HP accuses UK unit Autonomy as takes $9bn hit

21 November 2012
By Sofia Mitra-Thakur
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HP

HP

Hewlett-Packard has levelled an accusation of dodgy accounting at Autonomy, the British software company it bought last year, and is taking an $8.8 billion charge in the latest of a string of setbacks.

HP has discovered "serious accounting improprieties" and "a wilful effort by Autonomy to mislead shareholders" after a whistleblower came forward, the company said.

It has alerted regulators on both sides of the Atlantic.

Irish-born mathematics whiz Mike Lynch, who led the firm he had co-founded when it was sold to HP last year for a hefty $11.1 billion, denied the allegations. 

He blamed mismanagement by its new owners for shredding its value.

"We are shocked, this is a big surprise, it's completely and utterly wrong and we reject it completely," he said. 

"We have not heard anything from HP, they have not been in touch and we don't know what they are on about."

Lynch left HP's employment in May.

HP's announcement this week sent the company's shares plunging 12 per cent to a 10-year low of $11.71. HP, which for decades was synonymous with technical excellence and innovation as one of the bedrock companies of Silicon Valley, has seen its market value sink to roughly $20 billion from $155 billion in April of 2000.

CEO Meg Whitman took the helm at HP a little over a year ago when her predecessor, Leo Apotheker, was fired after less than a year on the job.

Apotheker's big strategic move during his brief tenure was the acquisition of Autonomy, intended to hasten HP's transformation into a software and services company - but which was criticised by many analysts at the time as over-priced.

Analyst Paul Morland at Peel Hunt said at the time that HP shareholders should be worried about the high price agreed, contracting margins and single-digit profit growth.

Whitman told an analyst call: "Most of the board was here and voted for this deal, and we feel terribly about that."

This week's announcement came just three months after the company took a write-down of almost $11 billion on its EDS services division.

HP has for years relied on deal-making, acquiring businesses ranging from EDS to Compaq to Palm, but has largely failed to articulate a clear strategy or establish a strong position in growth businesses like computer services or mobile computing.

"To put it bluntly ... this story has been an unmitigated train wreck, and it seems every time management speaks to the Street, there is new negative incremental information forthcoming," said ISI Group analyst Brian Marshall.

HP said it has referred the alleged accounting wrongdoing at Autonomy to the U.S. Securities and Exchange Commission's enforcement division and the UK's Serious Fraud Office for civil and criminal investigation. 

HP also said it would take legal action to recoup "what we can for our shareholders."

Both agencies declined to comment.

Whitman said the investigation of Autonomy's finances - both external and internal - will take multiple years as it wends it way through the courts in both countries.

She defended the board's handling of the acquisition and blamed HP's auditors for failing to detect the problems.

"The board relied on audited financials, audited by Deloitte. Not Brand X accounting firm, but Deloitte," she said, adding that KPMG was hired to audit Deloitte.

"Neither of them saw what we now see after someone came forward to point us in the right direction," Whitman said.

Earlier this week, a person familiar with the situation told Reuters that the Federal Bureau of Investigation was probing the HP-Autonomy allegations in concert with the Securities and Exchange Commission, although the inquiry was at an early stage.

HP and Autonomy were not available to comment on the FBI probe, and the FBI declined to comment.

The alleged accounting issues also put a spotlight on the investment banks and law firms involved in the acquisition.

Autonomy was represented by Frank Quattrone, an investment banker who was the target of widespread criticism - and criminal prosecution - for his activities during the first dot-com boom. 

After one trial ended in a hung jury and a second ended in a guilty verdict that was overturned on appeal, the charges were ultimately dropped.

HP's lead adviser was Perella Weinberg, a boutique investment bank with little experience in big tech deals. Its attorneys included the blue-chip firms Gibson, Dunn & Crutcher; Freshfields Bruckhaus Deringer; Drinker Biddle & Reath; and Skadden, Arps, Slate, Meagher & Flom, which advised the board.

Whitman this week stood by Autonomy's technology and products, saying the unit would still be the growth engine for HP. 

The sprawling company, which employs more than 300,000 people globally, aims to focus more on enterprise services in the mold of International Business Machines.

But the former eBay CEO and California gubernatorial candidate has yet to overcome years of management turmoil and strategic missteps, including a plan to sell the personal computer unit that was later dropped.

HP disclosed the Autonomy allegations in conjunction with its fourth-quarter earnings, which showed a 6.7 per cent decline in revenues as well as a $6.85 billion loss.

It took $8.8 billion in charges in the quarter, with over $5 billion tied to the problems at Autonomy. The rest of the charge related to the "recent trading value of HP stock and headwinds against anticipated synergies and marketplace performance," HP said without elaborating.

HP had embarked on its own internal investigation, including a forensic review of Autonomy's historical results by PricewaterhouseCoopers and HP General Counsel John Schultz.

It accuses Autonomy's former management of inflating revenue and gross margins to mislead potential buyers. 

