Making sense of HP's Autonomy acquisition

While the flurry of Tweets whizzing past my screen with #hp tacked onto them concentrated on what happens to webOS, I was digging around in the bowels of HP and Autonomy's financial reports.

As I noted yesterday, a number of colleagues were not impressed with the idea of the Autonomy acquisition announcement. Some think it is a case of HP looking through the rear view mirror, others find it confusing. Ray Wang, CEO Constellation Research dismissed it as buying into an old technology play that leaves HP enjoying a maintenance revenue stream but with light net new licenses. I'm going to disagree with all those assessments.

Investors have not been happy since Leo Apotheker came on board as CEO. From their standpoint, Mark Hurd, the previous CEO was a miracle worker and a tough act to follow. Now that we have the benefit of hindsight, that assessment may not be as rosy as it once seemed. Even so, Apotheker has been left with little choice but to restructure the business to keep investors happy or face the unpleasant prospect of a possible forced breakup.

In effectively putting the PC business on the market, HP is dumping a business that contributes around 35% to top line revenue but only 16% to operating income. While its scale is impressive, HP believes that business is going through structural change. By downsizing itself in this way, HP encourages investors to think of it differently, especially at the operating level.

Recognising that such a significant amount of surgery was required allowed HP to get bad news out the way. As Phil Fersht over at Horses for Sources succinctly put it:

HP may have just ripped off its own BandAid, relieving the agony quickly and avoiding a slow and painful journey at a time when the economy sits on a knife-edge.

That's a very good way to understand the way in which Apotheker has attacked the problem. He has clearly learned something from his SAP days as CEO when it seemed that every time he came on the earnings call there was some new crisis to discuss. On this occasion, Apotheker dumped all the bad news. Which brings me to the ill-fated TouchPad and webOS.

The popular media and much of the Twitterati will paw over those entrails. That's good news for HP. They're out of those businesses and anything that's now said is flogging a dead horse. It allows HP to concentrate on what it's really about without having to say a word on the mobile topics. Implicit in that is the fact that it was Apotheker's predecessor who made the fateful decisions that have cost HP so dearly.

In essence we've got a clearing of the decks with all that implies at the next earnings call. Apotheker can, with some degree of legitimacy, start saying something like: 'Excluding the one time charges for restructuring, disposing of the mobile hardware issue and taking PSG out of the equation our results would have been....' That focuses analysts minds on the road ahead and not the dead weight around HP's ankles. Now to Autonomy.

The numbers speak for themselves

Regardless of how you choose to view this acquisition, there's a few important facts worth noting. At its Q2 earnings call last month, Autonomy reported impressive numbers like:

• 50 deals worth more than $1 million year to date
• Average deal size $814,000
• Year over year organic growth in its SaaS business of 34% when taking into account its Iron Mountain business
• No net debt
• Operating margin in the 41% range; exclude the dilutive impact of its Iron Mountain acquisition and you're looking at 45% operating margin.

Apotheker talked some of that up in the earnings call but was largely drowned out by the peripheral noise around other topics.

When you crunch the numbers, Autonomy looks to be on a revenue run rate approaching $1.4 billion. Niche market or no, that's impressive and those deal/operating numbers are ones with which Apotheker is both familiar and comfortable. The fact Autonomy is transitioning to a SaaS model will provide HP's leadership with opportunities to learn from the experience of a company that so far has been successful in making the change. That's a rare experience among business software vendors. Finally, when you take a close look at Autonomy's balance sheet - it is clean. HP has no real financial engineering to worry about and is unlikely to find any gotchas once it gets it hands on the 'real' books.

A hidden gem

There is something else hidden among the commentary. Autonomy is in a business that is counter cyclical. The fact there is economic uncertainty plays to its strengths and increases the likelihood of it outperforming the business software market. That provides HP with a buffer factor while it figures out how to re-org the services business under what will be Mike Lynch, CEO Autonomy's leadership.

Ray Wang will say it as he sees it but dismissing Autonomy in the way he has is hardly even handed and misses important nuances. Autonomy may not have the sex, sizzle and glamor of a Salesforce.com but Autonomy is only three years older and has been impressively profitable for the last five years albeit at lower scale. Salesforce.com posted a loss on its latest earnings call. Ray's technology argument could equally be applied to Salesforce.com. I am more concerned about what it brings to the HP table.

