The Underinflated Bubble

[bbgold]

Heard on the radio there were $400B in Internet Writedowns
And that was just in 2003. Here are just a few of them from 2002. Will Abby's predictions hold true for 2003 also? :^)
Don't Write Off Writedowns
David Simons, 01.31.02, 8:00 AM ET

Goldman Sachs guru Abby Joseph Cohen said not to worry about her Jan. 24 estimate that massive writedowns of acquisitions and other bull-market asset excess will cut into 2002 earnings of S&P 500 companies by 35%. Ms. Cohen maintained her year-end price target of 1,300 to 1,425 for the index. She noted that the writedowns would be excluded as special charges from the earnings Wall Street analysts look at. But don't ignore the writedowns. What's behind them can give clues about future performance of the companies doing the cutting.

A full-color preview of the 2002 action came last July when telecom-equipment maker JDS Uniphase (nasdaq: JDSU - news - people ) announced a $46.6 billion haircut of $61.4 billion worth of deals done near the peak of the bubble.

Based upon the acquired companies' quarterly reports just prior to the deal closings, JDS Uniphase paid a princely 43 times the combined $1.4 billion of their annualized revenue, and a drunken maharajah multiple of 156 times the combined earnings before interest, taxes, depreciation and amortization. Annualized net losses totaled $330 million.

Accounting rules require a writedown if the fair value of an acquisition or investment has fallen significantly and, in bean-counter lingo, the decline is deemed "other than temporary," meaning fat chance that it will recover. The implosion of the telecom sector clearly had made the JDS Uniphase acquisitions fit that bill.

Yet within four days of the writedown announcement, JDS Uniphase shares had more than made up a brief 10% reflex dip. Investors took the perspective, also espoused by the company, that the writedown didn't matter because JDS Uniphase had merely overpaid for the companies with overpriced stock. Had the deals been done after the bubble had burst, they say, the amounts subject to writeoff would have been smaller or nonexistent.

Apart from being a shaky rationale for overpaying, the logic ignores significant implications of the nuts and bolts of the writedown process.

What's written down is goodwill--the difference between the purchase price and the book value of what was acquired. Investors often downplay goodwill, because in accounting terms it's deemed an "intangible asset."

But the prescribed method chosen by JDS Uniphase to compute the writedown is quite tangible. The present value of cash flows from the acquired businesses over the next five years was estimated. The difference between that and the goodwill that hadn't already been amortized was written off.

In doing so, JDS Uniphase was saying that five-year cash flows from the acquired businesses would be $4 billion, rather than the $57 billion implied by the acquisition prices. So much for the common perspective that the goodwill "intangible" is merely a plug factor to make accounting statements balance.

Of course, much of that cash-flow deficit was reflected by the bubble-bursting of JDS Uniphase stock and the waterfall decline of the bottom line from a best-face $137 million pro-forma profit in the June 2000 quarter to a $477 million loss a year later.

Still, the assumptions JDS Uniphase used to arrive at the cash flow were optimistic. In filings with the Securities and Exchange Commission (SEC), the company said it used annual growth rates of 15% to 60%, and a 13.75% average discount rate. The discount rate is supposed to reflect the risk in the growth rate. Nortel Networks (nyse: NT - news - people ) used a 20% discount rate in arriving at a $12.4 billion June writedown of four bull-market acquisitions. The JDS Uniphase discount was more appropriate to a cement plant than to a supplier of new-age telecom gear looking for double-digit growth in an uncertain sales climate.

The company warned in SEC filings, "It is reasonably possible that the estimates and assumptions used...may change in the near term, resulting in the need to further write down our goodwill." In other words, the cash flows from the acquisitions would be even less.

Investors who dismissed the writedowns as irrelevant probably also ignored the implication of that warning. Sure enough, on Jan. 24, JDS Uniphase announced a $1.3 billion downward adjustment of the writedowns, amidst a companywide revenue decline of 52% since they were first made.

At the least, the warnings and the aggressive calculations that preceded it signaled that JDS Uniphase remained prone to overly optimistic projection. Then, in its Jan. 24 earnings announcement, the company recanted its estimate made only a month earlier that the March quarter would mark the low point of declining sales.

Nortel's writedown was more conclusive at the outset. It wiped out the 90% that remained of $14 billion goodwill from $17 billion of bubble-era outlays for three companies. That translates to estimated cash flow generated over five years being 78% less than what Nortel paid.

Fiber-optic king Corning's (nyse: GLW - news - people ) June writedown of its September 2000 deal to buy Optical Technologies USA shows just how tangible goodwill can be. In the nine months prior to the deal, Optical Technologies had lost $5.6 million on $17 million in sales. Corning paid $4 billion--176 times the annualized sales--and paid not in stock but in cold cash. The writedown reduced the value to $800,000, meaning that Corning literally had done the equivalent of totaling 80,000 brand new Cadillacs.