San Francisco/New York: Hewlett-Packard Co. (H-P) stunned Wall Street by alleging a massive accounting scandal at its British software unit Autonomy and taking an $8.8 billion writedown, the latest in a string of reversals that renewed questions about the competence of the storied company’s board and senior managers.
H-P said on Tuesday it discovered “serious accounting improprieties” and “a willful effort by Autonomy to mislead shareholders,” after a whistleblower came forward following the May ouster of former Autonomy Chief Executive Mike Lynch.
The news sent the company’s shares plunging 12% to a 10-year low of $11.71. H-P, which for decades was synonymous with technical excellence and innovation as one of the bedrock companies of Silicon Valley, now has a market value of roughly $20 billion, down from $155 billion in April of 2000.
CEO Meg Whitman took the helm at H-P a little over a year ago when her predecessor, Leo Apotheker, was fired after less than a year on the job. Apotheker’s one big strategic move during his brief tenure was the $11 billion acquisition of Autonomy, intended to hasten H-P’s transformation into a software and services company but which was criticized by many analysts as over-priced.
“Most of the board was here and voted for this deal, and we feel terribly about that,” Whitman said on a call with analysts.
Tuesday’s announcement came just three months after the company took a write-down of almost $11 billion on its EDS services division.
H-P 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.
H-P said it has referred the alleged accounting wrongdoing at Autonomy to the US Securities and Exchange Commission’s enforcement division and the UK’s Serious Fraud Office for civil and criminal investigation. H-P also said it would take legal action to recoup “what we can for our shareholders.”
Both agencies declined to comment.
Lynch, in an interview with Reuters, “flatly rejected” HP’s allegations and said he was “shocked” but confident he would be absolved of any misdeeds. The Irish-born executive said he had not been notified by H-P about the allegation before it was made public, nor had he been contacted by any authorities.
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 H-P’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.
On Tuesday, a person familiar with the situation told Reuters that the Federal Bureau of Investigation was probing the H-P-Autonomy allegations in concert with the Securities and Exchange Commission, although the inquiry was at an early stage.
H-P 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.
H-P’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 and Crutcher; Freshfields Bruckhaus Deringer; Drinker Biddle and Reath; and Skadden, Arps, Slate, Meagher & Flom, which advised the board.
Inflated sales, revenue
Whitman on Tuesday stood by Autonomy’s technology and products, saying the unit would still be the growth engine for H-P. 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 Corp.
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.
H-P disclosed the Autonomy allegations in conjunction with its fourth-quarter earnings, which showed a 6.7% 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 H-P stock and headwinds against anticipated synergies and marketplace performance,” HP said without elaborating.
H-P 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 mischaracterized 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 40-45% range, while realistically they were in the 28-30% range.
Moreover, Autonomy always represented itself as a software firm but 10-15% of its revenue came from money-losing sales of low-end hardware, H-P 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 H-P 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% market share against the likes of Microsoft Corp., IBM and EMC Corp. in the field of e-discovery.
Autonomy’s stated margins of around 50% did not seem to translate proportionately into cash flow; and it was reporting double-digit organic growth in software licence 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 H-P.
Last year, software firm Oracle Corp said it had looked at Autonomy but passed on it.
Whitman said Tuesday 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 H-P 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 H-P, Enderle said.
But Darren Robbins, a San Diego-based plaintiff lawyer who represents shareholders, said he fielded several calls on Tuesday from institutional investors about HP. The tech icon spent billions on a company without undertaking proper due diligence, Robbins said.
“I think they have serious troubles,” he 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, H-P said net revenue fell to $29.96 billion for the quarter ended 31 October, from $32.12 billion a year earlier. Analysts, on average, had expected $30.43 billion, according to Thomson Reuters.
Revenue from its main business units declined, with the personal computer division recording the steepest drop at 14%. Revenue from printing fell 5%.
H-P reported a quarterly net loss of $3.49 a share, versus a profit of $239 million, or 12 cents, a year earlier.