After the Mergers, The Pain of Goodwill - Barron's

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TECHNOLOGY TRADER

Huge acquisitions by Avago, Facebook, and Microsoft can come back to haunt them with big charges to earnings.

Updated July 3, 2015 12:46 a.m. ET

Its well known by now that the market for technology mergers is running wild withmegadeals. A month ago, chip maker Avago Technologies (ticker: AVGO) announcedthe biggest-ever tech deal, saying it will purchase competitor Broadcom (BRCM) for $37billion.Similar eye-popping price tags, and the billions used to finance them, are just part of thestory. Even more striking is the phantom value, known as goodwill and intangibles, thatis being piled up.These phantom assets have ballooned to tens of billions for leading companies such asFacebook (FB), Microsoft (MSFT), Cisco Systems (CSCO), and Oracle (ORCL) inrecent years, as they have sought to buy assets with seemingly huge potential, butwhose actual value at present is far lower than the purchase price.The upshot is that investors should be particularly cautious about the actual value theysee in the companies mentioned, and the price of their shares.Stocks dont trade on goodwill and intangibles, but when megadeals go wrong, theres adirect hit to a companys earnings and balance sheet, and the intangibles get revalueddownward, a lot.HERES HOW IT WORKS: When a company buys another for a price above thecurrent value of the targets assets, the disparity is recorded on the balance sheet asgoodwill and intangibles. Intangibles are amortized over the course of years, as a costof operations.Goodwill, which can be something as nebulous as an imagined future revenue stream,is checked each year to see if that imagined potential is still as valuable, or if it has lostvalue, which, in the latter case, results in a hit to earnings and a reduction of acompanys assets.We dont yet know the size of the goodwill pile Avago has gotten itself into, as the dealhas yet to close, and the same for other megamergers like Intel (INTC) buying Altera(ALTR), and NXP Semiconductors (NXPI) buying Freescale Semiconductor (FSL).But Microsoft is a great example of a ticking intangibles time bomb. The companysgoodwill has ballooned to $21.7 billion from $12.4 billion five years ago, the result of the$9.4 billion purchase in 2014 of the phone business of Nokia (NOK). As a result of thatdeal, almost $10 billion was added to Microsofts goodwill and intangibles balance.Microsoft has taken some heavy charges in the past. In 2012, it found that the 2007acquisition of advertising network operator aQuantive wasnt going to pay off asexpected. Microsoft took a $6.2 billion charge, a direct reduction to its operatingincome, to pare the value of the goodwill on the books.Sometimes, those losses are the canary in the coal mine: Things are seriously goingwrong with the business. The massive aQuantive charge, for example, came after thesearch-advertising and display-ad business failed to live up to expectations that year.O

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week, the company said it would divest its display-ad business to AOL.The Nokia business may be next. In its most recent quarterly report, the fiscal thirdquarter ended in March, Microsoft said that the unit didnt meet its sales goals.Microsoft said its beginning its budgeting process for the new fiscal year, and itdeclared the Nokia assets to be at an elevated risk of impairment.The writing is on the wall: This will be another multibillion charge for Microsoft. Lesscertain, but a distinct possibility, is that Microsoft may have to reconsider whether itreally wants to fight a losing battle in mobile devices against the overwhelming might ofApple (AAPL) and Google (GOOGL).Maybe that will be seen as a failure for the new era of CEO Satya Nadella, or maybeinvestors will breathe a sigh of relief. But it certainly wont be pretty.ANOTHER GREAT EXAMPLE is Facebook. A year ago, it said it would buy messagingservice WhatsApp for $19 billion, a price that made this column wince, given thatWhatsApp had almost no revenue. Most of the price, $15 billion, was recorded asgoodwill.No one knows what that goodwill really representsFacebook has never laid out theexact logic of the purchase, in dollars and cents. Presumably, CEO Mark Zuckerbergand team envision turning the free service into a source of either advertising revenue orservices revenue. But Facebook did not respond to our request for an explanation.Facebook is a good company, and one with a bright future. The mysterious acquisitionprobably wont dent that future. But just like Microsoft in 2012and, probably, again thisyearFacebook may make new headlines with a similarly awesome hit to earningswhen it finally admits some substantial chunk of the deal was a fantasy.

TIERNAN RAY can be reached at [email protected], http://blogs.barrons.com/techtraderdaily or www.twitter.com/barronstechblog

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After the Mergers, The Pain of Goodwill - Barron's