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November 21, 2012 7:49 pm
Things got quite exciting in London at noon on Tuesday. First Kweku Adoboli, the rogue trader formerly employed by UBS, was sentenced to seven years in prison for fraud. Then Hewlett-Packard accused the former management of Autonomy, the UK software company, of wrongdoing. The moral appeared to be, as a New York journalist wryly tweeted: “Don’t trust the British.”
Hold on a minute, though. This is HP we’re talking about, a company that has a sorry record of overpaying for acquisitions and then writing off most of the value shortly afterwards. If Autonomy inflated its value in its $11bn sale to HP last year, which it firmly denies, it was bought by the world’s biggest deflater.
As Meg Whitman, HP’s latest chief executive, disclosed a writedown of $8.8bn on the Autonomy deal, she made it sound like a unique scandal. But three months ago, she wrote down $8bn on its $13.9bn purchase of Electronic Data Systems in 2008. Not even that collapse matched Léo Apotheker, her predecessor, who wrote off more than the $1.2bn HP had paid for Palm in 2010.
With management and accounting like that, it is surprising HP has a balance sheet left. Indeed, the EDS writedown triggered a revaluation of its other assets that contributed $3bn to the Autonomy kitchen-sinking. This cascade took $20bn of goodwill and intangibles off its assets this year – almost matching its $23bn market capitalisation.
Even in a world where mergers and acquisitions are risky, and big companies struggle to make them work, this is remarkable. As any shareholder might ask – and many do – what is going on?
The initial temptation – one encouraged by HP – is to blame Autonomy for the debacle. But although it bears plenty of responsibility for what occurred, it isn’t the entire story. In many ways, Autonomy and HP were natural partners in an industry that is prone to wild misvaluation.
One reason is that Silicon Valley companies, and now those from London’s Silicon Roundabout, have always lived or died by growth. Venture capitalists fund software and internet companies on the promise of rapid growth and high margins. When growth slows, as it has for HP, they have an identity crisis.
The temptation, indulged by HP’s various chief executives over the past few years, is to restore it by buying high-growth companies at inflated prices to tack on to mature operations. Autonomy was a classic example: Mr Apotheker paid an eye-watering premium in an effort to shift HP from hardware.
It is also relatively simple to inflate the value of software companies with sharp accounting. “There is more scope for abuse because you can press a button and record a sale at almost zero cost,” says Paul Morland, a technology analyst at Peel Hunt in London. “In other businesses there tends to be more involved, like making and delivering something.”
Mike Lynch, Autonomy’s founder and former chief executive, insists that HP is making baseless charges and that it spoiled his business after buying it. But the tactics HP accuses Autonomy of using – for example, prematurely recognising the lifetime value of a software licence sale – have been employed by others.
In some extreme cases, that has led to fraud charges against those involved. Seven senior executives of Computer Associates, the US software company, were jailed in 2006 for fraud and obstructing justice after massaging their results by recording sales made in one quarter in an earlier one.
In other cases, companies manage to test the boundaries of accounting practice without breaching any rules. HP has handed its complaints about Autonomy’s former senior managers to the Securities and Exchange Commission in the US and the Serious Fraud Office in the UK, and those bodies will decide.
The mystery is why HP, and the advisers that handled the deal, did not dig deeper in the first place. It was not a secret that some analysts and investors thought Autonomy was flattering its figures. “When the deal was announced, I wrote to HP telling them they were making a big mistake,” says Mr Morland. “I never got a response.”
Jim Chanos, founder of Kynicos Associates, a US hedge fund, told investors in 2009 that Autonomy was hiding weaknesses in its results by buying companies and adding their revenues to its own. Autonomy “appears to have consistently overstated revenue and grossly understated expenses as part of its acquisition strategy”, he wrote.
Yet Autonomy’s reported record of vibrant software sales and high margins made it a tempting target for HP under the growth-hungry Mr Apotheker. Mr Chanos was also critical of HP, describing it last year as “a tech roll-up whose constantly changing management team has wrecked the balance sheet”.
That was his view even before Ms Whitman went on the balance sheet writedown spree of the past few months. It does not encourage much faith that HP has changed its ways since she replaced Mr Apotheker. Whatever the merits of her case against Autonomy, it was a timely distraction from HP’s own operational weaknesses.
Ms Whitman, who sat on the board of HP when it approved the purchase of Autonomy, is trying to remodel her company into something more stable and better under control. She talked to analysts last month of providing “a steady hand on the tiller” and of halting HP’s tendency to keep changing strategy.
She has used some pretty punchy accounting methods herself to write off HP’s past acquisition errors and false hopes. With those taken from the balance sheet, it needs time to rebuild. A good start would be to stop acquiring exciting-looking growth companies.
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