Like many companies, AstraZeneca excludes intangible asset amortisation from its adjusted performance metrics. The stock currently trades at a price earnings ratio of 23x based on ‘core’ 2018 earnings, but without the add back the PE would be about 37x. Is the add back justified? And if so do companies add back the right amount?
The intangible amortisation problem in equity analysis arises from the inconsistency between the accounting for purchased and self-developed intangible assets. We argue that the accounting treatment of subsequent expenditure, either capitalised or expensed, determines the appropriate adjustment to reported earnings.
One of the most common adjustments made by companies in their alternative performance measures (APMs) is to add back the amortisation of intangible assets, particularly that of intangibles recognised as a result of a business combination. But is this appropriate and are the resulting adjusted measures more useful for investors? Most adjustments in APMs relate to income and expense items that have limited predictive value, perhaps because they are regarded as non-recurring, such as restructuring expenses, or are simply volatile and unpredictable, such as estimate or value changes. Intangible amortisation is neither of these, so why adjust?
One possible explanation is that the expense is non-cash, but that does not really stack up given that amortisation is merely an allocation of a very real cash out flow – the purchase of intangible assets themselves. It is rare to see ‘non-cash’ depreciation of tangible assets added back (unless the objective is to represent a partial cash flow proxy such as EBITDA), so why single out intangible amortisation for a different treatment?
The answer lies with how intangibles are recognised, and not recognised, in financial statements.
Pharmaceutical company AstraZeneca provides a good illustration of the intangible amortisation adjustment and how this can result in APMs that are very different from the reported (IFRS) figures.
AstraZeneca adjusted earnings disclosures
The total amount of intangible asset amortisation that AstraZeneca adds back for the purpose of the core results is $2,085m. The amortisation is not separately identified in the table above as it is included within other items, but it is disclosed in the accompanying explanations – $1,663m is included in “Intangible amortisation and impairments” and $422m in “Diabetes Alliance”. The company does not provide sufficient analysis of the tax line for us to identify the tax related to only the amortisation. However, using the effective tax rate applicable to ‘amortisation plus impairments’, we estimate the tax credit related to intangible asset amortisation to be $433m. This means that the core earnings includes an add back of $1,652m or $1.31 on a per share basis.
AstraZeneca excludes all intangible amortisation from their core profit except that related to capitalised software development costs. The adjustment mostly relates to ‘product, marketing and distribution rights’, that arise from separate asset purchases and business combinations. None of the company’s significant spending on in-house research and development ($5.9bn in 2018) is capitalised because, according to the company, it does not meet the criteria for capitalisation under IFRS.
The impact of AstraZeneca adding back the intangible amortisation on valuation metrics is significant. For example, the current price earnings ratio based upon the company’s core earnings per share for 2018 is currently 23.3x, but we estimate this rises to about 37.4x if the add back of intangible amortisation is removed. The question is which one of these alternative price earnings ratios is more useful for equity valuation?
We think that amortisation, like tangible asset depreciation, is a very real recurring expense and therefore should be a component of performance. However, at the same time, we think it is appropriate that investors should add back some elements of amortisation for the purpose of calculating metrics that are used to estimate value. But before we explain precisely when and what should be added back, we need to look at the accounting and how intangible assets are recognised (or not) in financial statements.
Intangible asset recognition
Intangible assets increasingly dominate the resources that businesses employ. The challenge for investors is that not all intangible assets are recognised in the balance sheet. In fact often only a small portion of intangibles end up as fixed assets. This is in contrast with tangible assets where it would be unusual to have a property or item of equipment that is used by a business not reported as an asset.
If intangible assets are purchased, either individually or together with other assets in a business combination, then they are always capitalised in the balance sheet. There are some restrictions on precisely what qualifies as an asset in these circumstances, but there is essentially no difference between the accounting for purchased tangible and intangible assets.
