Solar Integrated Roofing Corp (SIRC)

[WeTheMarket]

SIRC Analysis – Why so Much Goodwill?
March 28, 2022 by Sam Aker
https://samakerfinance.com/sirc-analysis-why-so-much-goodwill/

I’ve seen this question kicked around a bit on Discord and figured it warranted its own article. This is also a bit of an important topic because SIRC specifically said this topic is what’s holding up their audited financial statements.

First, we’ll get into what goodwill is. Then, we can talk about why SIRC has so much goodwill on its balance sheet. We’ll then wrap up with a discussion on if all of this goodwill is good, bad, or not anything of concern.

What is Goodwill?

When a company is purchased, the purchasing company will have to record both the assets and liabilities of the purchased company on its balance sheet. In terms of assets, these include both tangible assets, such as factories, land, etc. as well as identifiable intangible assets, such as patents, licenses, trademarks, etc.

Let’s take an example. Say I am purchasing a company for 100m in cash that has the following characteristics based on the fair market valuation by my auditors:
Assets:
- Tangible: 50m
- Factory: 20m
- Land: 10m
- Inventory: 10m
- Intangible: 10m
- Patent: 5m
- Trademark: 5m
- Liabilities: 20m
- Long term debt: 10m
- Accounts Payable: 10m
- Net Assets (equity): 50m-20m = 30m

Now, I’ve paid 100m for this company, which means that I’ve paid more than the net assets of the company. So when I take control of the company, does that mean I only recognize a 30m asset even though I paid 100m in cash for it?

Nope. This is where goodwill comes in.

After you have properly calculated the fair market value of each of the above line items and arrive at net assets, anything above and beyond this amount is considered goodwill. In our example, 70m would be booked as goodwill on the balance sheet.

Why Does Goodwill Happen?

Now you might be thinking, why in the world would I purchase a company for more than its net assets?! How silly is that?! Well believe it or not, this happens all of the time and occurs in most acquisitions to varying degrees.

What happens is an intersection of 1. Drivers of business success and 2. Accounting.

Take a look at my example above of the target company and think about what all else goes into a successful business. What else isn’t listed there? To name a few:
- Human Capital – you could be a technology company and have Albert Einstein be your chief technology officer, but that wouldn’t be considered an asset. Or you could be an amphetamine distributor and have Jordan Belfort be your head of sales (I kid, I kid).
- Internally Developed Processes – similar to the above, say you’ve been refining your supply chain model, SIOP, or whatever, for decades and have the process down perfectly. This would likely not be considered an identifiable intangible asset but drives extreme margin improvement.
- Notoriety – While not necessarily captured in the valuation of a brand, an extremely well-known company within an industry can have a massive impact to financials. Even if Apple removed their brand entirely and just said “we’re Apple, buy our phone”, think of how many people would still buy them.

In general, goodwill takes into account all of these above items that aren’t captured as a specifically identifiable asset. In some acquisitions, this could be a very small component. But in some other companies, this could be 95% of the purchase price.

So when you see goodwill, think of it as the company’s estimation of what they see as identifiable net assets versus all of the other value potential in a company that will be utilized. Remember, goodwill is an asset, so we as investors expect that goodwill to drive some value for us in the future.

One last thing. Goodwill is not depreciated/amortized like a traditional asset. So it just sits on the balance sheet at its initial value unless…

Goodwill Impairment?

Now, say the company you bought ends up being the next Theranos and you’ve booked your 70m in goodwill on the balance sheet. The company is a complete loser, and an asset is supposed to result in future inflows, right? So what do you do?

You impair it!

You would identify how much of the goodwill is no longer able to produce an appropriate inflow based on some valuation, and you impair the goodwill by the resulting difference. Say my analysis says the goodwill is now only worth 10m. I would have a one-time impairment charge of 60m on the income statement, which would likely result in a massive loss for the company that year.

But if you think about it, the loss on the income statement is warranted. You bought a dud company and now you have to show the hit the company took.

SIRC – Why so Much Goodwill?

