Let’s Impair That Goodwill

Caveat Ballmer, or something.

Microsoft made waves recently by disclosing in its quarterly 10-Q document that its Phone business, which generates billions in yearly revenue, isn’t performing as well as it expected. As Microsoft is carrying billions of dollars of goodwill related to the Nokia purchase on its books, the warning landed like a brick in a puddle of lukewarm slop.

History as prelude in this case is the aQuantive boondoggle, during which Microsoft wrote of billions of dollars of value relating to that purchase. As Business Insider’s Matt Weinberger recently wrote: “[T]he last time Microsoft used language like this in an earnings report was back in 2012, three months before it took a $6.2 billion charge to its bottom line for its aQuantive acquisition.”

So the tea leaves aren’t bright. Let’s take a look at the potential impact of a write down.

What The Hell Is Goodwill, Nokia Edition

Good question. According to Investopedia, goodwill is “[a]n intangible asset that arises as a result of the acquisition of one company by another for a premium value.” Or, put more simply, it’s the value you doodle onto your balance sheet after you buy something and can’t count every dollar you paid for as resulting in material assets.

Microsoft currently counts quite a lot of goodwill as an intangible asset on its books. In its most recent quarters, the dollar amount of goodwill sourced from the Nokia deal, in which Microsoft bought the majority of the Finnish company’s hardware assets, sat around the $5.4 billion mark. That’s about a quarter of the company’s total goodwill, which it reports as just over $21.7 billion.

To put that in perspective, Microsoft has around $95 billion in cash and equivalents.

How Do You Calculate That?

How do you calculate the amount of goodwill that Microsoft should carry? The company is somewhat brief in explaining why it has goodwill at all from the Nokia deal. Here’s the quote from its most recent quarterly report:

Goodwill was assigned to our Phone Hardware segment. The goodwill was primarily attributed to increased synergies that are expected to be achieved from the integration of NDS.

That doesn’t help much. Let’s take a look from the other side, and see how Microsoft describes what has gone wrong to understand how it thought things were going to go right — that ‘going right’ bit is where the theoretical value of the goodwill is stored, of course.

Here we go (emphasis mine):

The valuation of acquired assets and liabilities, including goodwill, resulting from the acquisition of NDS, is reflective of the enterprise value based on the long-term financial forecast for the Phone Hardware business. In this highly competitive and volatile market, it is possible that we may not realize our forecast. Considering the magnitude of the goodwill and intangible assets in the Phone Hardware reporting unit (see Note 8 – Business Combinations of the Notes to Financial Statements), we closely monitor the performance of the business versus the long-term forecast to determine if any impairments exist in our Phone Hardware reporting unit. In the third quarter of fiscal year 2015, Phone Hardware did not meet its sales volume and revenue goals, and the mix of units sold had lower margins than planned. We are currently beginning our annual budgeting and planning process. We use the targets, resource allocations, and strategic decisions made in this process as the inputs for the associated cash flows and valuations in our annual impairment test. Given its recent performance, the Phone Hardware reporting unit is at an elevated risk of impairment. Declines in expected future cash flows, reduction in future unit volume growth rates, or an increase in the risk-adjusted discount rate used to estimate the fair value of the Phone Hardware reporting unit may result in a determination that an impairment adjustment is required, resulting in a potentially material charge to earnings.

This is better. Not for Microsoft’s future earnings, of course, but for our understanding. In short, Microsoft had certain financial goals in place for Phone, predicated on handset volume, revenue and implied profit (margins). And Phone, as a group for Microsoft, isn’t doing well in those areas.

Microsoft sold 8.6 million Lumia handsets in the quarter, generating revenue of $1.4 billion. Lumia volume was up 18 percent year-over-year. It seems that Microsoft had anticipated quicker sales and stronger price points. The company is driving volume with lower-cost handsets, which lowers its average selling price and, likely, margins.

Let’s Talk Pain

Microsoft may not be forced to write down any goodwill relating to the Nokia deal. Or it may have to write down quite a lot. In terms of scale, how bad could the damage be?

A massive write down could tank a quarter of the company’s profit, using normal accounting methods (GAAP). Using adjusted metrics, Microsoft could take the non-cash charge in stride, more shamefaced than materially castigated.

On a GAAP basis, things get more interesting. The $5.4 billion in goodwill that the company currently counts as an asset is more than the company’s last-quarter GAAP profit. So, in theory, a massive write down could erase a full quarter’s profits both per-share and in aggregate.

We can look back to the aQuantive write down to see the potential impact. Here’s Microsoft, from the fourth quarter of its fiscal 2012 (emphasis mine):

Microsoft Corp. today announced quarterly revenue of $18.06 billion for the quarter ended June 30, 2012. Operating income and loss per share for the quarter were $192 million and $0.06 per share.

The financial results reflect the previously announced non-cash, non-tax-deductible income statement charge of $6.19 billion for the impairment of goodwill and the deferral of $540 million of revenue related to the Windows Upgrade Offer. Adjusting for these items, non-GAAP fourth quarter revenue, operating income, and earnings per share were $18.60 billion, $6.93 billion, and $0.73 per share, which represented increases of 7%, 12%, and 6%, respectively, over the prior year period.

In short, the write down essentially erased the company’s profit for the quarter. When one of the most valuable companies in the world reports non-GAAP earnings, things are odd.

So What

The actual impairment of goodwill, if it happens, is likely a smaller deal than the implied lackluster performance of the Phone group itself. Microsoft has invested billions into growing its mobile market share. Instead, the company has managed to merely defend a few points of global market share.

Losing a non-cash asset to a company as wealthy and profitable as Microsoft isn’t the end of the world. But it would point out yet again that Microsoft is still not a mobile success. And that, much more than a bit of goodwill impairment, is dangerous.

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