THE HP HORROR STORY – A LESSON ABOUT DUE DILIGENCE

According to today’s Wall Street Journal , in October 2011, HP (Hewlett Packard) purchased a U.K. company, Autonomy for $11 billion.  It doesn’t matter how big you are, that’s a lot of money.  Fast forward to 2012 (a year or so after the purchase according to WSJ) and HP took a write-down of $8.8 billion.  In my opinion, this is a staggering failure of due diligence.  The allegations  are that prior to the purchase, Autonomy had falsified its financial statements.  It is claimed that revenue was recognized for which there was no basis.  Purportedly, they claimed transactions for which there was no customer and other assorted falsifications.  I want to point that as stated in the WSJ, Autonomy has denied these allegations.

As Controllers, we are all subject to being involved in acquistions.  That can include new companies, buying out someone’s division, etc.  Even large capital investments like new software systems or a certain piece of equipment should be subjected to thorough due diligence/analysis prior to the purchase.

I know that many of us (including me) have a tendency to ‘fall in love’ with these acquistions.  We’re excited to see our companies grow and we recognize that new blood in our company may help revitalize it (and us).   The problem is that we are almost physiologically driven to ignore the bad news about an acquisition.

If you were a shareholder or any stakeholder, wouldn’t you want to know how this happened.  I think we already know that audited Financial Statements are no guarantee that they are not fraudulent.  One would hope that the materially distorted numbers were discovered, but as we have seen time and again, that simply is not the case.

Here are some of the questions I would raise if I was involved in the investigation:

1.  Did anyone look at their comparative financial statements for the last three to five years to see if their sales growth and profit made sense?

2.  Did anyone look at their sales reports to see how they tied out to their financials?

3.  How was the valuation of the company reached?  Obviously it was not worth anything related to the purchase price.  How could you take an $8.8 billion write down on a company you paid $11 billion for, and just a year ago?  That’s an 80% write down.

Controllers……………….you cannot let something like this happen to you.  In SME’s, we tend to be very proud of how quickly we can push through acquisitions versus our larger corporate colleagues.  But there is a downside to this.

So here is my advice based on past experience.

1)  I always liked to look at tax returns.  Very often they can raise questions you probably should have asked.

2) Assuming you are buying a business or division in your same industry, you should have some ‘instincts’ about what a reasonable set of financials should reflect.  Do the labor costs seem in line?  How much are they paying the officers?  Too little or too much?  If it’s not in your industry, resort to outside help…..someone who was familiar with the industry you are investing in.  If no one is available, there should be statistics/data out there that might assist you in your analysis.

3) With almost every acquisition I have been involved in, Year 1 after the purchase, expenses go up (sometimes dramatically) and sales go down.  Customers who may have felt some obligation to the ‘old’ company feel none towards the ‘new’ company.  Expenses go up because ‘old company’ decided to sell  two years ago and stopped investing and upgrading systems and assets.  Don’t forecast increased sales when you are putting together that ‘pro forma’ for the new company.  And don’t cut expenses because you think there will be economies of scale.  This advice generally holds true for most SME’s.  This is where that ‘love affair’ with your acquisition really kicks in.  Beware!

Finally – ‘TRUST BUT VERIFY’.  Your career may depend on it.

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