Untouchable Value: The Importance of Intangible Assets
Intangible asset: “An identifiable non-monetary asset without physical substance.”
This is the International Accounting Standards Board’s definition of an intangible asset. Intangible assets are often critical to a company’s success, but this seven-word definition, unfortunately, does not shed much light on this important class of assets.
To be fair, IAS 38, which is the full standard that describes the accounting treatment of intangible assets, is much more descriptive. The standard provides considerable detail about how firms should go about identifying, measuring, and amortizing intangible assets. Still, the accounting treatment does little to help us assess the role that intangible assets play in a company’s future cash generation. As intrinsic-value investors, future cash generation is what matters most to us.
Some examples of intangible assets mentioned in IAS 38 include a company’s collection of brands, patents, and copyrights. The following table provides several examples from our International strategy of each of these types of intangible assets.
Intangible assets such as these are routinely valued and aggregated as a line item on a company’s balance sheet. However, the accounting value presented on the balance sheet often significantly understates the economic value of a company’s intangible assets for a variety of reasons. Moreover, even a company’s full financial statements provide us only a surface level understanding, at best, of how intangible assets contribute to the company’s competitive position, growth prospects, and, ultimately, intrinsic value.
|Type of Intanglible Asset||
|Examples of Intangible Assets Owned|
|Brands||LVMH Moet Hennessy Louis Vuitton||Louis Vuitton, Dom Perignon, Bulgari and other premier luxury goods support LVMH’s consistently strong free cash flow.|
|Diageo||Diageo has collected numerous well known spirits brands including Johnny Walker, Captain Morgan and Ketel One.|
|Beiersdorf||Nivea, Aquafor, Eucerin, and La Prairie are proven brands with ample growth opportunities.|
|Patents||Samsung||Patents spanning semiconductor, display and mobile technologies support Samsung’s strong position in multiple industries.|
|Numerous drug patents including GSK’s blockbuster Shingles vaccine Shingrix support
GSK’s improving industry position.
|Safran||An extensive patent portfolio helps protect Safran’s narrow-body jet engine franchise and
long-tail service revenue stream.
|Copyrights/Trademarks||Walt Disney||Mickey, Yoda, Cinderella and countless other iconic characters underpin Disney’s powerful media franchise.|
|Vivendi||Music streaming services like Spotify have raised the value of Universal Music Group’s
massive copyright-protected song catalog.
|Formula One||A new management team is revitalizing an already strong Formula One franchise, setting a
path for long-term growth.
Who Are You
Consider portfolio holding Unilever. The consumer goods giant sells a wide assortment of personal care, home care, and food products used by more than two billion consumers every day. In fact, 12 of Unilever’s brands generate at least $1 billion in annual sales. U.S. investors likely recognize brands such as Dove, Lipton, and Breyers, although the company’s entire portfolio encompasses roughly 400 brands globally. These brands are inextricably linked to Unilever’s competitive position and future growth prospects. Last year, Unilever generated more than 50 billion euros in sales and 5 billion euros in free cash flow. The company’s vast portfolio of well-known brands, strong brand management, and deep understanding of local markets gives us confidence that Unilever will generate strong free cash flow for many years.
In 2018, Unilever ascribed roughly 12 billion euros in value to intangible assets on its balance sheet and 10 billion euros in value to all its property, plants, and equipment. While it’s notable that Unilever’s intangible assets command a higher accounting valuation than its property, plants, and equipment, we would argue that 12 billion euros dramatically understates the true value of the company’s intangible assets.
Imagine that you were offered the choice between purchasing all of Unilever’s intangible assets, including all brands, patents, copyrights, customer lists, and proprietary information for 12 billion euros, or purchasing all the firm’s tangible assets, including all manufacturing plants, research and development facilities, distribution sites, and corporate offices, — for 10 billion euros? Which would you choose to buy?
The answer should be clear. Consumers buy Dove body wash and Breyer’s strawberry ice cream because they know what to expect when they consume the products. In short, they know the brands. Assume we’ve purchased Unilever’s intangible assets. We therefore own these brands, along with around 400 others, and all the intellectual property needed to make all of Unilever’s products. We can easily purchase manufacturing capacity to produce the products, lease warehouse space to store the products, and convince retailers to put our products on their shelves given that they know there is strong consumer demand for Unilever products. In fact, the sales process will be expedited because we also own customer lists and proprietary information related to sales, forecasting, and product placement. All we need is some financing to hire staff and build out inventory and we’ll have a global consumer products business up and running.
Now let’s assume that we own all of Unilever’s physical assets, and therefore have all the infrastructure in place to create, manufacture, and distribute a diverse portfolio of products to 70 different countries. What would we do? We own no recognizable brands. Consumers have no idea who we are. We can hire a smart team of product developers, marketers, and sales professionals, but we’re still a startup. We have to build a product portfolio from scratch while competing with established consumer goods firms like Procter & Gamble for limited shelf space at powerful retailers like Walmart. Additionally, we have massive excess capacity that we just purchased for 10 billion euros that needs to be put to use. We’re in for a long, difficult journey, and we’ll almost certainly fail.