What of the price paid?

Autonomy's share price has been on the slide since its last earnings announcement. Where at one time it was valued close to $7 billion recent weeks have seen that valuation knocked back to something around $6.2 billion. The premium therefore is pretty hefty at some 61% of yesterday's close price. But is it that far out of whack?

I regularly see SaaS businesses which think they can be valued at 9-10x revenues although recently that has slipped back to 7x on the basis of deals on the table. If you agree with that assessment then HP is paying about the right price. When I look at Salesforce.com's market cap at $15 billion, can anyone say for certainty that if it came up for sale it would not be looking at $20 billion plus as a figure guaranteed to attract investor attention? Even today, its cap implies a revenue multiple of 6.5. Viewed in those terms, HP got it about right.

Does the deal make sense in the context of transformation?

Yes it does but this is a first step. When you add up all the moving parts, throw in the fact HP is ring fencing this unit,taking advantage of Autonomy's leadership experience in transformational change and flavor with Apotheker's many successful years as a software salesman then you start to see a cocktail that could turn out to be very sweet.

One interpretation might be that Apotheker is being relatively conservative, sticking to things he readily understands and banking upon a safe bet. As he should given the extent of problems this last quarter revealed.

Apotheker can draw on his experience in building a software and services model and apply that to the strategy he has put in train while having no qualms about workforce changes that may be necessary in the interim. He's been there before. He knows the score and the penalties in store if he gets it wrong.

Some have argued that educating HPs bag carriers on what will now be a complex sale might be too much for them. If that's the case then I don't doubt Apotheker will have little difficulty finding rock star sales people who understand complex deals and are eager to earn good money from big ticket sale.

Does it make sense for HP in the long term?

Once again, when you step back, the answer is yes. HP is now much easier to understand. Back to Phil Fersht:

In one full swoop, Léo’s sent his firm on a path where we can actually understand what HP’s game-plan is all about.  If HP had continued down its confused previous path, it would surely have faced being broken up and spun-off into all sort of assortments and flavors.  Let’s be honest – could we really see HP giving Apple and Google a run in the consumer space? Was HP really in the right shape to lead PC sales in a fast-commodotizing market?

Meanwhile,  they’ve clung onto their enterprise IT and services businesses and are slowly rolling out some meaningful strategies that can leverage their global presence, their industry strengths and massive footprint of enterprise clients.

If you believe what I have said then that only leaves the small matter of execution.

For the first time, we are seeing a Leo Apotheker that was noticeably absent during his time as CEO at SAP. Clear thinking, decisive and focused on what has to be done but without the incumbrances of a committee approach to management that never suited his personality or temperament. He's done the right thing getting all the issues out the way in one go while providing a glimpse to the future. If the market didn't like the news, it might want to reflect on the manner in which Apotheker delivered the first of their demands.

Some closing speculation

I'll speculate that acquiring Autonomy gives Apotheker an exit of his own. Mike Lynch gets to run his business in an enlarged but protected environment. He is 46 years of age and close to the peak of his powers. I met him just once many years ago and suspect his personality is not that far removed from Apothker's. Check this quote attributed to Lynch to see what I mean:

...the Web 2.0 generation may be shocked to learn that everyone’s opinion is not equally valid on every subject

A couple of years shaping the 'new' at HP could be just the apprenticeship he needs to prove that he can run a mega business, while allowing Apotheker the opportunity to retire gracefully knowing he put out the smoldering fires that have been slowly draining HP of its greatness the last 10 or so years.

Then again, I could be 100% wrong and it all ends in tears.

Disclosure: I am a board advisor to Constellation Research. We don't always agree.

See also:

• Palm. HP. Who owns WebOS next?
• HP's Apotheker recounts TouchPad disaster in post mortem
• HP punts on WebOS, discontinues TouchPad, cuts outlook
• HP's eye on Autonomy means it sidesteps RDB and middleware in favor of enterprise information infrastructure
• HP acquiring Autonomy - is this HP's IBM moment?