However, there are significant differences between the treatment of tangible and intangible assets that are developed by the company itself.. For self-constructed tangible assets, the expenditure is always capitalised and the accounting is essentially the same as for separately purchased tangible assets. There can be challenges in determining precisely what the cost of the tangible asset is but, in effect, all are capitalised. This is not the case for intangibles. Some expenditure on internally generated intangibles is routinely capitalised, such as the cost of developing new systems or software. Other expenditure may be partially capitalised subject to restrictions in accounting standards, such as product development costs. However, much of the expenditure that can result in significant intangible assets is immediately expensed and not recognised as an asset at all. This includes most or all of the spending on research, product design, brands, training and development of customer relationships.
Intangible asset amortisation and performance metrics
The differing recognition of tangible and intangible assets in financial reporting presents challenges for investors. Both depreciation and amortisation reflect the allocation of historical investments and have relevance for performance measurement, particularly performance measures used for stewardship. They may also be a proxy for future investments in both tangible and intangible assets or ‘maintenance capital expenditure’, but not always, particularly in the case of some intangibles. Adjustments applied in alternative performance measures in respect of intangible amortisation are a direct consequence.
In our view, whether it is appropriate to exclude intangible amortisation from performance measures depends on what exactly is excluded and what the performance metric is used for.
Accountability and stewardship
If you use a performance metric to assess management accountability and stewardship, then we think it is appropriate to focus on profit after deducting all amortisation expenses. Management has taken the decision to purchase the intangibles, often as part of an acquisition, and must be held to account for that. Excluding the amortisation from profit but having a declining intangible asset in the balance sheet makes this accountability less clear.
Although AstraZeneca excludes the majority of intangible amortisation in its adjusted ‘core’ results, it is interesting that the company acknowledges that these intangibles and the related amortisation are not irrelevant for all purposes. In their supporting explanations they state “… a significant part of our revenues could not be generated without owning the associated acquired intangible assets’, implying that the cost and amortisation of these intangibles is relevant.
However, if you wish to use the performance metric in equity valuation, then we think some intangible amortisation should indeed be excluded. Consequently, we support intangible amortisation adjustments made by many companies in calculating APMs, but only if these adjustments relate to assets that we refer to as replacement-expensed intangible assets.
The key argument for adjusting is one of double-counting due to the inconsistency in the recognition of acquired and internally generated intangibles. The double-counting applies to amortisation of purchased intangibles where the intangible concerned, for example a purchased brand, will not be replaced by another purchase in the future (either separately or through another business acquisition). Instead, the asset is effectively replaced via expenditure that is immediately expensed, such as spending on product development, sales and marketing. As a result, the company recognises both the amortisation the purchased brand, as well as the ‘replacement’ expenditure on sales and marketing, in the same period – the double counting.
However, the argument is not valid for all intangibles. We believe that companies that adjust for all acquisition related intangible amortisation may be overstating profitability measures.
There is no double counting if the replacement intangibles would ordinarily be purchased (or internally developed and capitalised) – software and systems are a good example. In that case you should treat the intangible amortisation in the same way as depreciation. This would also apply if, for example, the intangible assets would require replacement and the most likely method is to do further M&A rather than develop internally. An example of this might be a pharmaceutical company whose business model is to purchase products that have been developed by other companies, either separately or as part of a business combination, rather than internally developing new products itself.
We use the term replacement-expensed intangible assets for those intangibles where replacement assets are not capitalised because the related expenditure must be immediately expensed under accounting rules. We use replacement-capitalised intangible assets for those that will be replaced by other asset purchases that themselves will be capitalised.
Only in the case of replacement-expensed intangibles do we advocate adding back amortisation for the purpose of deriving valuation metrics. The amortisation of the replacement-capitalised intangibles does not involve any double counting and, in our view, should be captured in all performance metrics and not added back in APMs.
To be clear, we don’t think the IFRS accounting regarding intangible assets is wrong. There are good reasons to have different recognition requirements for purchased and internally generated intangibles. However, in the case of valuation multiples we think that profit adjusted to remove replacement-expensed intangible amortisation is more useful and also more consistent with values arrived at using a discounted cash flow methodology.
