In my previous post I mentioned at the end that Kraft is looking attractive. The company released their earnings reports last week and the results were, well; there is no nice way to put it, crap. But Why?
Although they had less sales than estimated; their profit was way off the mark. They ended up taking a goodwill impairment of $15 Billion. Goodwill is something that always vexed me when I was in accounting school as it is an asset on the books of a company, but it really makes no sense. So imagine this scenario and keep in mind I am speaking in accounting/wall street/SEC terms here so stay with me.
Imagine that you are company A and you want to buy company B. Company B has total Assets of $1,000. Assets are things like cash, property, equipment, trademarks, copyrights, etc. Company B also has $800 in liabilities, like the mortgage on the property, and cash due to vendors and creditors. So company B is effectively worth $200. But you, at company A, believe you can manage company B better than current management, or you really want that copyright that they have so you are willing to shell out the full $1,100 for company B because you really want those assets. So the accounting transaction would look like this:
- Debit [Assets coming into company A] $1,000
- Credit [Liabilities company A will need to pay] -$800
- Debit [Goodwill] 900
- Credit Cash paid to acquire company B -1,100
So company A in this example would put up $900 in Goodwill because they essentially overpaid for a company for the benefit of company B’s assets. Now, after a few years you find out that company B really was not worth paying $1,100 for because the copyright you wanted that they owned did not really deliver in revenue the way you thought it would. You decide you are going to sell a piece of real estate that was acquired through company B’s acquisition and had a value at the time of $300 that was part of the total $1,000 presented above. You go to sell the real estate and find you can only get $200 for it if you decide to follow through in selling it; but you decide not to sell in the hopes that you can turn things around, but now you know the current value of the real estate. Now, you have to recognize a $100 expense for the difference between the value at purchase time and the value today. The $100 is an expense item called, “Goodwill Impairment” and now brings the value of your goodwill down from $900 to $800.
The above example is a simplified version of what Kraft experienced, but it was to the degree of $15 Billion. Knowing this; would you buy Kraft? Investors have been fleeing the stock, which has driven prices abnormally low. Should we follow Warren Buffet’s old adage of be greedy when others are fearful? This is one of those things that would be gut instinct; I am not familiar with the brand; although I am familiar with the products. This is a very unique scenario that does not happen very often. Let me know if you have any thoughts on the route you would take while I continue to decide if this is worth pouring cash into.