In a year of crummy headlines for Penn West Petroleum Ltd., I see another one coming in the not-to-distant future: A net loss of $2-billion or so.
That's because I suspect the company's current accounting review, which already identified nearly $400-million in incorrect entries on the income statement, might end up taking in the balance sheet as well. There among Penn West's assets rests roughly $2-billion in what's called "goodwill," an entry created when a company buys companies for more than their book value. And I think that when Penn West reviews that goodwill, it'll come to the conclusion that the correct amount should be closer to zero than to $2-billion – necessitating a large writedown that will go straight to the bottom line.
I could be wrong. Penn West has in the past insisted that no changes were necessary to its balance sheet, even as analysts and the U.S. Securities and Exchange Commission questioned the amount. It performed the required analyses and found the number correct, it has said.
Of course, that was before Penn West announced that it plans to reverse the accounting that saw hundreds of millions of operating expenses classified as capital expenditures and royalty payments. A new chief financial officer and relatively new top leadership at Penn West may decide that it's best to get all these matters behind it and take the hit when it finalizes its numbers in the coming weeks.
First, though, let's talk briefly about goodwill. When one company purchases another, it buys tangible assets like buildings and equipment, and takes on liabilities such as debt. When the purchase price for the company exceeds the value of these tangible assets, minus liabilities, the result is goodwill. The idea is that it represents the value of the acquired company's customer relationships, brand name and so forth.
Goodwill does not sit on a balance sheet indefinitely. If the cash-generating power of the acquired businesses cannot support the amount of goodwill, companies are supposed to determine that it's "impaired," write it down, and take that writedown as a charge against earnings. (Many dismiss these charges as "non-cash," but they represent failed acquisitions paid for with the valuable currencies of cash or company stock.) Companies are supposed to test goodwill at least annually, and perhaps more often, if events dictate.
At this point, we could take a stultifying tour through International Financial Reporting Standards. But let's note that one guideline for performing a goodwill-impairment test is when the value of net assets on a company's balance sheet is greater than its market capitalization.
For Penn West, this first happened in mid-2011. Since mid-2012, the company's shares have generally traded at 50 per cent to 70 per cent of its net assets, according to Standard & Poor's Capital IQ.
Morningstar analyst Rob Bellinski, who had previously worked measuring goodwill for a financial-valuation firm, noticed. He wrote a report in October, 2013, saying he believed Penn West's goodwill should be written down to zero. Of particular interest, he noted, was Penn West's reliance on the value of its resources, in addition to its economically viable proven reserves, to justify its goodwill.
The SEC noticed, as well. In a series of "comment letters," a routine practice in which its staff questions the accounting choices and disclosure found in filers' annual reports, it asked Penn West why it was apparently doing a company-wide goodwill-impairment test without drilling down to each operating unit and examining the cash flows.
Penn West conceded it should do that instead – and then told the SEC that after redoing the analysis, as suggested, for four separate time periods, it still didn't believe there was a goodwill impairment, in part because of the value of its resources. That pesky market-cap discrepancy? It was "indicative of the company operational performance and temporary market factors rather than an indication of impairment of the company's underlying assets," Penn West wrote to the SEC staff in an Oct. 15 letter.
Well, Penn West is still trading below the value of its net assets. It's even been trading below the value of its tangible assets for nearly two years. This strongly suggests investors have been valuing the company's goodwill at zero for some time. Now, with the coming restatement, we know that the cash-flow data that supported that goodwill was overstated.
This is likely to add up to a new determination by Penn West that it's time to erase most, if not all, of the goodwill.
David Milstead