Maintaining high growth isn’t the only reason leading companies, such as Google Inc (NASDAQ:GOOG) and Microsoft Corporation (NASDAQ:MSFT), acquire other tech businesses. It’s also a chance to integrate their core businesses with the newly-acquired technologies. But companies that purchase other businesses should also look for a return on investment, or ROI, which could be positive only if the investment is profitable.
By the end of 2006, Google Inc (NASDAQ:GOOG), the search engine giant, acquired YouTube for approximately $1.7 billion. Since the acquisition, YouTube has been growing very rapidly – the company reports it has more than a billion unique users who visit its site every month.
Google integrated Youtube with its AdSense ads-platform. Google Inc (NASDAQ:GOOG)’s search results also integrate videos by Youtube. Unfortunately, for a long time, YouTube wasn’t profitable. It is also questionable whether this acquisition, more than six year later, has returned the investment.
Some speculate that YouTube more than returned its investment last year. But even if the company has yet to return its $1.7 billion investment, the ongoing growth in both revenue and users is likely to eventually lead to profits that will also lead to a positive ROI.
Since Google Inc (NASDAQ:GOOG) has a gross profit margin of 63% from advertising, this makes it very likely that YouTube, one of the main components in Google’s advertising business, has a chance of reaching profitably.
On the other hand, Google Inc (NASDAQ:GOOG)’s $12.5 billion acquisition of Motorola Mobility will take a very long time to reach a positive ROI. In 2012, the gross profit from Google’s Motorola Mobility operations reached only 16%, but Google is trying to advance its mobile operations with the many patents Motorola Mobility has. So the jury is still out on this matter. But the intense competition in the mobile market and the relatively late arrival of Google Inc (NASDAQ:GOOG) to this market are likely to make it very difficult to see a positive ROI anytime soon.
Microsoft
The purchase of Skype for $8.5 billion was a higher-than-anticipated price tag. Microsoft Corporation (NASDAQ:MSFT) purchased the company from eBay Inc (NASDAQ:EBAY) in 2011 for almost three-times the price eBay Inc (NASDAQ:EBAY) paid for Skype six years earlier.
Skype is reported to have lost nearly $7 million in 2010, which made this company a non-profitable endeavor, at least when Microsoft bought the company. Microsoft Corporation (NASDAQ:MSFT), much like Google, doesn’t separate its Skype operations from other operations. But a close examination of Microsoft’s annual financial report reveals that the “entertainment and devices division” under which Skype is grouped grew 7.7% in 2012 mostly driven by Skype (according the financial reports). But the division’s operating profitability was only 4%.
Part of the reason was due to the sales and marketing expenses of $244 million related to Skype. The decline in profit margin from 15% in the fiscal year of 2011 to only 4% in 2012 calls into question whether or not Skype was actually profitable in 2012.
Moreover, Microsoft Corporation (NASDAQ:MSFT) won’t be able to integrate Skype with its core business (Office, Windows, etc.) as Google did with YouTube, which brings into question if Microsoft Corporation (NASDAQ:MSFT) will be able to augment Skype’s revenue and profits with Microsoft’s products and services.
Facebook Inc (NASDAQ:FB)
The acquisition of Instagram for nearly $715 million in August 2012 raised a lot of questions as to whether this purchase will have a positive ROI. But Facebook Inc (NASDAQ:FB), much like Google, has a very widespread platform to expand this app’s popularity. Instagram expanded its number of users from one million at the end of 2010 to more than 100 million users by the end of February.
But the high sticker price Facebook Inc (NASDAQ:FB) paid consisted mostly of goodwill: Facebook Inc (NASDAQ:FB) valued the company at $521 million with goodwill of $433 million. This means that goodwill accounted for nearly 83% of Instagram’s value. So Facebook Inc (NASDAQ:FB) paid a high price mostly for goodwill and a higher price than Instagram’s own estimated fair-value.
This could make it harder for Facebook Inc (NASDAQ:FB) to get its investment back in the near future, which could impede the company’s stock from rising.
The bottom line
I don’t think there is a clear-cut answer for if reaching growth by purchasing companies is the right way to go. If the company presents a very good integration with its core business and doesn’t pay most of the price for goodwill, then this could eventually lead to a positive return and not just growth in sales. Otherwise, the investor should consider these purchases might pull down a company’s value.
The article Is Buying Growth Companies Worth It? originally appeared on Fool.com and is written by Lior Cohen.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
