The amortization of intangible assets can sometimes be hidden in the consolidated financial statements because amortization is grouped in with depreciation. But as the economy increasingly becomes more knowledge and intangible asset-based, investors need to more closely understand the accounting behind the amortization of intangibles.
Depending on the intangible asset in question, a large amortization expense can suppress ROIC over the short term until that amortization is fully expensed, particularly after a large one-time acquisition.
The longer the “useful life” of these intangible assets, the greater the potential impact to the balance sheet, and balance sheet/profitability metrics such as ROIC.
To fully grasp this concept, we’ll need to work through these topics:
- The Basics of Amortization of Intangible Assets
- Capital Allocation Decisions and their Impact to Long Term Assets
- Example: Suppressed ROIC due to Large Intangible Assets
- Investor Takeaway
Buckle up, let’s dig in.
The Basics of Amortization of Intangible Assets
Dave recently did a superb primer on the basics of intangible assets, which I highly recommend reading through before tackling this post.
In a nutshell, intangible assets are added to a balance sheet when one company acquires another. Other than that, intangible assets will not be added to a balance sheet (as of the accounting standards today), even if they are developed internally.
Intangible assets, in contrast to tangible assets, can be classified as things like (taking this from a $CDW 10-k):
- Customer relationships and contracts
- Trade name
- Internally developed software
Notice how these assets are not the standard, brick and mortar type of assets that used to make up the majority of the “older” economy—things such as “plant, property, and equipment” (or PPE).
Though technology has empowered many new types of business models that can be run without traditional brick and mortar assets, such as those based on the internet, the drive of intangible assets is not a brand new concept.
Companies like Coca Cola drove a significant part of their profitability from things like the trademark of their brand and the marketing expense to promote that brand, both of which never showed up on the balance sheet for Coca Cola because they weren’t built through M&A.
Now, amortization of intangible assets works just like depreciation of long term PPE assets does, except for one key detail.
Companies usually add capex each year (adding to the value of PPE on the balance sheet at the same time that depreciation expense lowers it)—whereas many businesses tend not to utilize M&A every single year, so intangible assets tend to decrease over time through amortization unless a company frequently acquires new businesses with large intangibles.
Looking just at the income statement or cash flow statement, you won’t see a breakdown between amortization and depreciation.
You’ll always see a line item in the Cash Flow Statement called “Depreciation and Amortization”, and you’ll sometimes also see that line-item in the Income Statement (but not always).
To find the amortization expense of intangible assets each year you’ll have to visit the notes to the financials.
For example, going back to $CDW’s latest 10-k:
Capital Allocation Decisions and their Impact to Long Term Assets
Let’s review capital allocation because it is a key part of intangible assets, since by definition intangible assets can only be added to a balance sheet through M&A, which is one of the major types of capital allocation.
A company can choose to allocate its profits through one of these ways:
- Retain the earnings on the balance sheet (as cash or investments)
- Return the profits to shareholders through dividends or share buybacks
- Reinvest the profits in working capital (short term assets) or capital expenditures (long term assets)
- Acquire another company
There’s another less technical term for reinvestment in companies, and that’s through the income statement.
By spending more in any given year, whether on marketing or research, a company can reinvest in future growth, though this does not show up on the balance sheet either. Instead of taking earnings and applying them to the balance sheet, a company can sacrifice profitability as a form of reinvestment which was a key finding in Dave’s great post on intangibles.
Trying to get a big picture overview of a company’s capital allocation decisions becomes a little more nuanced from all of these options, though we can take a few great online tools to shortcut the process.
To do this, I used the download spreadsheet function from quickfs.net on a company called Fastenal ($FAST), also a distribution company like CDW but in the industrial market.
Quickfs instantly gives you 20 years of financial data all in one spreadsheet, which is perfect for this.
Making my way to the Cash Flow Statement tab, I can calculate a SUM function over the 20 years, like this:
To summarize our key capital allocation metrics:
- Depreciation & Amortization = $1,299 million
- Net purchases of PPE = ($2,189 million)
- Changes in Working Capital = ($1,640 million)
- Acquisitions = $222 million
- Buybacks = $830 million
- Dividends Paid = $4,514 million
- Debt added = $405 million
Clicking to the Balance Sheet, we can take the difference between 2001 and 2020 to see the following:
- Change in Net PPE = $1,152 million
- Change in Working Capital = $1,587 million
It’s important to distinguish between net purchases of PPE and the change in net PPE because depreciation is not always equal.
There could be many factors affecting depreciation, one of those being the effectiveness of the capital expenditure (net purchases of PPE) spend.
In other words, if a company has been spending a lot on capex but hasn’t seen much increase in PPE (and earning power), then they might be destroying capital. In the case of $FAST, their investments in working capital has risen in lockstep with its while about half of their capex spend has depreciated away.
In other words, half of their capex is more of the “maintenance capex” type.
$FAST has not made many acquisitions over these past 20 years, and carries a value of 0 on their balance sheet for intangible assets, so we don’t have to worry about amortization for a company like this.
But this plays into the next company we’ll look at with significant amortization expense: $CDW.
