goodwill hunting

Hi PEO followers...

I'm not a big poster on Hotcopper (long time reader) - but thought this might be of interest to those following this stock as the issue of goodwill was discussed some time ago regarding PEO on this forum. I posted this on the Swift Forum and got a brief response from Colin about it - will be pressing for more detail. If anyone has further opinions about this subject, I would be interested to know.

Here's the post:

"The single most important factor determining the current share price is, I believe, the large figure of goodwill (38 million) currently sitting on the PEO book. I could think of no better way of spending my Christmas, than by investigating the issue (my fam is interstate) - and the results have been very surprising. The introduction of the new accounting standards means this goodwill figure represents a vast X factor on the bottom line of the company. Rather than issues of liquidity, this uncertainty probably accounts for the coldness of the institutions and the SP's current value. Coming to an understanding of how this goodwill figure will be treated in the future has brought a number of other issues to light about which I will go into detail below.

The first thing I learnt about goodwill once the new accouting standards come in force in 2005 is that it will no longer be amortised. My understanding (and it was mentioned somewhere in the annual report) was that the goodwill would be amortised over 20 years, which meant a drag on earnings of about 1.8 million per year. This is not allowed under the new standards. Instead, the goodwill, as an asset, is subjected to an asset impairment test - and if deemed impaired, is written down by the amount by which it is impaired. The pro in this situation is that any drag on earnings is not necessary at all, but is relative to the estimated future value of that goodwill. There is the possibility even of there being no write down whatsoever. The other great pro in this situation is that goodwill will no longer be quite so nebulous an entity on any balance sheet. Investors will be able to gain a much greater insight into the value and success of an acquisition.

The great con of the situation applies particularly to investors who are in a situation similar to ourselves. It is very difficult to know exactly what the effect of this impairment test will based on the figures we have been given so far - because the figures we have been given have never had to meet these requirements. The potential effect is quite large and hence it is widely regarded that the effect on earnings is likely to be quite volatile. And given that the goodwill figure for PEO represents around 90% of the value of the company, the potential for the volatility could be considered even higher than that... hence the X factor.

The degree of uncertainty can be seen more clearly when we consider the actual situation under which an asset is considered to be impaired. An asset is impaired when it's net book value is higher than the recoverable amount. To perform the test, the company must divide its assets into distinct cash generating units (CGU). Because goodwill does not generate cash as such, it should be apportioned to the book value of the CGUs discriminated. Where the recoverable amount is less that this value for each CGU, the impairment is written down on the goodwill first, and then other intangibles in a pro rata fashion. The recoverable amount is taken as the higher of either the net selling price of the asset or its value in use. The PEO investor, then, who is looking to come to an understanding of the possible effect this test will have on the bottom line, will need to understand how PEO is likely to divide its business into CGUs; how it will apportion out the goodwill to these CGUs; and what the future holds for the earnings of these CGUs. No mean feat - and indeed, the information just isn't out there to make this assessment.

The market is taking no chances. It has PEO valued fairly closely to its book value (goodwill included). This is quite astonishing for a growth company. Make the comparison with IIN where market capitalisation is 3 times its book value (goodwill included). Goodwill here is a much smaller figure (about 50% of value) - which means a greater buffer against possible earnings shocks. As such, if it turns out that the premium paid on the old PT business turns out to be reasonable, the PEO will be highly undervalued... good times for all... but knowing before hand - that's the key. (Have a look at SOT also, the goodwill for their acquisitions have not yet shown up on their reports - hence its not so glaringly obvious... if they get ozemail, SOT investors should be concerned).

We should all be goodwill hunting - expect some questions on the question thread to follow this post shortly. Investors have a right to know what the possible effect this change in accounting practices will have on the bottom line of the company. Indeed, PEO could possibly do much good for its share price were it to give some indication of what the effect may be.

I think there are good reasons to believe that PEO directors have their fingers on the pulse of the situation - although I still feel the could be doing more to keep investors in the loop. (There are other things which indicate the opposite - I will list both).

One reason is the conservative temprement shown in the recent acquisition attempt of Ozemail. No doubt they were concerned at an increased goodwill figure sitting on the balance sheet.

Another thing, surprisingly, is the actual acquisition of PT itself. One of the things that always baffled me was why PT never just went public and buy SWT... why the backdoor takeover? Commentators at the time were absolutely convinced that SWT holders were getting a raw deal because of the valuation made on PT - particularly with respect to the high growth expectations of the SWT business as opposed to PT where growth was expected to slow. But given this issue of Goodwill, it begins to make a great deal of sense to me. Where the goodwill is apportioned to CGUs - presumably this will be apportioned out to CGUs that belong to the old PT business. This would be because the premium was paid on the PT business, not the SWT business. PT is a higher margin business than SWT and hence greater able to sustain the impact of the impairment tests. SWT, if it had been the one to be bought - would have been bought at a premium itself, (it was certainly overpriced at the time), but with the competiveness of its business would have found it much more difficult to butress itself against the writedowns of the goodwill (premium) paid for its business. This then, might suggest that all this was taken into account at the time.

The thing which may indicate enough at this stage is not known about what will happen with respect to the changes is this - taken from p55 of the annual report:

"Initial Assessment of the impact of IFRS
Relevant staff has undertaken training on the potential impacts of
IFRS by attending presentations made by industry bodies."

One would have hoped for more detail under this section. (To the credit of SOT - in their annual report they actually admit that they don't know what the effect will be).

I have generally been optimistic about the short to medium term prospects of PEO - and certainly in terms of revenue alone, there doesn't seem to be much cause for alarm. But I must confess that this goodwill situation has me uneasy - and I know now that this is higher risk than I thought it to be. however, I am at least going to wait and see what we can find out in the coming months - but seeing as how I don't mind a punt, I'll probably see myself staying in to see what happens.

For those who are interested in the accounting specifics - take a look at the following links from PWC.

If anyone else has opinions and/or resources on this issue I would be very interested to hear/read them.

http://www.pwc.com/extweb/industry....5256C9100531E7B

http://www.pwc.com/gx/eng/about/svc...les_March03.pdf

http://www.pwc.com/images/gx/eng/fs...03countdown.pdf

http://www.pwc.com/Extweb/service.n...0256C7E003535EC"


And Colin's response:

'Dan,

Ill have to get a good glass of Chardonnay and read this several times before a detailed reply.

A short one is you are essentially right , however at PT is a "Growing Asset" in terms af revenue,Margin and profitability it is unlikely the asset will be "impaired".

More detailed reply later.'

Disclosure: I hold PEO