2009-10-13

On Capitalizing Expenses -- a Practical Example

This article originally appeared on The DIV-Net on October 6th, 2009.

Recently, we talked about the need for investigating capitalized expenses. Now, let's illustrate that with a current example.

Formula Systems (FORTY) is a software and technology company engaged in software consulting services, developing software products and providing computer-based business solutions. Software development means paying software programmers to write code. The end product is the virtual concept of software.

As of the end of 2008, FORTY had a reported book value of $170M and has been trading in the last four months between $84M and $122M. At first glance, it seems like a bargain.

According to the company, FORTY capitalizes "development costs of software which is intended for sales that are incurred after the establishment of technological feasibility of the relevant product". They also start to amortize capitalized software development costs "when the product is available for general release to customers". Typical amortization period is 3-5 years.

Sounds reasonable. Until one thinks about the nature of software. Unlike a building or a factory, as in our previous example, software has a dynamic nature that is unpredictable -- a new one can quickly obsolete the old one, much faster than 3-5 years.

Also, software development costs vary widely. What one company paid to develop one can seem like fortunes to another, more efficient developer. It's unlikely that a software without a moat such as Windows or Google Search can fetch a lot of money if sold to an informed buyer, especially since new programming technology can also change the cost of building new applications.

Going back to its most recent annual report, FORTY had at the end of 2008, $46M of capitalized costs and other deferred charges listed as "Other Assets".

It also had $143M of goodwill from two acquisitions that are not amortized since 2002 but instead tested for impairment every year. Moreover, the value of these assets is calculated based on future cash flows expected in the future, like our sprocket factory example in Part I of this article. We concluded then as we conclude now, that this type of valuation can be very misleading, since the future is unknown.

So, what's FORTY worth without capitalized costs? Let's subtract all the capitalized costs and assume the software is worthless at liquidation: $170 - 46 = $124M. That's more inline with its current market value.

Now assume that we don't fully trust the company's estimate of the fair value of their goodwill. If we subtract $143M, the company is worth nothing. Of course, it must be worth something or they would have been out of business by now. But figuring out what portion of these $143M are inflated is an exercise I prefer not to engage in, especially because what's left after subtracting capitalized costs is already too small a margin for my taste.

For now, I'm passing on FORTY.

Disclosures: None.

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