The Wall Street Journal has an interview with Mike Lynch, former CEO of Autonomy, the company HP acquired for $11.1 billion and which investment has been written down by $5 billion amid allegations of financial irregularity. Aside from vehemently denying any wrong doing, Lynch raises points that further muddy the waters around the Autonomy debacle. Key points from the Q&A along with my commentary:
WSJ: When were you first made aware of these allegations?
ML: We were not made aware. We have been ambushed. The first we knew was when the press release came out at around 1pm U.K. time.
POV: HP alleges criminal acts. In the UK, where HP claims to have informed the Serious Fraud Office, I would expect to see people brought in for immediate questioning based upon information held by the police. Lynch says he knew nothing and has not been approached by any regulatory or enforcement body. Strange.
WSJ: You have seen the allegations about irregular accounting practices , price inflation, presumably everything was cleared by auditors, you were a FTSE 100 company?
ML: We were audited on a quarterly basis. It was Deloitte who knew the company well. We had 10 years as a listed company; during that time Deloitte would have had their work reviewed by the various boards. Of course H-P did what its senior management called “a meticulous due diligence” involving hundreds of people that was highly intense, involving KPMG Barclays as BARC.LN -1.30% well. They threw everything at it.
And of course they have run the company for four quarters, they have been doing the books.
The figures are just mad. You are talking about handing them an asset worth $12 billion and they are saying $9 billion of that they are taking off. That would be such an obvious massive thing with 300 people and all these firms doing due diligence, how could you possibly not spot it?
POV: This is where things get very messy. It's not clear whether Lynch received any PR advice but he has got the numbers wrong. The Autonomy related write down is $5 billion. That shouldn't surprise. Most drive by analysts made the same basic mistake. Even so, he sets up the auditors and possibly the investigative accountants to take a fall by deflecting responsibility to them.
Francine McKenna, who understands this world better than most says that all of the Big Four audit firms are involved one way or the other. I am of the view that Deloitte (Autonomy's auditors) and Ernst & Young (HP's auditors), will be feverishly checking their professional indemnity insurance policies and calculating their share of the compensation that HP will likely seek in the future. Assuming of course that Whitman is around long enough to exact recompense. Right now, all the audit firms are hiding behind 'client confidentiality' and saying nothing.
WSJ: Do you have any concept how they arrive at these figures, or where this is coming from?
ML: No. The only concept I have of it is that it does seem to be coincident with them releasing the worst set of results in their 70-year company history.
I think what has happened here is that they have got themselves in a mess.
They did the acquisition of EDS, they had to write that one down. They had to write Palm down. When Autonomy was acquired it was done by a CEO who wanted to get rid of various divisions of that business and lead with software.
He was ousted in an internal coup d’etat. From that point Autonomy was at odds with the divisions that were in power.
There was a series of mismanagement steps. They lost hundreds of the talented people at Autonomy. The whole management team basically went out of the door. Sadly they are left with the results of having destroyed all that value.
Now they are trying to cover it up with this big write off.
POV: Now we're into the hubris of pointing to post acquisition mismanagement. If you think this sounds familiar then you wouldn't be wrong. HPs failed acquisition history is well known. It all adds up to a defense that Lynch is building. I should point out that while not named, he is an obvious candidate for questioning as the Autonomy accounts clearly state that he was running the ship pretty much single handedly when it came to making the big decisions. Anyone who thinks this would not involve revenue recognition is naive.
Elsewhere, commenters point variously to Autonomy's past history of changing the revenue recognition game from time to time. AllThingsD tries to set the financial irregularities into three easily digested buckets. It's never that simple. Some argue that the UK method of accounting is sloppy. Silicon Angle's John Furrier claims:
Autonomy basically overstated their product revenues by including the service revenue as product sales at the time of the sale...Many companies try this move, but in this case, HP was handcuffed by UK law...
... What Autonomy did was hide from HP the future service revenue and put it as product revenue at the time of the sale. In other words, Autonomy recognized all that “future” service revenue as product revenue when the “booked it” instead of over the 12 months it “serviced it,” as accounting standards dictate.
This is a fundamental lack of understanding between “bookings” and “revenue.” Mike Lynch can deny all he wants, but stupidity isn’t a defense for the crime. This can be viewed as a deliberate act to deceive HP in overstating the value and foreclosing future service revenue, which HP might have calculated as “synergy” to the deal.
UK accounting rules are different to the US but they don't allow companies to get past the revenue recognition rules applied to service or more generally on what is known as the 'fair value' test. If Furrier is correct then there is a genuine problem for Autonomy, its leadership AND the auditors. HP doesn't get off so lightly either.
This problem should have been almost immediately apparent to HP upon completion of the acquisition. It would have had costs against which it could not book revenue coming out of unfulfilled contracts in both the unended quarter prior to the 2011 year end plus costs going into the early quarters of 2012. If you believe that, then HP's argument that it knew nothing until a whistleblower stood up some six months later is baloney. Futhermore, HP's efforts to unravel the deal after Leo Aptheker left as CEO would suggest the board was already deeply concerned prior to consummation of the deal.
However, as Vinnie Mirchandani alludes and to which I can attest having listened to some creative arguments why past rev rec issues emerging from due diligence in an acquisition are NOT important, the US system of revenue recognition is a mess. It is easy to screw up and makes a laughing stock of SOX intentions. The reliance upon non-GAAP earnings in quarterly reporting is a farce, reflecting an engineered method of pacifying financial analysts while confusing investors. Is it any wonder that we see a steady stream of restatements, fraud accusations and the like?
None of which excuses Meg Whitman, CEO HP but rather leaves her with more questions.
- Can she explain why she was prepared to sign off on the Autonomy acquisiton as part of the HP board at the time yet had the company feverishly looking for ways to unscramble the deal after Apotheker left?
- What was it about the deal they so disliked after Apotheker left the building that wasn't apparent beforehand?
- Surely revenue recognition and services revenue in particular would have been prime targets given the difference in the application of accounting rules between the US and UK? Regardless of difficulty did no-one spot problems?
- Is HP now trying to convince us it received written assurances that turned out to be wholly false or based upon false premises a la Satyam? Did anyone examine contract content?
Whether you believe Lynch is right or that HP has solid evidence of material financial misdeeds, the current balance of sentiment appears to be that HP royally messed up. The share price has cratered to a 10 year low. The HP board still looks dysfunctional. The handling of this latest set of revelations has hardly been pristine. HP's latest woes only add to a long term tale of tragedy. It's all rather sad.