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. "Synergies" was just a plug to get the equation to balance. The bankers' math in the board book to approve the deal was just there to be soothing - directors get twitchy3 if they can't look at a football field slide while approving an acquisition - not to have an impact on the outcome. You can hypothesize that H-P would have rejected the deal if it had known Autonomy's true revenue situation, because then the valuation numbers wouldn't work, but that is a silly hypothesis because even using fake4 revenues the valuation numbers didn't work and it didn't reject the deal.
That is too glib - off by a lot is worse than off by a little, and "oh you're a massive fraud actually" is a great point to make in negotiating down the asking price - but I think it's the right analysis. As Usha Rodrigues writes, "The die was cast on the Autonomy acquisition when the HP board picked Apotheker, a CEO 'bent on a high impact acquisition.'" If you have a CEO who really wants to do a deal, and a deal he really wants to do, it's hard to imagine that some accountant coming to him with some minor boring technical quibble like "all these revenues are fictitious" would cause any more trouble than - well, than some banker coming to him with some minor boring technical quibble like "the price you are paying is more than the discounted cash flow of this asset to you." Shut up, nerds! We're doing important CEO business here!
How should this make you feel about the social value of M&A? Sort of same as you always felt? Some deals are good and some are bad, and CEOs tend to like making acquisitions because they are optimists and doing acquisitions makes them feel like big shots, and boards should try to shut down acquisitions that are bad for shareholders, but sometimes they don't because country clubs etc. Everyone knew that already; this anecdotal confirmation is pleasing but, after all, just anecdotal. I'm sure H-P's current CEO would never do an acquisition that might destroy shareholder value.
How should it make you feel about Dragon Systems? Dragon, you'll remember, sold itself for stock to a company that turned out to be a giant fraud and whose stock turned out to be worthless; Dragon's shareholders then went out and sued their ragtag team of junior investment bankers at Goldman for not noticing that the acquiror was a giant fraud. And one of those junior bankers testified that they did a "great job" for Dragon, insofar as "We guided them to a completed transaction." This got them made fun of a lot, here and elsewhere, but you get the sense Léo Apotheker would approve. Dragon's, and H-P's, bankers saw themselves as service providers, providing a particular narrow service - roughly, transaction execution - and leaving other services (auditing, fraud detection) to other providers, or no one, as the case may be. It was clear - to the bankers, and H-P, though perhaps not to Dragon - who was in charge of the deal, and it sure wasn't the bankers.
One popular and reasonably promising path to medium-term success as an investment banker is to tell clients what they want to hear. This is good because then clients will find you pleasant to be around; it's also good because what they want to hear is frequently "oh yeah you should totally do this transaction that involves paying investment banking fees." So there's a synergy there. CEOs, after all, tend to (1) want to do stuff, (2) want to do big stuff, and (3) have a high degree of confidence in their ability to make investing decisions. If those decisions are systematically biased toward destroying shareholder value ... well, I mean, we just work here, y'know?
1.Though you should read the rest because it is pretty entertaining? Like this is good:
H-P became aware that bloggers and some financial analysts had claimed in the past that Autonomy was aggressive in its accounting. H-P asked Autonomy's [CEO] Mr. Lynch about how his firm recognized revenue, receiving answers and documents that allayed concern, said H-P General Counsel John Schultz.
Bloggers! That happened right after the acquisition agreement was signed, as did this: "[H-P board chairman Ray] Lane spoke to senior H-P executives and found a near-universal view that their CEO wasn't right for the job." Imagine being a board chairman and sidling up to like the CFO and saying "hey, everything good with this Apotheker dude?" and the CFO saying "no he's horrible you have to fire him." And you're like, hmm, that's discouraging. And you check in with the COO and hear the same thing. And then you ask everyone and get "a near-universal view that their CEO wasn't right for the job." Never mind the big acquisition you just signed. "Gee, you know that information really would've been more useful to me YESTERDAY," you might find yourself thinking.
2.Which we'll take as a given: it's a 50% premium to market price, which "wasn't unusual for a software deal."
3.For "twitchy" read "sued." Imagine that the rest of this footnote discusses the negative effects of Smith v. Van Gorkom on, like, life, and its positive effects on investment banking M&A advisory revenues.
4.This footnote runs the global "allegedly" macro. I have no idea. Lynch remains adamant that there was no monkey business at Autonomy.