(Bloomberg Gadfly) -- Lenovo Group Ltd. has a serious problem on its hands.
It's a problem that could wipe out this year's earnings and even threaten profits next year and beyond.
Despite spending more than $5 billion in a series of acquisitions four years ago, Lenovo's attempts to bolster its mobile and server businesses haven't amounted to much. Its income statement has shown management's flailing attempts to make good on promises, which included wringing a profit out of its new mobile division within six quarters of purchase, and reaching $5 billion in annual sales from its server (aka enterprise) division.
But investors focusing on Lenovo's P&L may be missing an iceberg on its balance sheet. Lenovo paid massive premiums for the Motorola Mobility smartphone and IBM server businesses in 2014, and the goodwill section of the balance sheet is where these markups sit. This is common, because buyers usually bid up the value of the assets they're pursuing, and you can think of goodwill as the "overpaid" column in the spreadsheet. For Lenovo, the result was a sudden doubling to more than $5.2 billion.
Buying assets and booking goodwill isn't a problem if the new divisions add value, usually through profits, or economies of scale that boost margins or cut costs. With the Motorola and IBM acquisitions, though, that clearly wasn't the case. So it's more likely than not that the current fair value of those units is less than the carrying amount Lenovo ascribes to them.
I choose these words carefully, because "more likely than not" is the term the Financial Accounting Standards Board uses to assess whether a goodwill impairment needs to be made. The IFRS Foundation, which also issues financial reporting guidelines, is a little more blunt in its IAS36 standard:
An asset must not be carried in the financial statements at more than the highest amount to be recovered through its use or sale.
Among the indications of impairment, according to the accounting firm Deloitte LLP, is whether the asset returns "worse economic performance than expected."
There's absolutely no doubt, based on management's previous public statements, that those units bought at a cost of $5 billion are performing worse than expected. What's extraordinary is that after four years Lenovo hasn't recognized such impairment and allows the goodwill to sit on the balance sheet.
Reporting standards only require a test of goodwill to be done annually, so it's reasonable not to see anything announced in the past few quarters. But the company's financial year is coming to an end March 31, so the clock is ticking.
You can understand management's reticence. After a slew of deals in the late 2000s, Acer Inc., a Taiwanese PC maker, clung to inflated goodwill figures despite clear signs that the acquisitions weren't bearing fruit. In the end, it had to conduct an IAS36 impairment test and recognized a NT$9.4 billion ($335 million) writedown, enough to plunge Acer into a record annual loss and spur the ousting of its chairman and CEO.
That impairment was equivalent to about 24 percent of Acer's total intangible assets at the time. For Lenovo, I calculate it would take a mere 10.3 percent writedown to push it into a loss for the current fiscal year -- and that's only for an impairment on goodwill, and only at the mobile and server divisions. A deeper, 20 percent impairment on those units would bring about a record annual loss.
When Lenovo reports third-quarter earnings this week, expect management to focus again on its awesome PC division, and to continue talking up the prospects of the mobile and server units. But listen carefully for any mention of goodwill, and be worried if you hear nothing.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Tim Culpan is a technology columnist for Bloomberg Gadfly. He previously covered technology for Bloomberg News.
To contact the editor responsible for this story: Paul Sillitoe at psillitoe@bloomberg.net.
©2018 Bloomberg L.P.
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