SIMON BROWN: The reality of writedowns

One unfortunate feature of listed stocks is that they occasionally write down assets, always making the claim that everything is fine and the writedown is not a cash entry. Sure — but, no. So here are the details.

Two recent examples are British American Tobacco (BAT) and Curro. The former wrote down £25bn while Curro’s writedown was R340m-R380m.

But let’s go back to the beginning.

BAT bought Reynolds American for $47bn. Naturally, it expects a return, and the board would have pencilled in what they expected that return would be. Say 12% a year, which would be about $5.6bn in profits.

But then reality strikes and they only manage, say, $2.6bn. So instead of a 12% return they’re getting just 5.5%. This is a problem; they did a bad deal.

This matters because of return on equity (ROE) and, frankly, directors’ misallocation of funds by wildly overpaying for an asset. But the ROE is what they really care about.

Equity in the ROE number is assets less liabilities, and the return is literally the return on that equity: how much they make from the things they own. A company will usually have a target ROE, and investors expect a strong ROE, otherwise an investment is simply not profitable enough to deliver strong share price returns.

The large deal, staying with Reynolds American, sits on the balance sheet as an asset at the purchase price of $47bn. So it inflates the equity number.

So how do you solve for the low ROE? Simple: you reduce the asset side of the equation, your equity value drops and the ROE number goes up. Hey presto.

With Curro the details are different in that the company built schools expecting a certain number of pupils would, over time, enrol. Those pupils pay school fees and this is the income, less cost of teachers and the like. There is a targeted number of fee-paying pupils you need to enrol to get the desired return on the school building.

Then, not enough pupils sign up, so there are not enough fees and the return on the cost of that building is suboptimal. The solution is to reduce the value of the school buildings by doing a writedown.

Again, this in no way actually reduces the monies paid to build them, just the value.

Yes, you’ll notice this is accounting trickery, and the company will always note that the writedown is not cash. True, but — and this is a big but — it was cash when it paid for it, so saying it’s not cash is nonsense. BAT spent a fortune on a bad deal and, really, the writedown is about protecting future returns and, dare we say, also director positions and bonuses.

The problem with mergers & acquisitions is simple. The buyer nearly always overpays and then has to reduce the value of that overpayment. Ultimately, it is shareholders who pay for the failed deal.