Is FactSet Research Carrying Too Much Goodwill on its Books?

By Motley Fool Staff Markets Fool.com

On this mailbag episode of Industry Focus, our podcast hosts answer a question about FactSet Research Systems (NYSE: FDS), which carries a disproportionately large goodwill account on its balance sheet. We review FactSet's goodwill in the context of both its acquisition strategy and the business as a whole. To find out our conclusions, simply watch the video below.

Continue Reading Below

A full transcript follows the video.

10 stocks we like better than FactSet Research Systems
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and FactSet Research Systems wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of February 6, 2017

Continue Reading Below

This video was recorded on March 21, 2017.

Vincent Shen: What else, Asit, do you think people need to know in terms of, specific to Ben's question, when it becomes a larger and larger part of a company's assets on its balance sheet? Are there concerns there? How should investors think about that?

Asit Sharma: Good question. It really depends on the industry that you're looking at. When goodwill reaches 40% on a common size balance sheet, that means that it represents 40% of total assets. That could be a lot of goodwill for no good purpose, especially if the company generates return off of its fixed assets, tangible assets. So, if you look at a company like Caterpillar, which makes most of its money off of heavy, earth-moving equipment, you wouldn't want to see an extraneous amount of goodwill there, because they're in the business of buying equipment, selling that equipment at a reasonable profit, reinvesting those profits, and generating cash flow, etc.

Once you start moving down the spectrum to more and more intangible types of revenue, goodwill starts to make a little bit more sense. If you're in the business of selling an intangible -- let's say you're Microsoftand you're selling software -- it might make sense for you to purchase lots of intangible assets. One thing that our listeners should consider if you do indeed go look at some of these annual reports is, there are actually two items that make up intangible assets on a balance sheet. One is goodwill, as we're talking about. The other is called exactly that -- intangible assets. Whenever a company can identify when it purchases another company the very things that Vince mentioned, such as copyrights, trademarks, patents, software, content, types of technology, to the extent that management can identify a value for each of those items, it books those to intangible assets. What it really can't assign a certain value to, and it becomes subjective, is goodwill. Investors should be aware that there are actually two items to look at on those balance sheets. Sometimes, the goodwill balance is small, but the intangible assets value is quite big. You have to make sure you look at both of those.

Shen: Yeah, that's a really good point, Asit. And that actually comes up in terms of some of the specific items that you mentioned. Software technology, for example, that actually comes up with FactSet. Let's shift gears a little bit and put things into context a little bit for this company. Can you give us a quick rundown of what we're looking at, in terms of FactSet and their situation in terms of their goodwill balance?

Sharma: Sure. FactSet provides market information content to the investment community. It's grown its goodwill balance through a series of small acquisitions. It's constantly looking to stay up-to-date with its competitors, who are also in the marketplace to buy information. So, when it acquires a company, it's not really acquiring fixed assets so much as it's acquiring intangible assets that, down the road, can parlay into more revenue. So, what an investor needs to understand is, if you have not looked at FactSet's balance sheet before this conversation, you have an expectation that maybe it's bigger, the goodwill balance plus the intangible assets, relative to a company which is dealing in hard assets, as we've talked about before.

I want to read from FactSet's most recent annual report to give you an idea of how intangible their revenue base is. "FactSet is a leading provider of integrated financial information, and big data analytical applications to the global investment community. We deliver insight and information to investment professionals through our analytics, service, content, and technology." Now, that asset base, if you were an accountant, auditor, showing up once a year at FactSet's premises, you wouldn't be counting boats, you would not be looking at mechanical things. You would be looking at software and trying to determine, what's the value of this software? What will this mean for revenue down the road? And this is what's important to understand about this company -- it is dealing in intangibles.

Shen: The example I pulled up, this was a big jump in terms of their goodwill balance, specifically toward the end of 2015 -- the company's balance sheet has goodwill currently of $508 million, just shy of half the total assets of the company at $1.05 billion. In the fourth quarter of 2015, the goodwill balance jumped from $308 million to almost $500 million, and that specifically was the result of the acquisition of a privately held company called Portware. The purchase price was just shy of $264 million.

Again, in FactSet's 10-Q, you can find a section called "Business Combination", if you want to look this up. The company specifies what assets it acquired, and how they value out. So, the company got in terms of tangible assets -- again, this company being much more in the intangible space -- those only amounted to $9.7 million worth of tangible assets. But then, things like the software technology, client relationships, came out to around $75.5 million. Deducting those liabilities again, assets acquired amounted to $76.2 million. So, that difference between the $76 million and the $260-some million they paid gives us the goodwill increase of about $187 million, which is what increased the balance toward the end of 2015.

Anything else, Asit, that you wanted to add, in terms of, specifically, FactSet? Do you have a concern here based on the rather acquisitive business model, and the way they have competed in the market, where they're trying to find other services to differentiate it in the financial service community, in terms of offering this research? I used this myself when I was still in banking, and FactSet was a very powerful and important tool for us on a day-to-day basis. It seems like they're branching out, Portware giving them things like automated trading. Any last thoughts?

Sharma: Sure. I do have a slight concern when you see that balance creeping up in that you do want a company to be able to innovate internally as it goes along, and not just always acquire the technology that's going to turn into revenue later on. I actually went back really briefly and looked at 2012's numbers. Goodwill to total assets was about 35%. So, it had a balance approaching at 40% that our listener, Ben, is concerned about. Its operating profit margin, FactSet's operating profit before taxes and interest, was about 34%. Now, fast forward to this year, goodwill to total assets is 41.4%, and the operating profit margin is 31%.

And that actually made me feel a little bit more comfortable. Yes, the goodwill balance crept up, but the operating margin has largely stayed the same. It's decreased a bit. And that's what you want to look at, when you see that year after year, a company is going out and acquiring these other companies -- look at that relative trend of goodwill to total assets, but also look at net income, because it might mean that acquisitions are sustaining stable profit, which is what you see in this case. Last point, in 2016, FactSet was able to sell one of its divisions for $112 million, which made up about a third of net income for the year. So, it's actually taking some of that intellectual property, repackaging it down the road, and selling it for a profit. That's also a positive sign. To me, bottom line, I'm not that worried about the goodwill balance here, but that's a really great question from Ben. You should always be skeptical of those large balances, and you should investigate.

Shen: Thank you, Asit, that's an awesome takeaway. For me, the way I look at it is, this isn't really something that you can necessarily evaluate in a vacuum. You need to look at some of those other metrics, like you mentioned, to see how they're impacting things on the bottom line, profitability, as some of these companies like FactSet have a more acquisitive business model.

The one thing I do want to add, in terms of how goodwill can change and how it's evaluated on an annual basis is, ultimately, these companies that carry these goodwill balances, they need to evaluate them each year to see if they have maintained at least that value that they paid for it. If not, then they can take an impairment charge. There's been some very famous, almost infamous examples of these goodwill writedowns, I think the most famous being the AOL-Time Warnerdeal from the early 2000s. They had to suffer a goodwill writedown of over $50 billion. In some cases, this can be an example of a company overpaying, but otherwise, something you need to look at more holistically.

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Asit Sharma has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends FactSet Research Systems. The Motley Fool recommends Time Warner. The Motley Fool has a disclosure policy.