January 11, 2000
Deals & Deal Makers
Megamerger Uses 'Purchase' Method
Of Accounting Despite Heavy Goodwill
By ELIZABETH MACDONALD and NIKHIL DEOGUN
Staff Reporters of THE WALL STREET JOURNAL
At first glance, to the average market watcher, it looks like
sheer insanity.
But on closer look, the accounting method America Online
Inc. and Time Warner Inc. are using to book their megadeal
-- known as "purchase accounting" -- says a lot about how
big mergers are going to get done.
AOL and Time Warner have opted to book their
megamerger under what, at first, appears to be the more
Draconian of two merger-accounting methods, purchase
accounting, as opposed to "pooling of interests," which is
the typical method used in all-stock deals such as this one.
However, with AOL and Time
Warner, the purchase method was
picked because it is less-restrictive
in certain ways than pooling. The
purchase-accounting route means the deal will generate
$150 billion in goodwill write-offs against earnings, says
Michael Kelly, AOL's chief financial officer and the
finance chief of the combined company. Goodwill is the
premium acquiring companies pay above a target's book
value for items such as research and development and
trademarks.
Not Scary Anymore
Normally, such write-offs would spook analysts. That is
because the sum translates into an annual $7.5 billion
smack to earnings during a 20-year period, or a $1.88
annual reduction in earnings per share. "We are talking
about an ungodly amount of goodwill," says Robert
Willens, a managing director at Lehman Brothers Inc.
Poolings don't create goodwill.
With U.S. accounting rule makers getting set to kill
poolings by year end and shrink the goodwill write-off
period to 20 years from 40, there has been widespread talk
that a slew of companies will rush to do poolings to beat
that deadline. So, many market observers are asking: Why
isn't the biggest deal ever being booked as a pooling? For
reasons that make perfect sense, that is why.
Under a purchase, AOL Time Warner can swiftly dump
unproductive assets, plus do stock buybacks to preserve its
share price. Under a pooling, the union would have to wait
two years after the deal was completed to make these
moves. The purchase route gives more "flexibility, they
didn't want the restrictions," a person involved in the
merger discussions said.
Most analysts likely will ignore the annual earnings hits
from goodwill anyway. Already, most analysts follow
Time Warner on a cash-flow basis as they do for most
media companies. That earnings model ignores goodwill
expenses, (cash flow is earnings before interest, income
taxes, depreciation and amortization of goodwill.) A
growing number of analysts also follow AOL on a
cash-flow basis.
Goodwill Seen as Artificial
Given that many market analysts regard goodwill as an
artificial, noncash charge, AOL and Time Warner "thought
the world is ready to not penalize you for purchase
accounting," the person involved in the discussions said.
Indeed, the AOL-Time Warner deal is being seen as "a
template for future deals" Mr. Willens says. For one,
Frederic Escherich, a managing director at J.P. Morgan &
Co., says 66 U.S. companies reported cash earnings a
share or a similar number in their most-recent quarterly
earnings releases, more than double from the same
reporting period in 1998. "The trend of following
companies on a cash-earnings basis is going to explode
now because of this deal," he says.
AOL-Time Warner's decision to go to the purchase route
could force other merging companies, such as Pfizer Inc.,
to reconsider their pursuit of poolings to seal deals.
Pfizer's $72 billion hostile bid for pharmaceuticals rival
Warner-Lambert Co., which had agreed to a merger of
equals with American Home Products Corp., is
conditioned on it being allowed to use pooling. If Pfizer
dropped its condition, observers say they believe it would
quickly win the battle for Warner-Lambert. A Pfizer
spokesman said it was "a little early" to say whether the
company would drop its pooling condition.
Already, it appears the market is ignoring goodwill
write-offs in some other important deals, including
drug-maker Roche Holding AG's recent purchase of
Genentech Inc. and MCI WorldCom's purchase of Sprint,
among others. "The market fully knows about the sizable
goodwill charges in these deals and so far has blithely
shrugged them off," Mr. Willens says.
-- Nick Wingfield contributed to this article.
Write to Elizabeth MacDonald at
elizabeth.macdonald@wsj.com and Nikhil Deogun at
nik.deogun@wsj.com