Check out the month America Online AOL had in March. The company's shares rose 70%, which works out to an increase in market capitalization of $55 billion. In one month. Sure, there was good news. The company announced a few tieups--one with online auctioneer eBay EBAY--and laid out the details of its e-commerce venture with Sun Microsystems SUNW. Plus, a Wall Street analyst raised his price target a cool 75%. (What's new?)
Haywood Kelly, CFA, is head of global research at Morningstar.
But $55 billion? Let's put that number in perspective. Only 60 or so companies in the world sport total market caps of $55 billion or more. AOL's market cap simply swelled that much last month. It had to be close to the biggest, if not the biggest, jump in market cap for a single month ever.
Lost in the shuffle is the fact that Netscape shares have tagged along for most of AOL's wild ride. AOL, you'll recall, agreed in November to acquire Netscape, the Web-browser specialist. Here's how the mechanics of the deal worked. AOL agreed to exchange 0.9 AOL shares (adjusted for splits) for every one Netscape share outstanding. As AOL's shares rose after the deal was announced, so did Netscape's--to almost $100 a share from about $40. The AOL/Netscape deal closed in the middle of March.
What that means is that AOL paid $10 billion for Netscape, as opposed to the $4 billion or so price tag when the deal was announced. In fact, the original deal didn't include a blow-out premium over Netscape's then-current share price; but it sure ended up being a nice premium for the Netscape shareholders who held on.
The common wisdom these days is that it really doesn't matter for AOL. What's a few billion lost when you're adding $55 billion in market cap in a month? But as a company, AOL has about $3 billion in assets. While the market value of AOL, which currently is $140 billion, puts it among the top 15 companies in the world, in terms of actual assets (or sales, or earnings) it's way down the list (about 900th among companies trading in the U.S. in terms of assets). For AOL the company, paying $6 billion extra for Netscape isn't small change.
You'd never know this from the most common form of accounting for mergers. As all companies do, AOL would like to account for the takeover as a pooling of interests. There's actually some question whether it'll be able to do so, as a Wall Street Journal article last week pointed out. (AOL's deal with Sun Microsystems to sell Netscape software may violate the rules for pooling.)
Assuming it does use pooling, AOL simply takes Netscape's assets and liabilities and lumps them onto its own balance sheet. Whether it costs AOL shareholders $4 billion, $10 billion, or $100 billion doesn't matter--at least not in the accounting. The purchase price never enters onto AOL's books. Is it any wonder companies love pooling?
The big bad alternative is to use purchase accounting, with emphasis on the word "purchase." This accounting treatment forces companies to record the actual purchase price, whether in stock or cash, on their balance sheets. In AOL's case, since it paid $10 billion worth of stock to Netscape shareholders, $10 billion worth of new assets would wind up on AOL's post-merger balance sheet. Some of that $10 billion would be grouped under tangible assets--accounts receivables, property, investments, and so on--and the rest would be lumped into intangible assets, namely goodwill.
The underlying economics are the same whether it's purchase or pooling, but don't try telling that to a CFO. Companies shun purchase accounting for two reasons. First, they must amortize the goodwill gradually over time, which means they gradually reduce the value of the goodwill on the balance sheet, taking a hit to earnings in the process. And companies hate to do that lest short-term investors decide to bolt. Second, returns on assets look much worse if the actual purchase price of an acquisition finds its way onto the balance sheet. As opposed to taking Netscape's puny book value ($400 million or so) and adding it to its own, which it could do under pooling, AOL would have to record its $10 billion purchase price as an asset if forced to use purchase accounting. It's bad enough to pay $10 billion for Netscape. But to be expected to earn a return on that $10 billion!
Then again, is Netscape really a $10 billion asset? Did it really more than double in value in the four months between the acquisition date and the closing of the deal? It just goes to show what funny money Internet shares have become. Companies and their shareholders seem totally indifferent to the price paid in an acquisition--as long as it's paid in shares.
