One line on Salesforce's balance sheet gives a clue to the premium it's paying for its acquisitions - and the growing risk behind that strategy

• Salesforce's goodwill balance, or the premium it paid beyond the book value of its acquisitions, jumped to $25 billion last quarter.
• That's nearly twice the size of the previous quarter's balance, bringing it to over half of the company's total assets for the first time.
• Most of the increase in Salesforce's goodwill last quarter came from the $15 billion Tableau acquisition.
• The large goodwill balance shows the massive market opportunity and potential returns Salesforce sees in its acquisitions, but it also adds risk, as it could be written off as a loss.
• Some experts say it could be a sign that Salesforce is overpaying for these acquisitions by assigning them too much value for intangible assets like customer loyalty.
• Click here to read more BI Prime stories.

A closer look into Salesforce's goodwill balance shows how far the software company is willing to go for acquisitions - and the potential risk that comes with it.

Salesforce's goodwill balance, or the premium it paid for beyond the book value of its acquisitions, has ballooned to $25 billion in its most recent quarter, the company said in a filing last week. That's nearly twice the size of the previous quarter's balance, bringing it to over half of the company's total assets for the first time.

Most of the increase in Salesforce's goodwill last quarter came from the $15 billion Tableau acquisition. Goodwill from that deal accounted for $10.7 billion, or roughly 70 percent of the acquisition price, company filings show. Salesforce said in the filing that goodwill is "primarily attributed to the assembled workforce and expanded market opportunities."

The large goodwill balance shows the massive market opportunity and potential returns Salesforce sees in its acquisitions. But it also adds risk, as goodwill is tested for impairment every year, and is written off as a loss when those returns don't turn up as expected.

"The soaring goodwill signals Salesforce's strategy of growing by acquisition and reflects the premium prices paid for the target companies," J. Edward Ketz, an accounting professor at Penn State University, told Business Insider. Indeed, co-CEO Marc Benioff has indicated that acquisitions are a pillar of Salesforce's strategy to double its revenue within 5 years.

"But there's the rub - if such future excess returns do not materialize, it will require at some point impairment losses on the goodwill, thereby lowering earnings," Ketz said.

A representative for Salesforce declined to comment on this story.

What is goodwill?

Goodwill is recorded when a business buys another company for more than the value of the hard assets on the target's balance sheet. That premium accounts for intangible factors like customer loyalty and workforce quality, rather than hard numbers like a company's share price or its revenue.

If, however, a company's accountants find in later assessment that those intangible factors were overvalued, a company might take an impairment, meaning they take a big write-off on some or all of the deal.

It's rare that goodwill impairments happen soon after an acquisition, but there is some long-term risk: Tech giants, like Microsoft and Hewlett Packard, had to write off billions of dollars in recent years after their respective acquisitions for Nokia and Autonomy failed to work out. Last year, Verizon wrote off $4.6 billion of its Oath business, which includes Yahoo.

Goodwill write-offs, in fact, are growing among publicly traded companies in the U.S. In 2018, total goodwill impairment of U.S. publicly traded companies reached $78.9 billion, more than twice the previous year's figure and the highest level since the 2008 financial crisis, according to last month's report by valuation firm Duff & Phelps. Much of the impairment in 2018 came from General Electric's $22.1 billion write-off, but even without it, the total would have grown 62% from the year before, the report said.

Also important to note is that Goodwill can technically stay on the balance sheet forever if no impairment is found each year.

Overpaying for acquisitions?

For Salesforce, acquisitions are a key part of its growth strategy, even as its core customer relationship management business slows.

Just a year before buying Tableau, Salesforce acquired Mulesoft for $6.5 billion, which helped expand its customer-base. Previous deals for companies like ExactTarget and DemandWare have also built the groundwork for getting into marketing and commerce industries. Salesforce hasn't had any meaningful write-offs from its past acquisitions so far.

Data shows Salesforce's goodwill balance is high compared to most other S&P 500 companies. Only 32 companies reported goodwill balances of over $25 billion, and just 19 companies had goodwill account for over half of their total assets, according to S&P Global Market Intelligence. Only two other companies - Fidelity National Information Services and Broadcom - had both goodwill exceeding $25 billion and accounting for the majority of their assets.

Paul Chaney, an accounting professor at Vanderbilt University, said that Salesforce's large percentage of goodwill raises the question of whether it overpaid for some of its acquisitions. It could also mean Salesforce is undervaluing other intangible assets that don't fall under goodwill, like brand names or developed technology, boosting the goodwill value instead, he said.

"Either Salesforce is overpaying for the acquisition, or the amounts assigned to other intangible assets might be lower (potential undervaluation)," Chaney said in an email to Business Insider.

Wall Street looks elsewhere

Wall Street analysts tend to care less about goodwill largely because it's a non-cash item. Even if write-offs occur, they don't directly impact the company's cash balance because the deal is already paid for.

Steve Koenig, an analyst at Wedbush, said the more meaningful metric may be how each company's goodwill compared to its market value, instead of their total assets. That way, you can measure the company's acquisitiveness (goodwill) against its ability to create market value, he said. Under that measure, Salesforce appears to be more efficient in terms of its spending, but it's still worse than the ratio you'd find at Microsoft or Adobe.

"I don't buy the argument that Salesforce's M&A hasn't created good return-on-investments for shareholders," Koenig said.

Salesforce reported third quarter revenue of $4.5 billion last week, up 33% from the year-ago period. The company's shares have more than doubled in the past three years, but they are up just 14% this year, underperforming the broader S&P 500's 25% gain.

At last week's Wells Fargo TMT Summit, Salesforce co-CEO Keith Block emphasized the importance of looking at intangible assets when making acquisitions. He said Salesforce does a "deep evaluation" of those factors, including the culture of the company and quality of customers.

"A lot of companies, when they do acquisitions, they don't look at the soft stuff," Block said. "And actually, all of those are huge difference makers."