Autonomy deal gives HP a headache
January 2013 | FEATURE | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
Since ascending to the position in September 2011, Hewlett Packard (HP) chief executive Meg Whitman has reiterated that the company is in the formative stages of “a multiyear turnaround”. In retrospect, 2012 will be viewed by the company as an ‘annus horribilis’. The company’s worrying financial results continued, with the latest blow coming in November when HP announced an $8.8bn write down stemming predominantly from its $11.1bn purchase of software firm Autonomy Corporation in 2011.
The embarrassing write down was the catalyst for the company launching what is likely to be a lengthy legal battle intended to re-coup some of the money lost in the deal. This is the second time in a year that HP has been required to announce a significant write down. In August 2012 HP confirmed it was writing off $8bn in connection with its $14bn purchase of Electronic Data Systems (EDS) in 2008.
Improprieties, misrepresentations and failures
In light of the announcement HP has gone on the offensive. The company asserts that at least $5bn of the write down is due to “serious accounting improprieties” and “outright misrepresentations” by Autonomy executives. The remaining $3bn relates to the recent fall in the company’s share price, reflecting the travails the company has experienced in recent years. HP has seen more than 50 percent of its share value wiped away in 2012. Following the announcement, HP’s stock plummeted 12 percent to a 10-year low.
In a press release HP said that following an internal investigation it “now believes that Autonomy was substantially overvalued at the time of its acquisition due to the misstatement of Autonomy’s financial performance, including its revenue, core growth rate and gross margin, and the misrepresentation of its business mix”. It is alleged that Autonomy inflated its software sales by including revenue from its negative margin, low-end hardware in its figures. Equally, the UK firm is accused of prematurely counting sales through resellers, a practice known as ‘channel stuffing’.
The details of the alleged improprieties came to light when a senior member of Autonomy’s leadership team informed HP of “questionable accounting and business practices at Autonomy”. The Autonomy executive only came forward once Mike Lynch, founder of Autonomy, had left the company. Mr Lynch has angrily refuted the allegations levelled against his former company. He noted on a website set up to fight HP’s claims that “HP issued a statement accusing unspecified members of Autonomy’s former management team of serious financial impropriety. It was shocking that HP put non-specific but highly damaging allegations into the public domain without prior notification or contact with me, as former CEO of Autonomy. I utterly reject all allegations of impropriety”.
HP will now look to the courts to recover money lost on the deal. The company has handed documentation over to the US Securities and Exchange Commission and the UK Serious Fraud Office. “This will take a long time to work through, but we’re committed to seeking redress. I’m expecting this is going to be a multi-year journey through the courts,” said Ms Whitman.
Reinvention and criticism
At the time the deal was announced, former chief executive Léo Apotheker intended to usher in a new era for HP. In an attempt to restore the company to its former glory, Mr Apotheker hoped to transition HP away from its successful hardware operation by possibly selling or spinning off its PC business. The proposed move away from hardware production mimicked the decision taken by IBM Corp, which had successfully undergone a similar restructuring 10 years previously. Mr Apotheker’s decision to move away from the PC business took analysts by surprise and provoked anger among investors and employees alike.
In recent years HP has floundered, struggling to keep pace with a changing technological landscape. The company is not isolated in this sense, however, as one of its chief rivals in the PC market, Dell, also reported declining sales and profits in November. Revenue from HP’s Personal Systems Group (PSG), which is responsible for its PC business, was down 14 percent in Q4 2012.
Results released by the company show that HP reported losses of $6.9m compared to 2011, for the period ended 31 October. Q4 2012 also represented the fifth consecutive quarter of falling sales.
HP’s struggles in the PC market are not entirely of its own making, of course. A number of factors have led to declining sales figures across the entire industry. Most notably, the continuing global economic uncertainty has hamstrung sales. Consumers, meanwhile, are turning to cheaper smart phones and tablets for their computing needs. Analysts IHS Global suggested that 2012 will see a decline in worldwide PC shipments for the first time since 2001.
In light of these details, it would seem that Mr Apotheker’s reasons for attempting to transform HP into a services and software business was sound. The company’s proposal to spin off its industry leading – but still struggling – PC division would have enabled HP to focus on developing its software revenue, an area which currently accounts for only 2.4 percent of the company’s revenue.
Autonomy and its sophisticated analytical software was intended to help cement HP’s place in the software market. Autonomy and EDS, it was hoped, were going to lead HP away from its low margin PC, printing and hardware businesses, transforming the company into a high margin, cutting edge software firm. “Together with Autonomy we plan to reinvent how both structured and unstructured data is processed, analyzed, optimized, automated and protected,” said Mr Apotheker at the time of the deal.
