It will
happen again
HP’s Autonomy
acquisition has spawned dozens of media reports investigating possible technical,
financial and managerial reasons for the deal’s debacle ever
since HP announced last month that it was treating $8.8 billion as money lost,
out of the original price of $11 billion it paid.
Leading
investor blogs, tech experts and financial papers in the US and the UK, where
the acquirer and the target respectively belong, have discussed quite
insightfully the micro issues of the deal.
But
surprisingly no one seems to question what I call the soft issues of this deal
- the people and the culture responsible for this loss. Who are the company
executives empowered with such decision making? What drives them to decide in
one way or the other while dealing with billions of dollars of people’s money?
What about the globally awed financial institutions who bring these deals to
the executives, advise whether to buy and how much to pay, and often lend their
money to make things happen? How do accountants deal with tricky situations
where they are expected to know the subject and report the truth?
My big ticket
M&A experience is that when such deals are cooking, everyone involved loves
the deal to go through and share in the glory and the excitement. Of course
there are always a few boring old Board members and executives who question the
price and/or the rationale of large acquisitions i.e. before the deals are
closed. May be they are too conservative or they lack vision or they have
nothing to gain from the deal. Or simply they are wise as seen in hindsight!
Since
shareholders and decision makers are unwilling or too deeply conflicted to
debate the uncomfortable fundamental issues such as (1) the cult of ‘wealth
creation’ sans cash flows i.e. through enhancement of market capitalization, (2)
compulsion for constant profit growth and (3) personal heroics targeted at job
continuity and bonuses as a reward for the former two, I believe that American
corporations will continue to lose billions of dollars on such deals.
Let’s look at
some of these basic issues for the Autonomy acquisition.
Selling
shares worth more than selling wares!
When HP acquired Autonomy for cash, the latter had a market value of
$6.7 billion or just 61% of the price paid. Six months before the deal, its
market value was approx. 50% of the deal value. In other words HP was paying
almost double of what the stock market was valuing Autonomy before the
beginning of the deal discussions with probable buyers such as HP and Oracle.
By the way only a year ago Oracle described a price tag of $6 billion as
outrageous as it walked off a possible purchase.
Path breaking moves require unusual means, so we will not delve in to
the reasonability of Autonomy’s price tag, which was supported – as in any
closed deal - by both the buyer and the seller and advisors on both the sides.
We know that tech companies and other new age businesses are often acquired for
several times their revenue or asset size and may be hundreds of times their
cash flows or profit.
Few leading tech companies start in a garage like HP did in 1939. HP
started as a remarkable instrumentation maker, which business, still solid, was
spun off to create Agilent in 1999. On the way to its now shadowed greatness,
HP did create billions of dollars in actual cash flow, leading to tangible
wealth. Microsoft and Oracle continue to do so, even if they may not have
retained a leading edge at all times.
But not every tech company, Autonomy included needs to generate actual
cash to be worth billions. These latter companies create wealth by promising
future growth to innovation-starved behemoths like HP and Microsoft, which
constantly seek quick-fix solutions to keep their technology and market share
sharp. These potential acquisition targets are valued on the stock market as
well as in the buy-out market often on the hope that someone would eventually
turn up to buy these at prices much higher than their visible cash over next
15-20 years!
This way Autonomy created its, in my view, ‘terminal’ wealth of $11
billion for its shareholder by selling out to HP. However, the wealth it could
create by selling its wares was but a minute fraction of this amount that it
created by selling shares. Sadly,
Autonomy itself achieved its over 50% compounded revenue growth from
acquisitions rather than organic growth. To put it differently, the 1996 born Autonomy
did not create any substantial cash box wealth…neither in its original avatar
nor in the hands of its foster father HP!
Of course, we must exclude Autonomy’s co-founder Mike Lynch from this
discussion of phoney wealth creation, as he pocketed a real $800 million from the
sale.
The growth
compulsion leading to loss of real wealth
Bill Hewlett
and Dave Packard’s HP was a different animal than what it has been in the hands
of Carly Fiorina, CEO 1999-2005 and creator of HP-Compaq combination in 2001,
and her successors.
Recognized by
Wired magazine as the world’s first producer of mass produced PC, HP was
the maker of the first hand held scientific calculator and the first inkjet and
laser printers. However, these firsts stopped happening in the 1990s and that
logically started the age of lacklustre growth desired to be remedied by
numerous acquisitions. This was different from how Bill Hewlett explained the HP
Way, “…the company exists to make technical contributions for the
advancement and welfare of humanity.”
In recent
years HP has received the punishment for being a part of the tech world where
high growth companies even with cash flow-untested business models are valued
several times more than staid old companies with large but low growth cash
flows.
