Facebook Inc (FB) reported third-quarter earnings on Tuesday, exceeding analyst expectations for both earnings and revenue. Investors were more concerned with the social network’s forward guidance however, and FB stock dropped more than 7% in morning trading on Wednesday. The prospect of rapidly rising costs and lower-than-expected sales growth next year sent growth investors running.
While higher costs and less revenue never gets bulls excited, I happen to think Wall Street’s focus is misdirected. The thing FB investors should be most worried about wasn’t the third-quarter report or the company’s forward guidance. It was the $15.3 billion in goodwill Facebook will attribute to the WhatsApp acquisition it announced earlier this year.
WhatsApp Goodwill: An Ominous Warning Sign For FB Stock
WhatsApp, a messaging service that FB acquired for an adjusted $22 billion in February (including stock, cash and future incentives), has been a financially questionable deal from the start. I mean, WhatsApp logged a mere $15 million in sales throughout the first six months of 2014. How much money did it make on those sales? None — it lost $232 million. Even the mighty Facebook can’t afford to be wasting hundreds of millions of dollars every half year.
So why on earth would the social networking powerhouse buy the company to begin with? One way to look at the WhatsApp acquisition is a sort of insurance policy for if and when Facebook itself wanes in popularity.
Regardless, the $15.3 billion in goodwill Facebook will put on its balance sheets next quarter from the WhatsApp acquisition is financially inexcusable, and could be bad news for FB stock in the long-run. Goodwill is an intangible asset on the balance sheet that’s recorded as a result of most acquisitions. Investopedia elaborates:
“The value of a company’s brand name, solid customer base, good customer relations, good employee relations and any patents or proprietary technology represent goodwill.”
Goodwill exists so that when companies make acquisitions and pay a premium, they don’t have to register an immediate, steep loss — they can just claim they bought something “intangible.” As you might imagine, this can raise some major problems.
Hewlett-Packard (HPQ) and its notorious 2011 acquisition of software-maker Autonomy comes to mind. HPQ bought Autonomy for $11 billion in October 2011. $6.6 billion of that $11 billion, or 60% of the acquisition price, was initially recorded as goodwill. Just one year later, the Autonomy acquisition went famously and terribly wrong, as Hewlett-Packard was forced to take an $8.8 billion earnings write-down as a result of its dramatic overpayment.
The write-down was so obscene it sparked a Justice Department investigation, an HPQ stock price meltdown and a number of shareholder lawsuits.
FB stock could suffer a similar fate if WhatsApp doesn’t start proving its value soon. At least Facebook vowed to review WhatsApp’s goodwill annually, putting pressure on the messaging app to make itself worthwhile, and quick.
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As of this writing John Divine held no positions in any of the stocks mentioned. You can follow him on Twitter at @divinebizkid.
