Daily: A brief post about mergers, accounting and shareholder value using Hewlett Packard
Below are a number of articles I feel are worth reading on the Hewlett Packard acquisition of Autonomy and the accounting scandal associated with writedowns from that acquisition. I want to briefly analyse the fallout from this episode from a number of different levels from the economy-wide macro to the company specific and investing.
First, looking at the autonomy acquisition from an economy-wide perspective, HP’s quarterly report is interesting. Here’s how Tech Crunch reported the earnings report:
HP’s earnings for Q4 ending on October 31 show a gloomy quarter. Revenue is down 7 percent to $30 billion compared to Q4 2011. But the real problem comes from GAAP net income, with a net loss of $6.9 billion, or $3.49 per share, compared to a slim net profit of $0.2 billion for Q4 2011. Non-GAAP diluted earnings per share is at $1.16 compared to $1.17 year-over-year. Most of the bad news comes from a huge $8.8B write-down for $10.2 billion Autonomy acquisition due to accounting fraud.
In its earnings document, HP cites “serious accounting improprieties, disclosure failures and outright misrepresentations.” HP CEO Meg Whitman commented during the earnings call “we feel terrible about the deal.”
According to Thomson Reuters, analysts forecasted net income of $2.2 billion on revenue of $30.4 billion. The write-down is unexpected and represents the vast majority of HP’s loss. Without it, it would be a slight miss for HP on both revenue and net income. On EPS, HP slightly beat expectations. Instead of $1.14 non-GAAP diluted EPS, HP reports $1.16.
What you should notice is that HP’s reported non-GAAP earnings only dropped by one penny despite the company’s revelation of a massive destruction of wealth. Without the writedown “it would be a slight miss for HP on both revenue and net income” and HP beat on an EPS basis. Now clearly, HP is getting killed due to this massive writedown despite the non-GAAP reporting subterfuge. But the accounting game they are playing is par for the course for corporate accounting. What HP wants us to believe is that somehow these writedowns are anomalous and non-recurring, a one-off. And so they separate them out to give us a “true” picture of the company’s earnings.
And this is how the earnings game works. The key lesson here from an economy-wide perspective is that economy-wide aggregated reported earnings vastly overstate earnings at the nadir of an economic cycle as these non-GAAP writedowns proliferate. And so despite the happy face analysts sometimes put on S&P500 earnings and the forward P/E multiple that results from using these numbers, the reality is that these numbers are often highly suspect. As an investor, if you are thinking about portfolio allocation and risk-on and risk-off warning signs, you will want to use cyclically-adjusted price/earnings ratios that use GAAP earnings over a number of years (7-10) to capture a large part of the upcycle and downcycle of any business cycle. Below is a recent chart of the CAPE for U.S. stocks using a ten-year P/E and it shows that US stocks are still overvalued on a historical basis.
The results point to “significant outperformance by selecting markets based on relative and absolute valuation,” Buying only when CAPE was below 15 and shunning markets with ratios higher than 30 led to higher returns, the research showed.
The same techniques are instructive on an individual stock basis. Don’t look at the non-GAAP measures a company gives you at face value. No one is doing so in the case of HP because the writedown is so large but what the writedown represents is past management error and lost shareholder value aka destruction of wealth. The question investors need to ask is to what degree do the writedowns represent still ongoing company-specific problems that are likely to manifest themselves again. The non-GAAP numbers are supposed to strip out “non-recurring” items to tell you this. But many managements play with the accounting by adding as many writedowns into a single bad quarter as possible in order to make it seem like ALL of the writedowns are non-recurring when in fact they are not. I strongly suspect that some of HP’s writedown is recurring.
One comment in another article caught my eye:
One red flag pointed out by both [Dartmouth professor of accounting Philip] Stocken and Villanova professor Anthony Catanach was that companies that do a lot of acquisitions tend to have trouble keeping track of all the businesses that come in. Catanach notes: “… basically nine out of 10 acquisitions and mergers result in failure.”
This is very true. Mergers usually destroy wealth for the acquiring company because the company overpays due to synergies that never come to pass. It makes you wonder why companies engage in so many mergers when the academic study evidence consistently shows that mergers destroy shareholder value. It’s one thing to make many small acquisitions of insiginficant companies. But when a company makes large acquisitions relative to the size of your company in terms of employees or revenue, you should be aware that these kinds of moves often destroy value and are a sign for you to either stop accumulating shares or to sell. The HP acquisition of Autonomy was one such case.
“Non-GAAP diluted earnings per share is at $1.16 compared to $1.17 year-over-year. Most of the bad news comes from a huge $8.8B write-down for $11.1 billion Autonomy acquisition due to accounting fraud.
In its earnings document, HP cites “serious accounting improprieties, disclosure failures and outright misrepresentations.” HP CEO Meg Whitman commented during the earnings call “we feel terrible about the deal.””
“British entrepreneur Mike Lynch has angrily rejected allegations made on Tuesday that his software company Autonomy inflated its financial results before selling it to Hewlett-Packard for $11.1bn (£7bn).”
“It turns out there were, and a few smart short-sellers — the most obvious one is Jim Chanos of Kynikos Associates, who in the last 24 hours has been hailed as a bit of a god of short-selling wisdom on CNBC — who read the situation correctly and made money.
There are others who saw troubles at Autonomy that should have occurred to HP’s due diligence team. One is John Hempton, of Australia’s Bronte Capital. In a blog post this morning he sums it up this way: Good software companies tend to have low receivables and higher unearned income on their profit/loss and balance sheets. At Autonomy, it was the reverse.
Here’s a little Accounting 101: A receivable is a debt a company is owed and expects to be paid. If you buy a car from your neighbor and pay him half now and half next month, he’s counting on the fact that he’s going to be paid that other half next month. This is a receivable, and on a corporate balance sheet it goes in the assets column. This is how it tends to work for durable and tangible goods, which software is not.”
“in the wake of HP’s move to acquire Autonomy, Ellison said that at something north of $11 billion, HP had paid an “absurdly high” price, and cattily followed that by saying that Oracle had “taken a pass” on Autonomy.
Lynch, in an interview with The Wall Street Journal days later, said that no such overtures to Oracle had ever been made.
Oracle, just to set the record straight, mind you, with absolutely no other agenda in mind, fired back that Lynch apparently had a bad memory and had forgotten about a meeting, indeed a pair of meetings, involving Hurd, Lynch and Quattrone and some PowerPoint slides.”
“One red flag pointed out by both Stocken and Villanova professor Anthony Catanach was that companies that do a lot of acquisitions tend to have trouble keeping track of all the businesses that come in. Catanach notes: “… basically nine out of 10 acquisitions and mergers result in failure.”
HP has done 10 significant acquisitions in two years, which puts a lot of pressure on the company to make all those other companies fit together, like a complicated puzzle. Other acquisitive companies, like Groupon, have also been scrutinized for accounting troubles.
Another red flag: the indication that Hewlett-Packard’s information systems were so problematic that it couldn’t track its own income, as Stocken surmises. When a company publicly admits major weaknesses, it means that issues are too big to ignore. It also means they’re probably not completely in the past, because big problems take such a long time to fix.”
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