Maintenance capital expenditure
Another way to think about the intangible amortisation adjustment is by considering whether its inclusion is consistent with amortisation being a proxy for maintenance capital expenditure on intangible assets.
Depreciation and amortisation has relevance for investors simply because it is the result of applying accruals accounting to asset purchases. Its usefulness is enhanced if it is also a proxy for maintenance capital expenditure. This is the expenditure needed on an ongoing basis each period to maintain the operating capability of business activities by replacing assets. It is useful even without considering the issue of intangible assets because price or technology changes can result in the capital expenditure required to be higher or lower than the depreciation and amortisation expense. Replacing the reported depreciation and amortisation with a maintenance capital expenditure amount, covering both tangible and intangible fixed assets, gives adjusted performance metrics that are more forward looking, closer to cash and more relevant for valuations.
Warren Buffett agrees. He has previously discussed a concept of what he calls ‘owner earnings’, which is essentially the same as the adjusted metric we advocate. He defines owner earnings as reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges less the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.
He first advocated this concept in 1986 well before the intangible asset problem became a major issue in equity analysis. Nevertheless, like most things Warren Buffett says, it has stood the test of time and is arguably even more relevant today.
So how does all this support the exclusion of the replacement-expensed intangible asset amortisation in APMs? In effect the maintenance capital expenditure for these intangibles is zero given that any ‘replacement’ spending is already included in profit and loss as an expense. This simple adjustment does not go all the way to calculating a ‘maintenance capex adjusted profit’ or Warren Buffett’s ‘owner earnings’ as the remaining depreciation and amortisation may not always be a good proxy for the actual maintenance capital expenditure for those assets. However, removing the replacement-expensed intangible asset amortisation goes a long way towards it, with the remaining depreciation and amortisation a better proxy for maintenance capital expenditure.
Let’s return to AstraZeneca and the question of whether it is appropriate to add back all amortisation for the purpose of calculating valuation multiples. In other words, should the 2018 price earnings ratio be 23.3x or 37.4x?
We cannot answer this definitively. The fact that all in-house research and development is expensed may indicate that any existing intellectual property and product related intangibles previously capitalised should be regarded as ‘replacement-expensed’ intangibles. Therefore, based on our arguments, you should indeed add back the amortisation. This would mean that a price earnings ratio of 23.4x does fairly describe value.
However, this assumes that any future spending on externally purchased intangibles, including those arising in a business combination, is new ‘expansion’ investment and not, in effect, a replacement of existing assets. If that is not the case and further business combinations would be necessary in the future in order to maintain the existing level of operations then, in our view, the add back of at least some of the amortisation is inappropriate.
It may be clearer to think in terms of maintenance and expansion capex. The key question you need to answer is whether future acquisitions of intangibles, particularly future business combinations, represent an expansion of the business or are necessary to maintain existing productive capacity. The answer affects valuation multiples and is also key in any DCF based analysis.
Insights for investors
- Try to identify which intangible assets are replacement-expensed and which are replacement-capitalised. Just because a company excludes some intangible amortisation from adjusted earnings does not mean this is necessarily appropriate or that the assets are indeed replacement-expensed intangibles.
- Deduct all amortisation when assessing overall performance, particularly when focusing on management stewardship.
- Performance metrics that exclude replacement-expensed intangible asset amortisation are more representative of value creation and should be used for valuation multiples. But make sure that these include a deduction for the amortisation of replacement-capitalised intangible assets, i.e. those where the spending on replacement assets will be capitalised, whether through separate asset purchases or as part of a future business combination.
- Focus on maintenance capital expenditure. Depreciation and amortisation is backward looking and an allocation of a sunk cost that is not directly relevant to valuation. Replacing this with a current estimate of maintenance capital expenditure, in whole or in part, makes performance metrics more relevant for valuation purposes. Remember that necessary spending on future acquisitions may form part of that maintenance capex.