thoughts on Hewlett-Packard (HPQ) and Autonomy

background

In mid-August 2011 HPQ announced an all-cash, $11 billion+ bid for the British software company, Autonomy.  The offer came at more than a 60% premium to the latter stock’s close the prior day.  The deal, masterminded by HPQ’s then CEO Leo Apotheker, closed in early October last year.

By mid-May 2012 both HPQ executives who championed the deal, Mr. Apotheker and HPQ’s head of strategy, Shane Robison, had been shown the door, as had Autonomy founder Michael Lynch, as well.

Last week, when reporting its 4Q results for fiscal 2012, HPQ announced a whopping $8.8 billion writeoff “relating to the Autonomy business”!  In an 8-K filing with the SEC, HPW explained:

“The majority of this impairment charge relates to accounting improprieties and disclosure failures at Autonomy Corporation plc (“Autonomy”) that occurred prior to HP’s acquisition of Autonomy, misrepresentations made to HP in connection with its acquisition of Autonomy, and the impact of those improprieties, failures and misrepresentations on the expected future financial performance of the Autonomy business over the long-term.  The balance of the impairment charge relates to the recent trading value of HP stock (emphasis mine).”

What’s going on?

two aspects to the mammoth charge

first, according to the statement above, HPQ now realizes it paid twice as much as it should have ($5 billion+ extra) for Autonomy.  It feels this happened because it received false, misleading or incomplete information about Autonomy’s business while considering the acquisition.

HPQ has asked both the FBI and the UK’s Serious Fraud Office to determine whether any laws were broken.

second, HPQ says something like $3.5 billion of the charge comes from “the recent trading value” of HPQ stock.   Huh!?!

let’s start with the second item

Oddly, the company gave no further explanation on its conference call, even though, assuming it’s $3.5 billion–we’re talking about a writeoff equal to 15% of HPQ’s market cap.  No analyst asked about what the charge was about, either.  Nor have I seen any financial media comment explaining what the charge is.

What really gets my attention is that in thirty years of looking at stocks, I’ve never before seen a statement/explanation like this one.   What can it mean?

–To begin with, the charge is big enough that it had to be disclosed.

–HPQ isn’t making an off the cuff remark.  The 8-K statement above was repeated, word for word, at least twice during the earnings conference call.  So the wording has been carefully crafted and presumably approved by batteries of lawyers.  It also can’t be an accident, in my view, that there’s no further elaboration (isn’t this a “disclosure failure”?).

We have a few other clues.  The $3.5 billion or so is a non-cash charge (meaning no actual money is being paid out by HPQ).  It relates to the Autonomy acquisition.  It appears to have been triggered by the recent declines in HPQ stock.

On the other hand, the charge appears to have nothing to do with the wildly optimistic estimate of the present state and future profit potential of Autonomy that HPQ made in 2011.

My guess:  to me, it looks as if the recent decline in HPQ stock below some level, say, $20 a share, has triggered a contingent liability of HPQ’s–one by which it either forfeits a payment of $3.5 billion or which requires it to issue new stock with that market value.

If so, this could be “related” to the Autonomy acquisition in the sense that HPQ interprets the fall in its stock to be a direct result of Autonomy’s shortcomings (how you can make that argument is beyond me, though).

Or it could be “related” in the sense that the bank agreement HPQ struck to finance the Autonomy purchase called for stock issuance in the event the riskiness of the loan increased–as measured by a fall in the HPQ stock price.  I’ve looked at the Autonomy acquisition-related documents, including the bank financing arrangement pretty carefully (okay, sort of carefully)–and have found nothing.  A good bit of the loan agreement has been redacted, however, so it’s still possible that the banks have demanded collateral.

All in all, this part of the writeoff seems to me to have more to do with HPQ decisions on how to shape its capital structure than about Autonomy per se.  The worst part is the lack of explanation.

HPQ’s information shortfall about Autonomy

As I understand it, there are several questions of accounting technique that HPQ is now calling improper:

–when Autonomy delivered software to OEMs or other distributors, it booked the revenue immediately, rather than waiting for the distributor to resell it to an end user.  This isn’t the most conservative approach, but it’s what sellers of video game software customarily do.

–when Autonomy sold multi-year software licenses, it recognized all the profit immediately, rather than over the term of the license.  Again, not the most conservative  …but the way Apple accounts for its iPhone sales.

–when Autonomy sold directly to end users, it recognized revenue when the sale was agreed to, unless there was an acceptance period, in which case it would wait until the user signed off as satisfied on the installation.

None of these practices are in themselves deceptive, in my view.  Autonomy maintains they’re fully disclosed in the annual report (which, in general terms, they are).

HPQ has made more than fifty IT-related acquisitions over the past decade.  So it should know that the way a company chooses to recognize revenues and costs is perhaps the question in understanding an acquisition target’s financials–and that the devil is in the details, not in the annual report generalities.  Nevertheless, it sounds like neither the top management at HPQ nor the directors of the company asked for any elaboration.  The firms HPQ hired to do due diligence also found nothing wrong.

I’ve seen intimations in the press that during the time Autonomy was shopping itself to other software firms it may have “stuffed” its indirect distribution channel with more software than distributors could reasonably be expected to sell, or persuaded direct customers to start the software purchase process early–measures calculated to make recent growth rates look better than they actually were.   Anyone with a skeptical bone in his body would check for this.  And either tactic should be relatively easy to detect–for anyone who had some knowledge of accounting, the experience to be aware of typical “tricks” used in the industry, and a willingness to do due diligence.    Apparently in this case no one did until mid-2012.

In short, it’s hard to understand how a group of seasoned technology veterans in an M&A-intensive firm could have allowed itself to be as thoroughly deceived as HPQ is now claiming.

And then there’s Oracle, which asserts Autonomy pitched itself to it on April Fool’s Day 2011.  Oracle says it knew simply on the basis of a short presentation that Autonomy was substantially overvalued, even at the then market price of $6 billion (Oracle has posted the slides presented by investment banker Frank Quattrone.  The fine print Disclaimer at the end of the first set says it’s sent “in connection with an actual or potential mandate,” meaning an M&A transaction.  Ugly slides;  not much pertinent info.)

call for criminal/civil investigations 

I suppose it takes a certain amount of courage for a highly compensated group of supposed battle-scarred businesspeople to admit to having been bamboozled out of $8.8 billion of shareholder cash.  On the other hand, coming clean is probably the best option the HPQ management and board had.  Certainly, trying to disguise the facts would be worse–and would weigh on reported results for years.

The call for criminal and civil probes of the Autonomy transaction may well boomerang on some present or former HPQ executives.  But alerting the regulatory authorities eliminates a lot of possible skepticism that HPQ might be downplaying the affair.  Of course, so far as I’m aware, none of the HPQ directors who rubber-stamped the Autonomy acquisition feel bad enough to have offered to resign.

a stock market buy?

Deep value investors might be tempted.  Why?  …precisely because the company has a recent history of inept management and because the stock has lost 3/4 of its market value since ex-CEO Mark Hurd departed in a personal conduct scandal.  The S&P is up by about 1/3 over the same span.    The argument would have two aspects:

–the same assets in more competent hands could be worth a lot more than the current $12.44 a share.  Mr. Hurd demonstrated during his tenure how that can happen.

–you can’t fall off the floor.  i.e., the worst is already in the HPQ share price.

The big imponderables are:  whether all the company’s dirty laundry is in display, and how different from current management the new hands might be.

As a growth investor I don’t have the background/skills or inclination to reach a conclusion and place a bet.

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