"HP is extremely disappointed to find that….". With these ominous words began a shocking revelation by Hewlett Packard (HPQ) about a major alleged fraud that led to its over-priced acquisition of Autonomy. As a value investor, among your worst nightmares that erode any comfort about a "margin of safety" is the revelation of a nasty surprise about a past balance sheet event. It is one thing to fret about an over-priced acquisition, and account for it in your valuation model, but it is completely different to hear about outright fraud. The excrement has hit the fan with this announcement and as an HP investor, I am outraged. Getting to the bottom of this will take several months, possibly years, before the full truth comes about. There are, however, more questions than answers raised by HP's shocking announcement about Autonomy. HP cannot divorce itself so easily by blaming Autonomy alone for this mess. Let's try to analyze the announcement itself.
"HP today announced a non-cash impairment charge of $8.8 billion related to Autonomy in the fourth quarter of its 2012 fiscal year. The majority of this impairment charge, more than $5 billion, is linked to serious accounting improprieties, misrepresentation and disclosure failures discovered by an internal investigation by HP and forensic review into Autonomy's accounting practices prior to its acquisition by HP."
This is not a simple impairment - $8.8 billion is nearly 90% of the acquisition value. This means the Autonomy valuation model - presumably developed by leading investment bankers, vetted by the finance and strategy wizards at HP, validated by the accounting geniuses at Deloitte, ratified by the independent auditors at KPMG, and finally blessed by HP's illustrious Board of Directors, most of whom are still there - is off by an order of magnitude. How can this happen with so many checks-and-balances and layers of review within HP? How can this even be possible in a post-Enron, post-Sarbanes Oxley, post-"mark to market" and post-recession environment, when the accounting and finance functions had been chastised to the point of forced conservatism even in tangible asset valuation. The announcement continues:
"The balance of the impairment charge is linked to the recent trading value of HP stock and headwinds against anticipated synergies and marketplace performance."
Even if HP's estimate of $5 billion impairment allocated to "fraud" is true (investors may wonder if HP's management could over-state this figure to make the acquisition look less of a foolish "over-payment" and position itself more as a victim "OMG, we were deliberately fooled!"), the "true" over-payment impairment as per HP's admission above is $3.8 billion, or about 38% of the acquisition value. An acquisition where 38% of the value is attributed to synergies post-acquisition is already a dangerous place to begin, which means the business must be superbly complementary to HP to allow such synergistic value to be taken out from structural savings. Looking at HP's acquisition announcement last year, the price it paid for Autonomy was a 58% premium to its prior month average stock price. This means even if HP did not suspect any fraud, and given that Oracle (ORCL) snubbed Autonomy a year ago so publicly within a month of HP's acquisition, alarm bells should have rung within HP's Board as far back as late September 2011 that there is something substantially wrong about its valuation of Autonomy. So, why did HP not initiate a forensic analysis in October 2011? If it did, does it not have an obligation to mention this to investors during any of the last 4 quarterly announcements or even as a brief investor announcement?
What better reason does HP need than when a leading enterprise company like Oracle publicly announces that even $6 billion is too pricey for Autonomy? Had HP acquired Autonomy at $6.2 billion (entirely removing the 38% synergy value), by Oracle's reckoning, even that would have been too pricey. Note that this assessment was done at a time when neither Oracle nor HP would have suspected any "accounting irregularities" or "willful effort to mislead investors" by Autonomy. This means HP cannot couch its Autonomy acquisition fiasco on fraud accusation alone as it is attempting to broad brush with the recent announcement, which goes on to add:
"HP launched its internal investigation into these issues after a senior member of Autonomy's leadership team came forward…..HP initiated an intense internal investigation, including a forensic review by PricewaterhouseCoopers of Autonomy's historical financial results, under the oversight of John Schultz, executive vice president and general counsel, HP. As a result of that investigation, HP now believes that Autonomy was substantially overvalued at the time of its acquisition due to the misstatement of Autonomy's financial performance,…."
So, despite all the supposedly water-tight due diligence done earlier where two of world's top 4 firms in accounting were involved, it required a whistle-blower from Autonomy to really get HP to act? Did it take a forensic investigation from PwC to get HP to realize that Autonomy acquisition was "substantially overvalued?" If $6 billion was publicly snubbed as too pricey by Oracle, did it take HP one full year after that to recognize that its payment of 67% premium on top of the figure that Oracle already deemed it pricey was "substantially overvalued?" Was this investigation designed to make HP look the "innocent victim" here? In the same announcement, it says:
"We remain 100 percent committed to Autonomy and its industry-leading technology."
Yeah, right. Has HP ever bothered to quantify how much has HP truly gained from Autonomy's technology since the acquisition? Will HP care to list any major customer acquisitions enabled by its integration of Autonomy' technology, which would not have occurred without this technology? After all this mess, doesn't this statement appear vacuous? Instead of writing off nearly 90% of the acquisition value, HP should perhaps write off the whole acquisition and we can all pretend that it never happened. This way, it can remain 100% committed to Autonomy while having 0% of its value on its books.
If you are long HPQ, do you want to hold on in the hopes of "crazy cheap" intrinsic value at HP? Do you have faith in the valuation of its other assets? No matter how "cheap" a stock looks, it can plumb new depths if this is the kind of gross negative surprises that are buried in its balance sheet. HP needs to answer many questions for its investors.
Disclosure: I am long HPQ.