It said Autonomy executives mischaracterised revenue from low-end hardware sales as software sales and booked some licensing deals with partners as revenue, even though no customer bought products.

It said Autonomy claimed its gross margins were in the 40 to 45 per cent range while realistically they were in the 28 to 30 per cent range.

Moreover, Autonomy always represented itself as a software firm but 10 per cent to 15 per cent of its revenue came from money-losing sales of low-end hardware, HP said.

The company also claimed that Autonomy was booking licensing revenue upfront before deals closed.

Schultz said since the accounting troubles occurred prior to the acquisition of Autonomy, it took a long time before HP was in a position to make the news public.

"Not surprisingly, Autonomy did not have sitting on a shelf somewhere a set of well-maintained books that would walk you through what was actually happening from a financial perspective inside the company," he said. 

"Indeed critical documents were missing from the obvious places, and it required that we look in every nook and cranny."

Yet there had been rumblings in the industry for years that Autonomy's results might not be quite what they seemed.

As early as 2009, hedge fund manager Jim Chanos had identified Autonomy as a shorting opportunity, according to a source familiar with his views.

Chief among his concerns, according to the source, was that Autonomy was claiming a 40 per cent market share against the likes of Microsoft, International Business Machines and EMC in the field of e-discovery.

Autonomy's stated margins of around 50 per cent did not seem to translate proportionately into cash flow; and it was reporting double-digit organic growth in software license revenue while rivals battled shrinking sales, the person said.

During a presentation a few weeks ago entitled 'Faking Reported Income 101' at the Santangel's Investor Forum in New York, hedge fund manager John Hempton of Sydney, Australia-based Bronte Capital highlighted items on Autonomy's balance sheet that raised his concerns.

"Is it odd that in a software company you have receivables of 4.5 months? Or that deferred revenue is under half receivables?" asked Hempton, who has a short position on HP.

Last year, software firm Oracle said it had looked at Autonomy but passed on it.

Whitman said earlier this week that her predecessor, Apotheker, and former Chief Strategy and Technology Officer Shane Robison were the key people behind the Autonomy acquisition. 

Robison left shortly after Apotheker was ousted in September 2010.

In a statement, Apotheker said he was "stunned and disappointed" by the revelations and offered to help HP and the authorities to get to the bottom of the matter.

Robert Enderle, a tech analyst at the Enderle Group, said he has never seen such a potential misrepresentation of financials.

"You have to rely on what the firm gives you during due diligence and I've never seen a misstatement at this level," Enderle said.

If the charges are true, it could result in a huge punitive damages award for HP, Enderle said.

But Darren Robbins, a San Diego-based plaintiff lawyer who represents shareholders, said he fielded several calls this week from institutional investors about HP. 

The tech icon spent billions on a company without undertaking proper due diligence, Robbins said.

Other analysts hoped it was the end of the bad news for HP.

"This kind of feels like the last of the bad news," Forrester analyst Frank Gillett said.

In announcing its quarterly results, HP said net revenue fell to $29.96 billion for the quarter ended Oct. 31, from $32.12 billion a year earlier. 

Analysts, on average, had expected $30.43 billion, according to Thomson Reuters I/B/E/S.

Revenue from its main business units declined, with the personal computer division recording the steepest drop at 14 per cent. Revenue from printing fell 5 per cent.

HP reported a quarterly net loss of $3.49 a share, versus a profit of $239 million, or 12 cents, a year earlier.

Victor Basta, managing director of Magister Advisors, said: “HP’s pursuit of a “buy software to get out of hardware” strategy has failed. Autonomy was always an off piste deal.  

"Many large businesses will do a series of bread and butter mid-sized deals, but in HP’s case they went for broke.

"HP are clearly on a mission to change but it was essential they worked first to fix the culture and revamp the business before making a game-changing acquisition. 

"HP’s leadership made a huge mistake by attempting to ‘fix by buying’.

“Autonomy’s business is based on a one time software licence model as opposed to a subscription model.  

"At the time of acquisition it was also growing very fast.  Put that speed of growth and the one off sales model together and you have a business that is incredibly difficult to value and very challenging to manage and integrate.   

"Candidly, it was like putting an 18 year old who just passed their driving instruction behind the wheel of a Ferrari.

“The markets, quite reasonably, have been asking the question: “what happened to the $13 billion?”  What’s clear is that the business hasn’t been able to cohere around a strategy for integrating Autonomy and transforming the HP business.”

“It needn’t have been this way.  IBM achieved it, Dell has been hard at work doing the same through a range of acquisitions, including Quest and Perot Systems.  It is difficult, not impossible.

"HP would have been far better off targeting, like IBM and Dell, a range of smaller acquisitions, with more predictable revenue, and which they could gradually build around.  It takes a decade, not a year, to achieve this kind of change.

"HP’s culture has however made it impossible.  Transitioning from a hardware business to a software business requires a fundamental shift in corporate culture – and that is something that you simply can’t buy.”

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