Microsoft Recognizes A Multi-Billion Dollar Error (MSFT, GOOG, IBM, ORCL)

Relative to companies like Oracle (Nasdaq:ORCL) and IBM (NYSE:IBM), Microsoft (Nasdaq:MSFT) is perhaps not as acquisitive as investors might expect for a company of its size. Coupled with top-line growth that is not exactly robust, it would seem to set up the question as to why Microsoft isn't more active. Perhaps the announcement of a $6 billion goodwill writedown in the Online Services business goes some way toward explaining it.

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Paying the Price for a Bad Deal ... Twice
When Microsoft acquired aQuantive for $6.3 billion in 2007, there were a few objections to the hefty price tag (approximately 14 times sales, and an 85% premium). Bulls countered that it was a necessary deal for Microsoft to carve out an attractive position in the fast-growing online advertising space that companies like Google (Nasdaq:GOOG) and Yahoo! (Nasdaq:YHOO) also coveted.

SEE: Advertising, Crocodiles And Moats

Unfortunately, this deal has never really worked out. Microsoft continues to trail Google in the online ad space (and by a sizable margin), and Microsoft's online business has never shown all that much momentum or strength. And now another nail is being hammered home. As part of the company's year-end audit process, the company is required to test the goodwill it carries as an asset on its balance sheet. The details of this process go beyond this article, but Microsoft has determined that the earnings potential and carrying value of the asset is not what it once was. As a result, the company will write down $6.2 billion of the goodwill carried in the online services business. This charge will not affect the cash earnings of the business, nor is it likely have any meaningful influence on future growth expectations.

SEE: Can You Count On Goodwill?

Another Reminder That Value Matters?
Microsoft isn't the first company to see a major write-down tied to an ill-fated acquisition, and it most certainly won't be the last. There are already some signs, for instance, that Hewlett-Packard's (NYSE:HPQ) acquisition of Autonomy has not gone completely to plan and that HP may have overpaid.

This is especially an issue with growing software companies - much of the value lies in company reputation, employee expertise and other intangible assets. What's more, growth is so highly prized by the Street that these assets seldom trade cheap.

SEE: Did Facebook Overpay For Instagram?

It doesn't help matters that it can be difficult to trace back the true value added by deals. Google's ongoing online success has seemingly made the price paid for DoubleClick a moot point, and it must be noted that Microsoft has done numerous small deals over the years - many of which have been worthwhile. If there's any lesson, then, it may just be that paying high premiums meaningfully increases the risk of the deal. This is hardly a revelation, but it does seem to be a lesson that bears repeating to company CEOs.

SEE: Biggest Merger And Acquisition Disasters

The Bottom Line
Time will tell if Microsoft's Skype deal ultimately follows the same path as aQuantive did. At a minimum, the difficulties in making a go of the online services business should serve as a warning to those pushing for the company to acquire Nokia (NYSE:NOK) or Research In Motion (Nasdaq:RIMM) as a way to close the gap with Apple (Nasdaq:AAPL). Although Oracle and IBM have arguably done well with deals that looked a little pricey at the time, they were at least deals that fit in with pre-existing competencies at both companies.

The final accounting aftermath of a deal long since recognized as unsuccessful really has no bearing on Microsoft's ongoing value. Microsoft remains a company that looks undervalued, but also deficient in growth - a difficult combination in tech. While patient investors may see this value come to fruition, there could be more risks here if management gets impatient and tries to use additional high-value deals to boost its growth rate.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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