Criticism of the deal has been fierce from the outset. Toni Sacconaghi, an analyst at Sandford C Bernstein, noted that the acquisition of Autonomy “will arguably go down as the worst, most value-destroying deal in the history of corporate America”.
From a financial standpoint the acquisition made little sense. The $11.1bn price that HP announced for Autonomy in August 2011 represented a 58 percent premium on Autonomy’s July 2011 average stock price. The purchase price was also 12.6 times Autonomy’s annual revenue for 2010. Effectively, the write down is an admission that HP overpaid for Autonomy by approximately 380 percent.
While Ms Whitman goes about the unenviable task of trying to rebuild HP’s balance sheet, it would seem that the company’s board will face a legal battle on multiple fronts. Not only will HP itself pursue recompense for its shareholders, board members will be fighting to clear their own names of any culpability.
On 28 November, an HP shareholder filed a lawsuit against the members of the company’s board over their roles in the deal. The suit, brought by Phillip Ricciardi, was filed in federal court in San Jose, California, and named Mr Apotheker, Mr Robison, Ms Whitman, Mr Lynch and other members of the HP board as defendants. The suit accuses the defendants of breach of duty and negligence for their respective roles in the acquisition of Autonomy. The suit contends that “simply put, HP grossly overpaid for Autonomy”. Ms Whitman said “the board relied on audited financials”. In reference to Mr Apotheker and former chief technology officer Shane Robison, she added that “the two people that should have been held responsible are gone”.
Auditors KPMG and Deloitte have also been named as defendants in the case. The paperwork states that the two auditors “consistently misled the public with improper statements” and “consciously disregarded numerous red flags”. Both firms have rejected any wrongdoing on their part. KPMG said “we can say with confidence that we acted responsibly and with integrity”. Barclays and Perella Weinberg Partners, who advised on the transaction, were also named in the suit. A second lawsuit has also been brought by investor Allan Nicolow. However, this suit has been brought only against HP and its executives; the auditing and advising firms were not included.
One of the most concerning aspects of the Autonomy scandal for investors will be the apparent unwillingness or inability of the company to respond and react to a number of red flags which were raised before the deal was completed.
Notably, in September 2011, Oracle Corporation confirmed it had turned down the opportunity to purchase Autonomy for $6bn in April of that year. Oracle felt that even at that level the company was “extremely overpriced”. A number of Wall Street analysts have also raised red flags regarding Autonomy. As far back as 2007 CFRA added the company to its ‘biggest concerns list’, noting its reported cash flow and income “appear to have benefitted significantly” from questionable changes in the way it classified items.
Furthermore, in 2009 Paul Morland of Peel Hunt described Autonomy’s financial statements as “wrong and misleading”. In 2010, hedge fund manager James Chanos referred to Autonomy’s accounting as “absolutely dreadful, a disaster”. Marc Geall of Deutsche Bank warned that the “management structure, control and systems at Autonomy are more representative of a startup up than a major global player”.
In an interview with CNBC following the announcement of the acquisition, Ms Whitman noted that “a number of blogs...came to the fore about potential issues at Autonomy”. Ms Whitman has subsequently expressed regret at not heeding the warnings of the blogosphere.
How the alleged financial irregularities were missed by HP’s due diligence is something of a mystery. HP staff and their financial advisers all carried out audits and due diligence on Autonomy’s accounts, as well as carrying out extensive questioning of Autonomy staff.
Sources familiar with the details of the deal have noted that Mr Apotheker was so keen to push through a transformative move for HP that he agreed to Autonomy’s allegedly questionable published and audited accounts. After pursuing the acquisition of a number of different companies to no avail, the Autonomy deal struck by Mr Apotheker was supposedly motivated by “desperation and frustration”.
It is evident that the true nature of the accounting situation at Autonomy will not be known for some time. As the legal battle rumbles on it is imperative that the company regains investor and shareholder confidence. HP is in the midst of a crucial, transitional period in its history and how it responds to the challenges ahead will ultimately determine the fate of the company.
HP has appointed four chief executives officers since 2010. Despite increasing pressure on Ms Whitman, it would appear that the revolving door to the chief executive’s office is closed – for the time being at least. Only time will tell whether HP has the willpower to the stay the course and hopefully emerge from its latest crisis intact.
© Financier Worldwide