Now, if you were reading the above discussion with SIRC in mind, this should hopefully start clicking for you. When we think about the companies SIRC has been acquiring over the last year or so, they are almost exclusively service oriented companies which distribute and install solar systems, chargers, whatever. These companies earn their keep by being great at those things, which generally means they have great salespeople, a strong reputation, and shrewdly negotiated supply arrangements.

Because of this, these companies are typically extremely asset light and really only have intangible assets to their name, all of which I mentioned above. For tangible assets, we would expect them to really only own some inventory and maybe some equipment. The rest, typically, is just leased office space, equipment, a warehouse, etc.

Now, put this in the context of an acquisition. These companies that SIRC are acquiring are asset light and generate strong profits by utilizing their intangible assets. So, while a company may only have 5m of net identifiable assets, it could be generating 10m a year in profits. If we put a 4x multiplier on that, that a 40m purchase price with 5m of net identifiable assets, so 35m of goodwill.

SIRC – High Goodwill, Does it Matter?

With analyzing Goodwill, you can’t really look at it in isolation. You need to know the context of the deal. Taking our above example, once we know the context, we wouldn’t go “why would they pay 40m for a company with 5m in net identifiable assets are you crazy?!” We would go, “we’re paying 4x net profit which results in a 40m purchase price vs. 5m in net identifiable and 35m in goodwill. This 35m in goodwill represents everything else awesome about this company that isn’t specifically identifiable.”

Period. End of story. That’s all it means.

Based on everything we’ve seen with SIRC’s acquisitions, they have generally paid off almost immediately. We’ve seen extreme margin, profitability, and revenue growth all over the last twelve months which is directly related to acquisitions. So, in my opinion, the goodwill is nothing to be worried about.

If you want to sense check it, just compare the purchase price of the acquired company and its subsequent performance after being under the SIRC umbrella. Don’t worry so much about the goodwill piece, it’s just an accounting mechanism.

Now, if we start seeing massive goodwill impairments on these acquisitions, then we have to start questioning management. But to date that has not happened and may never happen.

Why is it Delaying Financial Statements?

If you couldn’t tell, the way a company accounts for goodwill is incredibly subjective and confusing. As such, my theory is that much of the goodwill booked during the unaudited financial statement periods is going under some intense scrutiny from auditors.

This is not a cause for concern for me. If anything, I think it makes complete sense given they booked over 30m in goodwill and now need auditors to essentially re-value several acquisitions and their purchasing price accounting. So have some patience with this, but we should still have financials out by the end of March.

Wrap Up

So we’ve gone through goodwill, what it is, and why SIRC has so much of it on its balance sheet. In the end, it is not something we should really be concerned about unless we start seeing SIRC take massive goodwill impairments. But until then, we have to trust the company and its auditors in telling us that the goodwill on the balance sheet is, well, good.

Personally, we have already seen instant success from their acquisitions which resulted in goodwill. So the fact that there is goodwill is even less of a concern because the goodwill is clearly generating a benefit for the company.

Hopefully this discussion was helpful for everybody!

DISCLAIMER – AT THE TIME OF WRITING THIS ARTICLE I HAVE A LONG POSITION IN SIRC. THIS ARTICLE IS NOT FINANCIAL ADVICE AND IS INTENDED ONLY FOR EDUCATIONAL PURPOSES. I AM NOT A FINANCIAL ADVISOR. AT THE TIME OF WRITING THIS ARTICLE, PERSONS AFFILIATED WITH THE COMPANY ANALYZED ABOVE MAY BE PROVIDING MONETARY COMPENSATION AS MONTHLY PATRONS THROUGH MY PATREON. THIS COMPENSATION IS NOT PROVIDED IN RETURN FOR ANY SERVICE, WRITING ABOUT A PARTICULAR TOPIC, AND/OR FAVORABLE OR UNFAVORABLE OPINIONS. MY PATREON SUPPORTERS HAVE NO INFLUENCE ON THE CONTENT OF MY ARTICLES.