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Red Flags Preceded HP's $11-billion Autonomy Deal

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Long before Hewlett-Packard (HPQ) paid $11 billion for what turned out to be its disastrous purchase of Autonomy, a handful of industry experts were raising red flags about the British software company's accounting practices and claims of continuous growth.

HP said this month that it only recently discovered what it characterized as fraud and other problems that made it realize it spent billions of dollars too much on the deal. But a vocal group of critics -- albeit a minority at the time -- were sounding alarms about the company as far back as 2007.

In a 2009 report, for instance, one analyst termed some of its financial statements "wrong and misleading." The following year, another said its "earnings momentum appears to be negative." And after HP announced its plan to buy the company in August 2011, a third analyst predicted the acquisition would "destroy" HP's stock value.

With sales of their computer gear faltering, HP's leaders had desperately hoped to transform the company with Autonomy's products. But the transaction has turned into one of the most embarrassing debacles in the storied Palo Alto corporation's history. And many critics contend HP never should have done the deal given what some experts had long been saying about the software company.

"Our concern was the organic growth that Autonomy was reporting was overstated," said Dan Mahoney, research director at CFRA, summarizing the skepticism of other analysts. While not alleging fraud, Mahoney said his forensic accounting firm began sounding alarms in reports to its investor clients in 2007, adding "it seemed like they were constantly moving things around in their financial statements to make things appear better than they are."

HP now admits it erred in paying what it did, claiming it was duped about the British company's sales. But while acknowledging in a statement to this newspaper that it had been aware of apprehensions expressed about Autonomy, it said it had "relied on the audited financial statements and the representations of Autonomy's management and its auditors."

In an interview with CNBC two weeks ago, Meg Whitman, who had been on HP's board when the deal was announced in August 2011 and became CEO in September, a month before the Autonomy purchase was finalized, said "I regret that I voted for this deal but we are where we are."

Whitman added that "after we announced the acquisition there were a number of blogs that came to the fore about potential issues at Autonomy." But she said "the former management team ran that to ground and came up with the conclusion that there was nothing there ... Obviously we know different now."

HP has asked U.S. and British regulators to conduct a "civil and criminal investigation" of the transaction, but Autonomy's former CEO Mike Lynch has denied his company misrepresented its finances.

Founded in 1996, the software company was little known in the United States, but favored by many European investors because of its record of rapid growth and its reputation for cutting-edge technology. With its sophisticated search engine for analyzing commercial data, Autonomy made an attractive purchase for Leo Apotheker, who was hired to be HP's CEO in November 2010 at a crucial time for the computer giant -- after a previous CEO had been forced out and as new technology trends were threatening to undercut HP's business.

Profit margins in HP's computer hardware business were shrinking in the face of low-cost competitors and changing consumer habits. Meanwhile, big competitors like IBM and Oracle (ORCL) were far ahead in the race to sell sophisticated commercial software that could help corporate customers sort through mountains of business data. Apotheker hoped that buying Autonomy would jump-start HP's move into the software business, which carried the promise of higher profit margins and rapidly growing demand.

Nonetheless, some industry experts had been issuing caveats about Autonomy for years.

In August 2009, Paul Morland of London brokerage Peel Hunt issued the warning about Autonomy's statements being "wrong and misleading." He followed that with other reports that Autonomy's "track record over the last few years has been exaggerated," and that it "needs to make an acquisition every twelve to eighteen months in order to sustain its apparent high rate of growth."

Some critics questioned the value of Autonomy's main product, a search engine called IDOL.

"There was some brilliant technology there," said Alan Pelz-Sharpe, a software industry expert at 451 Research. But he said it was expensive and so cumbersome that some early customers struggled to make it work.

Another skeptic was James Chanos of the hedge fund Kynikos Associates, one of the world's best known "short sellers," who make money betting that companies' shares will fall. In a speech explaining why he bet against Autonomy in 2010 -- months before HP bought the company -- he said "the accounting was absolutely dreadful, a disaster."

Autonomy didn't take kindly to such sniping. Pelz-Sharpe said it stopped talking to him. Other analysts dubious of the firm said it threatened them with lawsuits or punished them in other ways.

One of them was Daud Khan, who wrote a critical report on Autonomy for J.P. Morgan in September 2010. In an interview last week, Khan said he had become convinced "the wheels were starting to come off the business in late 2010."

Criticism continued through 2011 -- right up to HP's announcement in August that it planned to buy Autonomy. Deutsche Bank analyst Marc Geall in March 2011 wrote of Autonomy's sales that "things are looking bad."

HP's announcement on Aug. 18, 2011, that it was buying the company stunned some analysts. While applauding the goal of expanding HP's software offerings, they said the $11 billion price was too steep.

"We believe HP overpaid by $2 (billion) to $3 billion," groused Brian Alexander of the Raymond James investment firm. Calling it "a rich, ill-timed acquisition," Deutsche Bank analyst Chris Whitmore predicted the deal would "destroy" the value of HP's stock.

Two weeks before HP's board gave final approval to the transaction on Oct. 3, Larry Ellison, CEO of Redwood City software giant Oracle, said he turned down a chance to buy Autonomy after determining its $6 billion market value "was absurdly high." Even some top HP executives were concerned about the price. Among them, an HP representative confirmed, was its Chief Financial Officer Cathie Lesjak, who urged the board not to do the deal.

It didn't take long for the purchase to turn problematic.

On May 23, Whitman, who replaced Apotheker, reported that "Autonomy had a very disappointing license revenue quarter, with a significant decline year-over-year, resulting in a shortfall to our expectations."

Then, on Nov. 20, HP stunningly announced it had written down $8.8 billion for Autonomy, with more than $5 billion for "accounting improprieties, misrepresentation and disclosure failures" related to Autonomy's business.

It said it only discovered the problems after an Autonomy official came forward with the allegations. But a shareholder lawsuit filed after the disclosure accuses HP's board and top executives of having "consciously disregarded numerous red flags" about Autonomy.

John Hempton, an Australian money manager who has closely followed HP's Autonomy acquisition, said the fiasco offers two painful lessons. For one thing, he said, companies venturing into unfamiliar product lines through an acquisition need to be wary of "getting suckered." And they better heed the warnings of analysts covering the company being bought, he said, because those analysts "probably know a few things."

--January 2007: CFRA, which does forensic accounting for investor clients, adds Autonomy to its "Biggest Concerns List," saying the company's reported cash flow and income "appear to have benefited significantly" from questionable changes in the way it classified certain items.

--August 2009: Analyst Paul Morland of Peel Hunt calls Autonomy's financial statements "wrong and misleading."

--September 2010: J.P. Morgan analyst Daud Khan terms Autonomy's latest quarterly financial report "very disappointing," adding that its "earnings momentum appears to be negative."

--October 2010: Marc Geall, an analyst with Deutsche Bank, warns that "the management structure, control and systems at Autonomy are more representative of a start-up than a major global player."

--The same year, hedge-fund guru James Chanos bets Autonomy's shares will tumble, explaining later that he believed the company's "accounting was absolutely dreadful, a disaster."

--March 2011: Morland writes that Autonomy's sales growth is slowing and "things are looking bad."

--August 2011: After HP announces plan to buy Autonomy, Deutsche Bank analyst Chris Whitmore predicts it will "destroy" the value of HP's stock, and HP's Chief Financial Officer Cathie Lesjak urges the board not to do the deal.

Distributed by MCT Information Services


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