Thursday, January 22, 2015

The Serious Fraud Office Finally Passes on Autonomy: HP Should Move On

As recently as Q2:FY14, we had Autonomy on a list of big questions, not just from the legal and financial implications, but because the overhang was distracting for the marketplace. This acquisition again points to failures of the company's outside directors, the naive vision and defective business acumen of former CEO Apotheker, and an acquisition process which had run amok. 

Now, after three years of spinning its wheels, Britain's Serious Fraud Office concluded, "In respect of some aspects of the allegations, the SFO has concluded that, on the information available to it, there is insufficient evidence for a realistic prospect of conviction."  Presumably, potential civil issues will be picked up by the SEC. However, this shouldn't be a fertile ground for large cash fines given HP's having already consolidated and settled many shareholder derivative claims.  HP's impending break-up and its ability to thrive going forward should be where investor and management energies should be spent.

The most illuminating document summarizing the Autonomy acquisition debacle is the January 10, 2014 report of the" Hewlett-Packard Company Independent Committee's Resolution of Derivative Claims and Demands."

HP had a business relationship with Autonomy since Q4 2009, and so the IDOL product and Autonomy's management, especially founder Dr. Mike Lynch, should have been well known to HP's technology, business, and marketing executives.  In fact, thoughts of acquisitions had been circulating with HP for some time, but the disconnect between Autonomy's stand-alone valuation and its revenues precluded any pre-acquisition work. 

During HP board meetings from July 19-21, 2011 CEO Apotheker made a case for a "transformational acquisition" of Autonomy, which was to be the centerpiece of a complete makeover of HP from a hardware company into an enterprise software giant. 

The standalone value of Autonomy was set at $9.5 billion, and HP's internal business development group and others concluded that there were $7.4 billion of "revenue synergies" between HP and Autonomy, presumably with IDOL and Vertica's offerings primarily. This is an extraordinary number, even laughable.  $0.157 billion in integration expense and fees offset these numbers, and there were said to be $0.322 billion of tax synergies available to a combined company. All of this made for a value of $17.1 billion!

Apotheker argued to the board that HP had in place extensive, proven and reliable processes for screening, valuing, and integrating acquired companies, and the board should feel comfortable relying on the output of this machinery, along with the extensive roster of supporting advisers, like KPMG for accounting due diligence, and a bevy of American and British law firms and investment banks.

However, this assertion was belied by facts, including the most recent failure of the EDS acquisition and integration, which itself resulted in an $8 billion write-down.

Apotheker's putting forward that the acquisition of Autonomy would be "financially accretive" in addition to have strategic transformational value had to be a critical element in the board's giving him Authority to Negotiate with Autonomy.  Any board member, even those without financial background, should have disregarded a "revenue synergy" number equal to almost 80% of the target's standalone value.

During an August 8, 2011 conference call with Deloitte, Autonomy's auditor, questions were put forward about "revenue recognition, instances of fraud, control mechanisms" and the like.  Deloitte just answered questions, and no work papers were provided to demonstrate the revenue recognition processes.  Deloitte also noted that an individual whistle blower had filed a complaint about financial irregularities which Deloitte (and presumably Autonomy's audit committee) had investigated and found to have had no merit.  Apparently, this kind of lack of sharing of audit material or detailed financial records is the norm for British acquisitions, according to the report.

CFO Cathy Lesjak objected to the acquisition of Autonomy, but not for the specific valuation process or numbers.  She felt, (1) shareholders would object to the size of the premium paid; (2) HP's bankers underestimated the impact of the announcement on HP's share price, and (3) HP's "history of not executing on major acquisitions" should give the board and management pause about going forward.

Post-acquisition, Ernst and Young were hired as forensic accountants.  They received Deloitte's work papers on Autonomy and identified red flag areas, including audit issues such as differences between the principles-based IFRS and rules-based GAAP that could be problematical.  These were all ignored or swept under the rug during the out-of-control due diligence process.

Vertica and IDOL's product lines could not be integrated, which caused problems during conference call presentations by CEO Meg Whitman when she had to be very careful with her language about the future of HP offerings in the software area.  Revenue synergies clearly had been illusory; the synergy modelling had been prepared by the company's own Corporate Development Group, or internal bankers.  This is not the best way to go about this exercise.

HP's CEO Whitman's characterization that some $5 billion of the $8.8 billion write down of Autonomy post-acquisition was due to "accounting improprieties," "misrepresentation," and "disclosure failures" seems misleading, after reading the text of the report.

According to the report's description of the HP impairment model, the $9.5 billion standalone value of Autonomy had to be reduced by some $6 billion!  If this write down were due to differences interpreting the appropriate treatment of Autonomy's fiscal 2011 results under IFRS and the subsequent translation to US GAAP, this isn't improper or misrepresentation on its face; over a long-time horizon, the cash flows should be the same, unless the fundamentals of the companies technology products were misrepresented; this hasn't been suggested, and so HP's claim is, at best, unproven.

$5.3 billion of the assumed $7.4 billion of revenue synergies were deemed impaired. $3.9 billion of the impairment came from the decline in HP stock and the subsequent effect on the market capitalization reconciliation. This calculation accounts for former Autonomy CEO Lynch's assertion that $5 billion of the impairment came from HP's own reckless assumptions about revenue synergies and not from any proven accounting fraud.

$11 billion in carrying value of Autonomy less the net $2.2 billion revised value yields the $8,8 billion impairment charge.

If the SFO couldn't find the evidence to pursue and win a criminal conviction for accounting fraud, then CEO Whitman's claims don't seem to be above reproach.  Just for the other side, the report details Dr. Lynch's behavior and assertions when the integration work and post-acquisition forensic accounting work were going on.  His behavior seems inexplicable, petulant and unprofessional.  After all, he had just enjoyed a huge payday, and was likely still a contract employee of HP. Professionally and personally, his conduct wasn't exemplary.

For all the 'smart' people in Silicon Valley, this episode should underline for equity investors the need to really investigate, understand and monitor the qualifications, personal character and conduct of the the board members and managements whom they entrust with their clients' funds.

No comments: