The Acquisition of Sprint Through the Eyes of These Two Metrics

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

One of the favorite things, I've noticed, that Foolish writers like to do--especially mid-acquisition--is analyze two metrics that they believe are essential in "foreshadowing problems down the road," and I couldn't agree with them more. So, with SoftBank's recent acquisition of Sprint (NYSE: S) (or, at least, 70% of it), I decided to do the same.

A quick history lesson
First off, let's analyze what "problems down the road" really means.

One key term that will contribute to our calculations of these metrics is goodwill: goodwill is simply the difference between a price paid for a company and the net assets of the acquired company. 

Increasing net assets through the addition of goodwill can lead to problems. Because it is intangible, goodwill can dissolve as a result of a merger which doesn't add the value that it was expected to create. A great example occurred in the merger of AOL (NYSE: AOL) and Time Warner in 2000. Two years after the companies joined forces, $128 billion of goodwill was listed on the AOL Time Warner balance sheet, making intangibles 61% of the assets in total.  When that goodwill shrank by about 71%, investors responded accordingly, sending the stock down almost 60%.

How Sprint stacks up
With that case study in mind, let's look at some important values for Sprint:

<img src="/media/images/user_13310/20bb677405d55142398d1872060f563f_large.png" />

The key things to focus on here are the two metrics we are concerned with: Tangible Book Value (the yellow line) and Intangible Assets Ratio (not a line on the graph because it is expressed as a percentage.) The Intangible Assets Ratio at any given point can be found by dividing the total assets of the company (the green line) by its goodwill and intangibles (the blue line.)

Even though it is already calculated for you, Tangible Book Value is simply the result of subtracting goodwill and intangibles (the green line) from Shareholders Equity (the red line). Got it? Good.

So, now that you can visualize it, let's analyze it.

Bad signs for goodwill
Let's start with the intangible assets ratio. This ratio is designed to specify what percentage of a company's total assets are comprised of goodwill and other intangibles. As a general guideline, any value of 20% is considered worrisome because it may mean that SoftBank (in this instance) is, as Hewitt Heiserman, author of It's Earnings That Count, explains, overpaying for the acquisition that gave rise to the goodwill.

A company that has more than 20% of its assets as intangibles means that, if those intangible assets dissolve (as AOL Time Warner's did in 2002,) the company's net assets will shrink significantly. This 20% line ensures that even if intangibles do dissolve, the company can remain in good standing. In general, it isn't usually good for a company to rely on intangibles to boost its net assets.

Sprint's intangible asset ratio is 46%, a value that may suggest that the growth of the company is inorganic. Should their goodwill and intangible assets shrink over the coming years, their net assets will see a devastating hint. This is the problem with relying on intangible assets to fuel total net assets. This should be a pretty big red flag for SoftBank.

Going by the book
The tangible book value is simply the result of subtracting goodwill and intangibles from shareholders' equity. For this value, Heiserman suggests that investors need a positive value, because companies with negative values may be unable to protect themselves from a recession or competitors.

Investors want to see whether the shareholder's equity (or total equity) exceeds the amount of intangibles that the company has. Again, a positive number here signals that the company does not rely too heavily on its intangible assets to make up its balance sheet.

Sprint's tangible book value is -$13.19 billion. Or, as Heiserman might put it, a severe problem. Sprint has such a high goodwill and intangible ratio that itsshareholder's equity doesn't come close to equaling it. Also, let's not forget that the incredible debt and ongoing problems for Sprint have resulted in low total equity as well, regardless of intangibles. Still, this is another warning sign that a slip in intangible values could result in a devastating loss for Sprint.

This being said, not all companies boast strong numbers with these two metrics. AT&T, for example, has values that Heiserman would not approve of. That doesn't mean you should run from all of them. However, companies with debt as serious as Sprint's should be alarming to potential buyers, like SoftBank.

A blast from the past
To put this all into perspective, let's remember the 2005 merger of Sprint and Nextel, a merger that is still used as a classic example in schools as one of the worst moves in history and a decision that spiraled Sprint into chaos. 

Nextel Communication's balance sheet in December of 2004 (not an easy find, may I add) lists the following data for Nextel:

<table> <tbody> <tr> <td> <p>Total Assets</p> </td> <td> <p>Intangibles and Goodwill</p> </td> <td> <p>Shareholder's Equity</p> </td> </tr> <tr> <td> <p>$22.74B</p> </td> <td> <p>$7.22B</p> </td> <td> <p>$9.52B</p> </td> </tr> </tbody> </table>

Using these numbers, we can calculate the intangible asset ratio of Nextel to be about 31%, or rather significantly over our established guideline. It's easy for investors to say that Sprint should have seen this warning sign and backed off: "they could have avoided one of the worst mergers ever!" you may be screaming.

However, a look at the tangible book value confirms a positive value of $2.29 billion, which places a large check mark next to Nextel in this category.

So, in the end of our little test, Nextel came in at one-for-two. Is this good enough for you? It certainly was for Sprint. 

Foolish bottom line
If Sprint has such visible red flags, then why did SoftBank move in for the purchase? Well, good question. The simple answer is that it believes the Japanese market is tapped out, and that there is room to succeed in the American market. We'll see if Softbank is right.

The most important thing to remember is that there is much more to consider in terms of credentials for a company before being purchased. However, these two metrics give us some perspective as to the future path of the company. Do with them as you will.

Michael Nolan has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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