There’s a lot going on in today’s Wall Street Journal story about how Hewlett-Packard “missed a chance to back away” from its acquisition of Autonomy – which H-P now thinks did a lot of revenue recognition fraud and on which it has taken zillions of dollars of writedowns – but this description of the board’s approval process for the deal is the only thing you really need to know:1
H-P directors and bankers calculated how much revenue Autonomy would have to add over 10 years to justify such a price. Autonomy’s trajectory alone wouldn’t get there. The deal required assuming more revenue growth as a result of the tie-up than H-P usually assumed in acquisitions, said people familiar with the matter. But the directors believed they could make the numbers.
Those calculations were done without knowledge of the alleged fraud but who cares? Here is, roughly, H-P’s thought process:
- The price that Autonomy demands is X2
- Autonomy’s DCF value is Y1 based on expected revenue growth but no synergies
- Y1 < X
- Well but the DCF value is Y2 with regular-to-aggressive synergies
- Y2 < X
- Well but … well we could make up another number Y3
- Y3 >= X
- LOOKS GOOD.
If you notice that current revenue numbers are made up, then that changes Y1, but Y1 isn’t an input into Y3 – the actual value that H-P put on Autonomy – because that number was also just made up. Read more »