Thursday, March 3, 2016

When Does it Make Sense to Adjust for Amortization of Intangible Assets?

Buffet’s 2015 annual report contained his usual warning about amortization charges.
“… serious investors should understand the disparate nature of intangible assets. Some truly deplete in value over time, while others in no way lose value. For software, as a big example, amortization charges are very real expenses. Conversely, the concept of recording charges against other intangibles, such as customer relationships, arises from purchase-accounting rules and clearly does not reflect economic reality
Buffet goes on to say about 20% of Berkshire’s amortization charges are “real”, therefore adding back about 80% of amortization charges in his non-GAAP presentations.

For a lot of companies, non-GAAP earnings routinely doubles that of the GAAP version after adjusting for amortization of intangibles and stock-based compensation. Clearly these are no trivial matter. Since Buffett already criticized the latter, here I want to focus on the former.

Most Intangible Amortizations are Real Expenses

If the key question is, as Buffett suggested, whether the intangible asset depletes over time, then I would say most of them do. They are called “finite-lived intangibles” for a reason. Software and patents are fairly obvious - they deplete due to technological obsolescence and legal expirations, respectively. But even customer relationships and brands depletes overtime. 

Buffett cited customer relationship as an intangible asset that does not deplete. But I would argue even that decays overtime as your customers change (they move out of your geography, retire, move to another company…etc.) and competitors try to steal your customers. Brand value decays as well. If you literally buy out the Coca-Cola brand for a gazillion dollars and then subsequently spend zero on marketing, advertising, or promotional budgets while Pepsi continues their efforts, I believe even Coke would gradually lose “mind share” and its revenue will slowly decay overtime.

Criteria for Adding Back Amortization Charges

So when is it ok to add back amortization of intangibles? I think the real question is not whether something depletes – they pretty much all do. What really matters are 1) whether the company is spending to replace or maintain that earning power and 2) whether that cost is already accounted for.

Due to the quirks of accounting, intangible assets are capitalized when they are acquired. But the costs to internally replace that earning power (think R&D, advertising expense, marketing expense, and so on) are usually expensed. This means they already flow through the income statement, as opposed to getting capitalized on the balance sheet then amortized later.

Go back to the Coke example. Let’s say you buy out the Coke brand, and now you got a massive intangible asset and lots of amortization expenses. But instead of letting it rust, you actively incur expenses on sales/marketing/advertising to maintain or increase that brand value. Since these costs are already reflected in the income statement, not adding back amortization expense would be double counting.

Compare this to depreciation of hard assets. Since ongoing cost of maintenance would be capitalized and not expensed in the income statement, an accurate earning measure would either treat depreciation as a real expense, or add it back but subtract an estimate of maintenance capex.

The Verdict

To conclude, adding back amortization of intangibles makes sense. Not because they are not “real expenses”, but because the cost of replacing that intangible asset is likely already reflected in the income statement and you don’t want to double count. It is “likely”, but not always, because the appropriate treatment would differ company by company, and asset by asset. There’s no one size fits all answer.

Berkshire Hathaway is unlikely to skimp on spending to maintain its earning power, so Buffett’s adding back 80% of their intangible amortization seems sensible.

On the other hand, if a company’s core business model is acquisition of intangibles (say patents for drugs), yet does nothing to maintain or replace its decay (no R&D capability in house), then adding back amortization would be voodoo math.


1) Whether a number is “correct” will depend on how it’s used. So if you add back amortization to earning or free cash flows per share, then apply a low multiple to account for the gradual depletion of earning power, then I have no problem with that. But more often than not people add back amortization of intangibles to come up with EPS or FCF/share, then apply 15-20x or even higher valuation multiple – therefore implying the earning stream is perpetual.

2) Intangibles have to be judged on a case by case basis because the same thing could be expensed or capitalized depend on situation (as this article explains, it depends on whether the intangible is acquired versus internally generated, and “identifiable” vs “unidentifiable”)

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