Can Goodwill Be a Bad Thing?

By William Bias - September 3, 2012 | Tickers: AMZN, EBAY, MSFT | 0 Comments

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Let me pose a question: Can goodwill be a bad thing?

I am not saying a company can’t have too much goodwill towards a customer, employee or vendor. That would be detrimental to the success of the business. I am talking about an intangible asset that appears on a company’s balance sheet. Let me define what goodwill is from an accounting standpoint. Goodwill occurs when an acquiring company pays more than the fair value of the net assets (assets-liabilities)for another company. If you see a company that is piling on goodwill on their balance sheet year after year; then more scrutiny is required because it can have an impact on your investments.

Why Do Companies Incur Goodwill?

A lot of times companies pay a premium above net asset value because the target company has a portfolio of products that can complement or expand upon the current lineup of the acquiring company. For example, in 2009 Amazon (NASDAQ: AMZN) acquired Zappos.com for $ 1.1 billion creating goodwill of $778 million. The acquisition expanded Amazon’s entrance into the apparel and footwear market.

Other times companies incur goodwill because the acquiring company wants the technology of the target company that would give them an edge or augment the overall strategy of the acquiring company. For example in June 2011 eBay (NASDAQ: EBAY) acquired GSI and paid $2.4 billion and incurred $1.5 billion in goodwill. GSI is an online platform that enables other companies to sell online and have e-commerce. GSI had a sports merchandising business as well as other businesses that were divested. eBay wanted to leverage GSI’s e-commerce platform. This highlights their overall strategy of bringing buyers and sellers together on the internet and taking a cut for any transaction that may occur.

The most well known example is Microsoft’s (NASDAQ: MSFT) acquisition of aQuantive in 2007 for $5.9 billion and recording goodwill of $5.2 billion. Microsoft wanted a company to be added to their online search division that could aid them in serving up ads on their search engine. Of course, this acquisition didn’t pan out for Microsoft.

Impairment of Goodwill

Impairment of goodwill happens when a company evaluates the balance sheet of the acquired business. If the fair value of the net assets of the acquired company is determined to be less than the carrying value then goodwill is considered impaired. This usually happens when the acquired business is expected to generate a lower return on investment than anticipated. Impaired goodwill is a non-cash charge (see graph below) that lowers net income, goodwill and is not tax deductible. Goodwill impairment affects Wall Street’s perceptions because of lower net income, but it is also an indication that a company made a bad strategic decision in acquiring the business.

MSFT Net Income TTM data by YCharts

The most famous recent example is Microsoft’s $6.2 billion write off “related mainly” to the 2007 aQuantive acquisition. Since only $5.2 billion was recorded as goodwill in the aQuantive acquisition the other $1 billion must have been goodwill for other acquisitions within the online division. Microsoft’s revenue has been growing in its online search division but they have had a hard time making it profitable due to intense competition. This made the fair value of aQuantive's net assets less than the carrying amount of the assets on their balance sheet. So this caused Microsoft to determine their assets were impaired.

In 2007 eBay impaired goodwill by about $1.4 billion on their Skype acquisition. eBay simply had a hard time working the technology into their platforms. It simply didn’t complement anything they had very well. I think it was their intention to enable buyers and sellers on their auction sites to see each other when they bought and sold. Failure to meet expectations made the fair value of Skype’s assets significantly less and they impaired the goodwill.

Microsoft purchased Skype in Oct. 2011 because they felt that they could integrate their voice communications into xBox consoles and productivity software. They paid $8.6 billion dollars for Skype and $7.1 billion was goodwill. My hope here as a Microsoft shareholder is that they won’t repeat the past mistakes of eBay by not being able to successfully integrate it into their other products. Otherwise we will have more major goodwill impairment on our hands.

Conclusion

When a company has a lot of goodwill on its balance sheet then it is worthy of investor’s scrutiny. It could be an indication of strategic errors. Goodwill means first and foremost that the acquiring company paid a premium for the target company’s assets. They pay this extra amount for companies that produce products, services and technology that can complement their own business. However, if the acquisition looks out of place with the rest of the business then a likelihood of impairment is increased because of the acquiring company’s inability to leverage the acquisition. If impairment does occur it affects net income, but not cash flow, and is not tax deductible. A lower net income can sour attitudes on Wall Street, reduce a stock price, and thus its return. If impairment occurs too frequently then it affects long-term performance. So yes, goodwill can be a bad thing.

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