HP reacted by
being a serial acquirer chasing the growth of its more glorious peers. Interestingly,
between 2002 and 2007, it made over 40 acquisitions (its lifetime score exceeds
110!) moving it away from hardware and imaging devices and more towards
software and applications, but only a couple of these were multi-billion dollar
deals. However since 2008, HP’s strategy changed visibly, pushing it to over 20
acquisitions, but with six deals worth a billion dollars or more, such as EDS,
Palm, 3Com and Autonomy.
With big
acquisitions, came big write offs. While it received fame for writing down $8.8
billion on Autonomy acquisition, prior to doing so, in 2012 itself it wrote
down $8 billion (i.e. 57% of the value) on its 2008 acquisition of Electronic
Data System (EDS) for which it paid $13.9 billion! In 2010, it wrote off the
100% value of Palm, the PDA maker, which it bought in 2008 for $1.2
billion.
Its
lacklustre organic growth spiked by acquisitions has designed its share price chart
in to a zigzag, oscillating from $20 in 2002 to a high of $54 in 2007, back to
$25 in 2009, going up to $54 in 2010, finally succumbing to $12 post Autonomy.
In summary,
every time HP bought a company worth over $10 billion, it lost more in market
capitalization than the price of its target! Sadly the same high growth targets
that created wealth for their selling shareholders could not repeat the act for
HP.
By the way,
Bill Hewlett also said, “We did not want to run a hire and fire operation…” Its
CEO just announced that 27,000 or over 7% of its employees would be fired in
2012.
Analysts -
top ranked, but not good enough
Over 20 tech analysts, including some top ranked, covered Autonomy, a
listed company prior to its acquisition. However, the analyst community by and
large could not or did not see that Autonomy’s revenue growth was to an extent
supported by hardware sales, misrepresented as software sales. They did not see
that much of such sales were not cash flow generating, but creative accounting
made it look profitable by taking some direct expenses below the operating
profit line. Further, billings to resellers were treated as revenue even if
resellers could not push the products down to end customers literally requiring
revenue reversal. Analysts did not spot that or the fact that invoices on long
term contracts were treated as revenue while these should have been recorded as
revenue deferred over the several year life of the contracts.
Only a couple of analysts ever recommended
‘sell’ or raised questions on Autonomy’s financials or business model. Daud
Khan of JPMorgan Cazenove was one and he was reported to have been banned by
Autonomy from analyst meetings for almost a year. On rare occasions, it was
Mike Lynch, CEO, and not as usual company’s CFO, who emailed responses to
accounting queries.
It would be quite a revelation to know the true
answer to the question as to why over 90% of the analysts following the stock
did not question or suspect Autonomy’s reported performance. There could be
several answers, but pessimists might say that institutional investing and stock
broking community makes money from stocks doing well, not by making stocks go
bust!
Brittleness of the big institutions
HP management has accused Autonomy’s founder Mike Lynch of wrong doings.
In the wake of this, Lynch’s opinion last month of his bankers and accountants
to whom he must have paid millions of dollars in fees, and of HP management,
who made him a billionaire as a result of the buy-out, was telling.
He said, “HP did due diligence on the same with hundreds of people
involved and then ran the business for a year. You’d have to be pretty
incompetent not to spot something like this for a year.”
Consider who
he is talking about. On the face of it he is talking about KPMG, HP’s financial
due diligence adviser, but indirectly he is also damning Perella Weinberg and
Barclays – HP’s investment bankers, who blessed the deal at a value which
relied seemingly unquestioningly on KPMG’s due diligence report.
On the other
hand Meg Whitman has reported the case for a fraud investigation with SEC and
the UK’s Serious Fraud Office, thereby blaming not only Autonomy’s management
headed by Lynch, but also its auditor Deloitte and Frank Quattrone, the leading
technology deal maker who presented Autonomy to be worth the price, as well as
her own ex-CEO Apotheker. It will be silly for the five bulge bracket banks, which
joined the party on Autonomy’s side, namely Goldman Sachs, UBS, Citibank,
JPMorgan and Bank of America, to believe that they would remain untouched of
the muck.
HP has now appointed PwC as forensic auditor to get to the root of the
matter and report on the details of Autonomy’s misrepresentations.
This will not be the last time someone would question the validity of
the practice of paying the deal makers largely for closed deals rather than for
good advice irrespective of whether the deal closed. This will also not be the
last time people would wonder what makes accountants fail to detect or become
party to the most gigantic financial misrepresentations.
Perfect
resumes, flawed wisdom
And finally the people, who are at the forefront of Autonomy deal. The
brief biographies here are just by way of relevant examples, while the capitalism
of quarterly financials and YOY stock values is certain to feature dozens of
such resumes!
