In its Q4 earnings report last week, Hewlett Packard (HPQ) announced that it was taking an $8.8 billion impairment charge to write down the value of goodwill and intangible assets associated with the company's acquisition of British software firm Autonomy, PLC in 2011. On the company's conference call, CEO Meg Whitman alleged that HP had discovered serious accounting improprieties and misrepresentations made by Autonomy's management. These were discovered after an Autonomy insider came forward earlier this year. According to CFO Cathie Lesjak, "Of the $8.8 billion noncash write-down, over $5 billion is related to accounting improprieties, disclosure failures and misrepresentations that occurred prior to HP's acquisition of Autonomy and the associated impact on the financial performance of the business over the long term."
Unsurprisingly, public outrage has been widespread following these disclosures: particularly because this was HP's second multi-billion dollar writedown of the year. HP has already been the target of at least one lawsuit from a shareholder who alleges that the board and management misled investors about the Autonomy acquisition by not taking a writedown earlier. Since the news came out, financial media outlets (including Seeking Alpha) have aired numerous alarmist reports about the likely effects on HP's share price.
HP shareholders have a right to be angry about the Autonomy deal. Even for a company with more than $100 billion in annual sales like HP, a $10 billion acquisition is a huge decision and merits extreme caution. It's therefore hard to understand how the company's management and board could have miscalculated so badly. But shareholders should not be surprised: at least not any more. Ironically enough, the "news" about the problems at Autonomy was not really newsworthy from a shareholder perspective. By last week, HP investors already knew (or should have known) that the company massively overpaid for Autonomy. There is no compelling argument for assigning HP shares a lower valuation based on last week's allegations. To understand why, a short review of the company's recent performance is in order.
HP's History With Autonomy
On August 18, 2011, HP announced that it intended to purchase Autonomy at a total purchase price of more than $10 billion. At the time of the acquisition, HP's management lauded Autonomy's high margins, strong growth, and most importantly, the synergies it would create with other HP assets in the big data and cloud-computing fields. Autonomy's software can analyze "unstructured data", which complements HP's more traditional database software offerings. HP has already begun packaging Autonomy's technology as part of broader "big data" solutions. These should hopefully help HP compete more effectively against IBM (IBM) and Oracle (ORCL) in the data analytics field in the future.
At the time of the acquisition, the analyst community was divided on the wisdom of the move. While most seemed to believe that Autonomy would be a good strategic fit for HP, many analysts worried that HP paid too high a premium (the price represented roughly 50X earnings and 11X revenue). Thus, concerns about the proper valuation of Autonomy's business have been widespread since the acquisition was first announced.
Shareholders were hoping that HP's large sales force would be able to help Autonomy continue growing at a rapid clip by opening up new selling opportunities. However, they were soon to be disappointed. While management reported that the Autonomy acquisition was "going well" in February (one quarter after the deal closed), by May HP was acknowledging serious problems. CEO Meg Whitman stated, "Autonomy had a very disappointing license revenue quarter, with a significant decline year-over-year resulting in a shortfall to our expectations." At that point in time, management thought the problems were a temporary setback due to growing pains (i.e. the difficulty of scaling Autonomy). Still, Autonomy was supposed to be a high growth company, so revenue declines were a major red flag.
By August, the outlook was even gloomier. Whitman reported, "Among the many changes we've instituted is a global dashboard to track Autonomy's pipeline, a single global sales methodology, a single HP services engagement process and a global process to measure client satisfaction and service delivery progress.... Overall, we have a very long way to go, but we are taking steps to fix the problems and help Autonomy succeed." While HP still expects Autonomy-based solutions to be an important driver of future growth, by August at the latest it was clear from management's comments that the Autonomy acquisition had been a huge disappointment requiring a lot of fixing. Last week's announcement, by contrast, did not provide any new information on Autonomy's performance.
Where's the Downside?
There are three potential arguments for why last week's revelation of potential financial wrongdoing at Autonomy will be bad for HP shares. 1) shareholder litigation could distract management and even lead to a judgment against HP; 2) the writedown could be a signal that HP's future performance will be worse than expected; and 3) the writedown will leave investors with less confidence in the management team.
However, I do not believe these arguments have much merit. On the first point, most of the litigation decisions will be made in the legal department, and will not require significant attention at the CEO/CFO level. The worst plausible outcome of the litigation is that HP will have to pay more for directors and officers insurance in the future. On the second point, Autonomy's underperformance has been well known for months. Furthermore, HP updated investors and analysts on its FY13 expectations just last month, and predicted relatively modest growth in the software segment. The majority of the goodwill writedown can be attributed to assigning Autonomy a lower earnings/revenue multiple based on the already reduced expectations for growth. Lastly, I think the market's confidence in Meg Whitman and her leadership team will be determined by HP's turnaround progress over the next year or two, not by mistakes made before Whitman was appointed CEO. Others may argue that Whitman should be held responsible for the Autonomy debacle because she was on HP's board at the time, but corporate board members rely on information provided by others to make decisions. As Whitman pointed out on the recent conference call, the leadership team responsible for recommending the acquisition has already been replaced.
Any minor remaining downside risk from these three factors is offset by the potential upside from last week's news. Only one Seeking Alpha article that I have seen has pointed out what should be obvious: if HP can prove its claims of financial wrongdoing at Autonomy, the company could potentially recover a portion of the more than $5 billion loss it attributes to those problems. HP has already stated that it is likely to pursue financial redress through the civil courts. Autonomy's founder and former CEO Mike Lynch has emphatically denied wrongdoing, but HP's management would not have made such serious allegations unless they had solid evidence. (The need for thorough investigation probably explains why the company waited until now to disclose the accounting problems.)
There is plenty of blame to go around. Between Autonomy's former management, Autonomy's auditors, and HP's various investment banking and accounting advisers, HP has plenty of potential litigation targets. If HP can eventually recover half of the $5 billion lost, this would provide shareholders a very tangible benefit that could not have been expected two weeks ago. I do not think that investors should buy HP simply out of hope for a favorable litigation settlement. On the other hand, last week's news does not alter my previous conviction that HP is a good value for long-term investors. Ultimately, from a valuation perspective, it was not news at all.
Disclosure: I am long HPQ.