Example: Suppressed ROIC due to Large Intangible Assets
If we were to take the same process of mapping out $CDW’s capital allocation over the past 20 years, we would see something quite peculiar.
In most companies you examine, you’re likely to see depreciation & amortization slightly below net purchases of capital expenditures, with the difference representing the retention of value from growth capex investments.
But remember Depreciation & Amortization includes amortization, which is not a factor in many older economy, tangible asset businesses (like $FAST above), so it doesn’t get much attention.
Where the financials throw you a curve ball is when Depreciation & Amortization is much higher than capex, which can happen if:
- A company is in a “cash cow” state, where minimal (maintenance) capex investments can support higher profitability (through pricing power or competitive advantages)
- A company is essentially slowly liquidating itself (as Gary Mishuris astutely pointed out)
- Or, in our case, a company’s amortization expense is more significant than its depreciation
By summing CDW’s 12-year cash flow investments (because of their IPO/ private equity situation), we see the following:
- Depreciation & Amortization = $2,960 million
- Net purchases of PPE = ($961 million)
- Changes in Working Capital = ($309 million)
- Acquisitions = $489 million
- Buybacks = $2,239 million
- Dividends Paid = $822 million
- Debt paid off = $1,058 million
And from the balance sheet:
- Change in Net PPE = $140 million
- Change in Working Capital = $1,133 million
What’s the rub here? Well I gave you the spoiler already earlier; it comes down to the difference in intangible assets and how they’ve been amortized.
If we looked over the balance sheet over the last 12 years, we should notice that in 2009 there was a large $1,951 million value for Other Intangible Assets for the company.
Comparing that to 2020, the value for Other Intangible Assets has fallen to $445 million, and it’s from all of those amortization expenses falling off each year. Though the company has made about $489 million in acquisitions over the same time period, their accumulation of intangible assets has not been enough to offset these huge amortization expenses (remember from the screenshot above, they’ve been in the $200 million per year range).
The reason that $CDW had such a large intangible asset value in 2009 was because of their capitalization history. I’ll let the 10-k (from 2010) summarize that:
On October 12, 2007, CDW Corporation, an Illinois corporation, was acquired through a merger transaction by an entity controlled by investment funds affiliated with Madison Dearborn Partners, LLC and Providence Equity Partners, Inc. (the “Acquisition”). CDW Corporation continued as the surviving corporation and same legal entity after the Acquisition, but became a wholly owned subsidiary of VH Holdings, Inc., a Delaware corporation.
On December 31, 2009, CDW Corporation merged into CDWC LLC, an Illinois limited liability company owned by VH Holdings, Inc., with CDWC LLC as the surviving entity.
It was likely that December 31, 2009 transaction that created the intangible asset book entry for the company, because if you were to look at the financials before that time (2006 and prior) there was no intangible asset of this size.
And through this story we get a great lesson on the amortization of intangible assets and their effect on cash flows and the impact of capital allocation to a company’s financial statements.
There’s one more part to this story however.
Notice the company’s ROIC over the same 12-year period:
- 2009 – (16.6%)
- 2010 – (0.7%)
- 2011 – 0.4%
- 2012 – 3.0%
- 2013 – 3.5%
- 2014 – 6.5%
- 2015 – 10.0%
- 2016 – 10.2%
- 2017 – 12.9%
- 2018 – 16.0%
- 2019 – 17.1%
- 2020 – 17.4%
I’d recommend a few of our guides on ROIC to truly understand what I’m about to say next, but it’s significant (especially because valuation and ROIC tend to go hand-in-hand).
In most companies, the Invested Capital of a company stays the same or increases over time.
This is because companies will make capital expenditures, some of which will be offset by depreciation. But most companies (excluding cash cows, which can grow without capex) need reinvestment in capex or working capital to fuel future growth, and so Invested Capital increases with growth.
This tends to keep ROIC mostly constant unless a company can become incrementally more efficient with its investments/operations.
However, $CDW is a bit of a unicorn because its Invested Capital actually had a huge downward force even while PPE and working capital was increasing—because of that Intangible Asset amortization!
Since the amortization of CDW’s intangible assets were not being replaced by further acquisitions, their Invested Capital has been falling by that amortized amount each year.
Going back to the screenshot of CDW’s intangibles, most of them are from customer relationships.
Surely many of those relationships have been maintained or even improved over the years, but due to the quirks of intangibles and amortization accounting, the financials imply that these relationships are eroding while the reality is likely the opposite.
Hopefully we can see know why an intuitive understanding of intangible asset accounting can lead to finding clear value hidden in plain sight.
As a combination of all of these factors, it’s possible that CDW’s value and ability to compound capital has been vastly understated, at least using any balance sheet-type efficiency ratio such as ROIC.
But that situation has been improving, as evidenced by the company’s incrementally improving ROIC, which could reach a plateau once the rest of the intangibles have been amortized away.
It’s been the accumulation of almost $2 billion in intangible asset amortization that has initially suppressed ROIC and is now unleashing an upward trajectory.
We’ll see how Wall Street responds.
Disclaimer: I’m long $CDW at a cost of $165.75 per share and recommended the company to subscribers to The Sather Research eLetter in Apr ’21.