

How U.S. Steel's shares react depends in large part on whether new CEO Mario Longhi, who took over Sept. 1, convinces investors he can revitalize Mr. Carnegie's steel company.

Len Boselovic: lboselovic@post-gazette.com or 412-263-1941.

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