Qualiport

[ August 18, 2000 ]

Misys Goodwill

By Maynard Paton (TMFMayn)

Carburton Street, London -- If I were forced to sell any Qualiport member today, it would be Misys (LSE: MSY). The IT company doesn't have the greatest of investment qualities -- a toppy valuation, an uninspiring acquisitive history and, as we'll see, a mundane return on equity performance.

With Misys shares edging slightly higher after the group's full-year results, I'm keeping a watching eye should the company ever become "grossly overvalued".

Anyway, after admitting to being uncomfortable holding Misys shares, I promised to dig deeper into the company's acquisitions, goodwill and resulting return on equity in more detail.

Although I'm aware that this may seem to be going over "old ground" a little, the actual details of Misys' history of acquisitions and accounting practices do, I feel, need to be aired. It all adds up to an intriguing goodwill case study.

(As a refresher to the importance and interpretation of goodwill, and the associated jargon, you may wish to read the Qualiport's Goodwill Guide first)

Read the accounting small print...

This is how Misys presented their shareholders' reserves in the 1998 annual report, using the old SSAP 22 presentation practice.

Capital and Reserves                 1998       1997
                                     (£m)       (£m)

Share capital                         5.6        4.3
Share premium reserve                17.2       12.1
Profit and loss reserve              17.9       49.0
                                     40.7       65.4

Goodwill reserve                   (393.8)    (263.6)
Shareholders' deficit              (353.1)    (198.2)

Misys made a £66m profit after tax during 1998. So from the above figures and adjusting for goodwill, the company's return on average equity (ROAE) is calculated at 17.4% (£66m / ((£40.7m+ £393.8m + £65.4m + £263.6m) / 2)).

Eagle-eyed investors would probably raise an eyebrow at the above table. If Misys made a profit in that year, why has the profit and loss reserve (reflecting all earnings retained within the business) declined from £49m to £17.9m? It's all to do with Misys applying a very unusual accounting practice prior to the late-1998 introduction of FRS 10.

Movements in the reserves

Up to and including 1998, Misys would annually "appropriate" a portion of its goodwill reserve to the profit and loss reserve. This was purely a book-keeping transaction that had no effect on cash flow. But this practice continues to have a disruptive effect on today's ROAE calculations.

Here's how the "appropriation" worked, again using Misys' 1998 accounts.

Reserves                         Profit and Loss   Goodwill
                                    Reserve        Reserve
                                     (£m)            (£m)

At 1st June 1997                     49.0           (263.6)
Profit retained for the year         13.4                -
Goodwill written off                    -           (216.1)
Goodwill written back                   -             37.9
Appropriation                       (44.6)            44.6
Other                                 0.1              3.4
At 31st May 1998                     17.9           (393.8)

The effect of the £44.6m appropriation is significant for ROAE calculation purposes. The movement artificially decreases the size of both the profit and loss reserve and the goodwill reserve. If we ignore the appropriation, the profit and loss reserve would have been £62.5m and the goodwill reserve would have been £438.4m.

Using this revised reserve calculation, ROAE adjusted for goodwill would now decline to 15.9% (£66m / ((£62.5m+ £438.4m + £65.4m + £263.6m) / 2)).

Window dressing

Of course, the 1997 "starting" figures for that ROAE calculation were affected by a previous appropriation too. So again, adjustments would also have to be performed for 1997's £49.0m profit and loss reserve and £263.6m goodwill reserve too. And then the figures from prior years will also have to be altered for their appropriations...

Adjusting for the rather underhand appropriation movements will give a more accurate reflection of the underlying ROAE performance of today. Needless to say, the further you go back in time, and the more "appropriation adjustments" made, so the decrease in ROAE at Misys will become ever greater. And when the 1998 figure of 15.9% isn't too hot in the first place, you can see my concerns.

The trouble with this historic appropriation practice is that the investor has to travel back several years, perform numerous adjustments, to then arrive at a realistic figure for the profit and loss reserve. Once this has been determined, only then can the current (and accurate) ROAE be deduced. This balance sheet "window dressing" of yesteryear adds further fuel to my aversion towards Misys.

Growth by acquisition

Rather than fiddling about with several year's worth of accounting appropriations, Misys' acquisitive history lends itself nicely for an incremental return on equity http://www.fool.co.uk/qualiport/2000/qualiport000126.htm type calculation.

Here's the company's acquisition expenditure and resulting goodwill since 1992.

Year       Cost      Goodwill created    Reported Earnings
           (£m)           (£m)                 (£m)

1992       4.5             5.2                 8.9
1993       9.5            10.0                10.5
1994      41.0            46.4                13.0
1995     195.0           285.7                18.6
1996       3.7             7.2                36.8
1997     108.2           121.9                45.9
1998     605.4           549.1                65.8
1999      42.5            37.8                93.1
2000      83.0           100.1                85.0

Total   1092.8          1163.4

Misys have spent £1.1b on acquisitions since 1992. Over the same period, the group has managed to generate an additional £76.1m of earnings. The resulting 7% "incremental return on acquisition costs" is very poor.

Revisiting Misys' acquisition of Medic in 1998 easily explains part of the reason behind the dire performance. Medic originally cost £580m and now produces earnings of around £20m. Therefore, the return on that £580m expense is just 3.4%.

Granted, debt has been used to fund some of the corporate purchases. Any borrowings would have reduced the burden borne by shareholders in funding the company's growth, and so increase the aforementioned 7% return on acquisition costs. But, by and large, it's been shareholders' money (via rights issues and retained profits) that has been used to jack up the profits.

Although recent purchases still have to come up to speed, the ongoing nature of the Misys corporate activity suggests that this will always be an ROAE factor. And that being the case, not making any adjustments in this respect is perhaps a more prudent policy.

Run of the mill

From these and other rough calculations, I suspect Misys' ROAE, adjusted for goodwill, is somewhere around the 10% mark. Because of the company's corporate history and accounting practices, it's impossible to calculate the ROAE figure exactly.

In short, there's nothing to suggest that Misys is anything other than a run-of-the-mill company when it comes the all-important equity reinvestment performance.

For me, the only real question mark about Misys is judging the level of "gross overvaluation". At a share price of 727p, the shares perch on a prospective price to earnings ratio (P/E) of nearly 40. As I wrote earlier, I'm keeping a watching eye should the company ever become grossly overvalued.

Where next?

• Review the latest annual results from Misys.
• Visit the Misys discussion board | website