Autonomy HP row – what does it mean for investors?

27th November 2012

The battle lines are drawn between Mike Lynch, former head of UK technology giant Autonomy, and new Hewlett Packard CEO Meg Whitman.

HP has been forced to take a write-down of up to $8.8bn (depending on the report) on the value of Autonomy, which it bought in 2011 for over $10bn.

Lynch blames HP for the destruction of Autonomy's value, saying the group has systematically destroyed a once-great company. Whitman believes that Autonomy executives inflated the value of the company prior to the takeover as part of a 'wilful effort to mislead'. The case has been referred to the Serious Fraud Office.

The background

HP has had a chequered history. It sacked Mark Hurd in 2010 after a series of expense account irregularities and a sexual harassment claim. Hurd had a reputation for aggressive cost-cutting and an emphasis on short-term results, which led to some strong gains in the share price, but – many thought – to the detriment of the long-term well-being of the business. The Autonomy acquisition is not the first time the group has made controversial acquisitions.

It bought Palm for $1.2bn in 2010, makers of the Palm Pilot (remember those?). Previous CEO Carly Fiorina also made a widely-derided purchase of Compaq. HP bought Autonomy for $42.11 per share in August 2011 – around $10.2bn. Former Autonomy chief executive, the maverick Mike Lynch left his role in May 2012 after a significant drop in revenue in the previous quarter.

What the papers say:

HP has certainly taken the bigger hit in the press, perhaps because Mike Lynch is now simply a man living with his millions, rather than a multi-national company with shareholders. Also, the conclusion has been, whether HP was duped or not, it says relatively little for its due diligence and the army of advisers that it employed to investigate Autonomy that accounting irregularities that were flagged by analysts and fund managers should have eluded their analysis.

– In Forbes, Richard Saintvilus controversially states that HP made a mistake firing Hurd, but that the latest revelations change little about the prospects for the company. Forbes asks "What do we know now about HP that has altered our expectations in any meaningful way? Did this news suddenly hurt its market lead? Or did it worsen its chances of beating AppleGoogle and now Research in Motion in the age of new tech? Not really.

"The company’s board has made one poor hire after another, it highlights what I consider to have been its most egregious mistake – its failure to stand behind former CEO Mark Hurd in the guise of corporate governance. Hurd’s departure shook the grounds of Wall Street and rightfully so. He was the one person that had HP heading in the right direction. HP’s performance before and after Hurd is startling. Nonetheless, nobody could have envisioned what his departure would have meant for the company’s future."

In the Lex column, the Financial Times wonders how these accounting problems, if true, could have been missed: "If Hewlett-Packard failed to do adequate due diligence on its $11bn acquisition of Autonomy, leading to an $8.8bn writedown, it is not because too few experts were hired. Two auditors, Deloitte on the Autonomy side and KPMG on the HP side, worked on the original deal. PwC is doing an autopsy; Ernst & Young is, presumably, sulking and waiting by the phone. Then there are the banks, six on Autonomy’s side (Qatalyst, Goldman Sachs, Citigroup, UBS, Bank of America, and JPMorgan) and two on HP’s (Perella Weinberg and Barclays).

 "It is astonishing that this army of number-crunchers – and HP’s board – could have approved a deal of this size only to claim, after the fact, that the target was manipulating its revenue accounting on a grand scale."

The Sunday Times reports Lynch's side of the story: " Mike Lynch claimed that a stifling corporate culture and management infighting destroyed the search software firm he founded in 1996.

"Some HP managers tried to bar sales staff from offering Autonomy products to clients because of a “crazy” bonus structure that gave higher rewards for selling rival software, according to Lynch. “There were emails to the HP salesforce saying they were not allowed to sell Autonomy software.

“We worked very hard over 10 years to create a business that was No1 in its field, and it has been mismanaged into the ground in a year.”

Silicon Beat is more balanced – pointing out that Autonomy may have been engaged in a massive fraud – however, it also points out that for those who would deflect blame for the current scandal from current CEO Meg Whitman, that the deal was signed off by the board, of which Whitman was a part. "The folks that ran Autonomy look like they were engaged in massive fraud, ginning up the company’s financials to boost its value before a sale….

"HP’s board — of which Whitman was a part — signed off on the Autonomy deal. It was the board’s responsibility to review it and the accounting reports thoroughly; obviously they weren’t skeptical enough.

"Also the Autonomy deal was finalized on Whitman’s watch. With the deal already in progress when she assumed the CEO’s chair, she might not have been able to stop it. But Autonomy has been a part of HP for about a year now, all under her leadership. With HP acknowledging as long ago as May that Autonomy was underperforming, it’s hard to believe that it took the company this long to figure just why that was so."

What does it mean for investors?

HP's share price has been sliding consistently since early 2010 – from a level of around $50 per share, to its current level of just over $10 per share, underperforming the S&P 500 index by around 75% over five years. It has a market cap of $24.5bn, a dividend yield of 4.24% and remains in the S&P 500 index, for the time being at least.

However, the majority of investors have not shorted Hewlett-Packard, but a number shorted Autonomy. They have now been proved right in theory, but many suffered at the time after Autonomy was bought out at a substantial premium to the then market value. It highlights some of the problems of shorting a stock purely on the basis of poor fundamentals. The market cannot be assumed to be entirely rational.

Tim Steer, manager of the UK Growth fund at Artemis, has been one of a group of analysts and fund managers who had long questioned Autonomy's accounting practices. In particular, they highlighted the group's cash flow numbers, which were not as strong as the group's high profits would suggest. In a Citywire article, he says: "It is surprising that HP never opened up the reports and accounts ahead of offering $12 billion for Autonomy. The warning signs were written all over the accounts…It was obvious to quite a few of us that this company had issues. I was short of it…other managers got lucky.".

Paul Morland, an analyst at Peel Hunt, was perhaps the most vocal doubter of Autonomy The Sunday Times reported that he has been flagging up problems with the accounts since 2008 and in particular, the discrepancy between Autonomy’s soaring profits and the relatively paltry amount of cash it was generating, suggesting growth was not as strong as it seemed.

The only question remains is whether HP now makes a reasonable contrarian investment. Buzz Money asked the question six months ago as to whether anyone could save HP:

It concludes that "The best thing people will be able to say about HP is that it's a widows and orphans stock for the 21st century." Its share price has halved since that was written. It would certainly take a brave investor to bank on a reinvigoration of HP.

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