With or Without You
As intrinsic-value investors, we are most interested in how intangible assets impact a company’s future cash generation. Some intangible assets can be linked directly to a future stream of cash flows and valued on a standalone basis in a straight-forward manner. Drug patents are an example.
Novartis owns patents on the highly successful psoriasis drug Cosentyx. Our international health care analyst, Chendhore Veerappan, forecasts a stream of future revenue associated with Cosentyx by estimating the patient population for all potential treatment indications, Cosentyx’s market share, and pricing through the life of the drug’s patents. He then anticipates a period of decline after the patents expire and biosimilar competition takes hold. As Chendhore receives new information, he updates his forecast accordingly, so that we always have a current opinion of the long-term revenue and profit outlook for Cosentyx. While we don’t explicitly value Cosentyx, we could readily do so using Chendhore’s forecast.
If Novartis were to sell its Cosentyx franchise, we could compare our estimate of Cosentyx’s value with the price Novartis was able to capture. We then would have an informed opinion as to whether the transaction was value additive or destructive. Moreover, our new estimate of Novartis’s intrinsic value would be straightforward to calculate. All else equal, we would simply subtract the value of the Cosentyx drug franchise from Novartis’s intrinsic value and add the cash Novartis received in the transaction.
Copyrights are another example of intangible assets that can be linked to future cash flows. The majority of media company Vivendi’s intrinsic value comes from the music label Universal Music Group (UMG). UMG owns a large collection of copyrights, including some of the most popular songs in history. Its collection includes music from the Beatles, Taylor Swift, Kanye West, and Nirvana. UMG collects royalty payments based on its share of music consumption on streaming services like Spotify and Apple Music. In aggregate, these payments sum to billions of dollars in revenue each year and allow UMG to participate in music streaming’s secular growth.
Relative to Cosentyx, it is difficult to gain as much confidence in our long-term forecast of UMG’s royalty revenues due to how quickly the music industry is evolving. But like Cosentyx, we can also observe how much industry participants would pay to acquire UMG and evaluate our estimate of Vivendi’s intrinsic value accordingly. For Novartis and Cosyntex, our example is purely hypothetical. In contrast, Vivendi recently agreed to sell 10% of Universal Music Group to a consortium led by Chinese internet and media giant Tencent (another portfolio holding) based on an enterprise value of 30 billion euros for UMG’s entire business.
Never Tear Us Apart
Many intangible assets are inextricably linked to other assets owned by a company. Intangible assets are therefore often difficult, if not impossible, to value effectively on a standalone basis. Consider portfolio holding British Telecom (BT). The company is the largest fixed-line and mobile service provider in the UK, with millions of home broadband and mobile phone customers. The average customer subscribes for more than five years, and BT’s customer base is therefore a valuable intangible asset. However, BT maintains its customer base only because its customers generally perceive BT’s services to be at least as reliable and fairly priced as alternative options. BT can meet these customer expectations while generating acceptable returns on capital because it already owns a well-developed network infrastructure.
If a new entrant were to buy BT’s customer base, it would still need to invest tens of billions of pounds to build a network. Since it would take many years to build a network that could support all of BT’s customers, the upstart would also have to lease network capacity from competitors for several years to satisfy customer requirements. The economics simply wouldn’t work. Therefore, BT’s customers are far more valuable to BT than they are to a firm that does not already own a network.
Portfolio holding Walt Disney provides another example. The business’s future cash flows are dependent on its rich collection of intangible assets, highlighted by iconic characters and stories as well as consumers’ trust in Disney’s brand to deliver high-quality entertainment. While each character has standalone value, Disney benefits from owning numerous characters that it can monetize through theme parks, retail sales, cable channels, and now, streaming services. Cinderella, for example, is far more valuable under Disney’s ownership than she would be if owned by a different firm. Moreover, because consumers know and trust Disney’s brand, the company is more likely than a competitor to popularize the next princess and build another lasting character franchise.
So Much to Say
We have only scratched the surface on the importance of intangible assets, and we expect to revisit this topic in the future. These assets play a crucial role in a firm’s competitive position, corporate strategy, and future cash generation power. As intrinsic-value investors, we consider all important corporate assets when assessing a business’s durability and long-term earnings power. In today’s world, intangible assets are often foundational elements of intrinsic value.
Originally published on January 1, 2020
As of November 30, 2019, Diamond Hill held Beiersdorf AG, BT Group PLC, Diageo PLC, GlaxoSmithKline PLC, Liberty Media Corp. Series C Liberty Formula One, LVMH Moet Hennessy Louis Vuitton SE, Safran S.A., Samsung Electronics Co. Ltd., Tencent Holdings Ltd., Novartis AG, Procter & Gamble Co., Unilever N.V., Vivendi S.A., and Walt Disney Co. (all Long holdings); and Walmart, Inc. (Short).
The views expressed are those of the research analyst as of January 2020, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.