Autonomy’s founder Mike Lynch OBE, graduated from Christ’s
College, Cambridge in natural sciences and electrical sciences. Later he
completed PhD in signal processing and communications research at the
University of Cambridge and followed it up with a research fellowship in
adaptive pattern recognition. The bright 1965 born engineer went on to design
Lynex, the first ever sampler for the Atari ST, followed by the ADAS sampler
for Atari and Mac. His innovations spanned audio products, computer based
finger print recognition and IDOL, which enabled conceptual harnessing of
unstructured data such as emails, images, audio and video data. In 2000, Time
magazine called him one of the 25 most influential technology people in Europe.
An aging HP leadership team with 1953 born Leo Apotheker at the helm,
in theory, could not have asked for a better resume to acquire and retain when
buying out Autonomy.
Yet, in its last month’s announcement, HP squarely blamed Lynch and his
management for financial misstatements concerning revenue growth and profitability
as well as misrepresentation of the business mix, leading to $8.8 billion
written off Autonomy’s value. He continues to be advisor to the British Prime
Minister in the area of science policy.
Apotheker himself had a prominent 22 year career at SAP, rising to the
position of its co-CEO before joining HP in 2010. A fluent speaker of five
languages, his lifetime work at enterprise solutions made him the most
qualified evaluator of Autonomy, dubbed ‘a global leader in infrastructure
software for the enterprise’ in HP’s deal announcement of August 2011.
Yet, he failed to see through the holes in Autonomy’s business model and
as a result lost his job to Meg Whitman (b. 1957). Whitman, a
billionaire and among the richest women in the US, also sports top class
academics - BA in economics from
Princeton University and MBA, Harvard Business School.
She is associated with big numbers – in 2007, she donated $30 million to
Princeton University, spent $144 million of her own money in 2010 to
unsuccessfully run for governor of California and bought Skype for $4.1 billion
in 2005 for eBay, eventually to be sold at $2.75 billion in 2009 to the firm of
Marc Andreessen (see below), a year after her departure from eBay.
However, her biggest achievement is leading eBay a $4 million revenue
company in 1998 when she took over as CEO, to the revenues of $8 billion and
over 15,000 employees in 10 years. With earlier stints at P&G and Hasbro’s
Playschool division, she understood the marketing side of both brick and mortar
and tech businesses.
Yet, as HP’s board member, she did vote in favour of buying Autonomy.
Marc Andreessen (b.
1971) is fittingly a star member of the board of HP, a company recognized as
the symbolic founder of Silicon Valley. Just like Mike Lynch, he sold his software company Opsware to HP in 2007 for $1.6 billion (but no
hiccups here) before joining the HP board.
Andreessen has a degree in computer science from the University of
Illinois at Urbana Champaign. While at the university, he co-authored Mosaic,
the first widely used web browser, which led to his co-founding Netscape
Communications Corp.
He also co-founded Andreessen Horowitz, a tech venture capital firm.
Among his hugely successful investments are Facebook and eBay, where he is also
a board member and Twitter, Groupon, LinkedIn and Zynga. He is a master at the
game of innovating and spotting big time innovations that would later grow into
real businesses worth billions of dollars in the IPO or the buy-out market. In
1999, MIT Technology Review named him one of the world’s top 100 innovators
under the age of 35.
At age 24, his creation Netscape had a successful IPO and at 28 i.e. in
1999, he sold Netscape to AOL for $4.2 billion. In 2009, his firm acquired a
majority stake in Skype for $2.75 billion and in less than two years Microsoft
bought Skype for $8.5 billion.
Yet when it came to one of the biggest investments in HP’s history, as
director, Andreessen voted in favour of what would be called tech world’s
biggest reported fraud, now investigated by the UK’s Serious Fraud Office.
Finally, HP’s CFO Catherine Lesjak, holder of a degree in biology
from Stanford University and MBA, University of California, Berkeley.
One of the most powerful women executives in the US, she has been
with HP for over 17 years and is in charge of HP’s finance, treasury,
tax, controls and real estate. In the past she directly managed HP’s finances
of enterprise solutions and software business units.
Yet when it came to advising her CEO and board on Autonomy’s finances, the
storied CFO did not seem to have raised some obvious and pertinent questions.
What explains this galaxy of bright stars playing blind when it comes to
investing shareholders’ money? Mind you – today’s stringent accounting
standards requires write downs on almost every buyout, but Autonomy is hardly a
case of underperforming business, a routine and acceptable phenomenon. It is a
case of misrepresentation and fraud supposedly perpetrated by a brilliant
techie Mike Lynch over a collection of even brighter stars consisting of a
financial wizard, one of the world’s most successful innovators and investors
and several grey haired corporate and financial services titans.
Well then,
let’s wait until the next headline. But in the meantime, feel free to invest in
high risk high reward takeover targets until things change, which seems
unlikely in foreseeable future.
