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Hewlett’s Loss: A Folly Unfolds, by the Numbers

Michael J. De La Merced and Quentin Hardy | The New York Times
Tuesday, 20 Nov 2012 | 11:32 PM ET

For Hewlett-Packard, the alarm bells started ringing less than a year after the technology company bought a British software maker for $11.1 billion.

Mike Fuentes | Bloomberg | Getty Images

Unhappy with the business's sagging performance, H.P. ousted the software company's mercurial Cambridge-educated founder and sent a team to England to review its books last May. It was then that a senior finance official at the British company stepped forward, raising questions about the accuracy of the numbers.

Months of investigation followed, prompting Hewlett's accusations on Tuesday that the British software maker, Autonomy, had engaged in "serious accounting improprieties." Before the deal, H.P. claimed, Autonomy inflated its sales. The problems went undetected by outside accountants — both Autonomy's auditors and a firm H.P. hired to vet the deal.

The accounting issues at Autonomy, which sells software that examines data for patterns, cost Hewlett more than $5 billion.

Now, the Autonomy matter has been referred to regulators in two countries, and the Federal Bureau of Investigation has opened a case, according to people briefed on the matter who were not authorized to speak publicly. H.P. is also considering its own legal action. "This took time" to uncover, said Meg Whitman, H.P.'s chief executive. The issues, she said, "were designed to be hidden."

(Read More: Under Fire: Dissecting the Words of Autonomy's Founder)

Hewlett can't escape the onslaught of bad news.

In recent years, what was once a giant of Silicon Valley has been buffeted by management turnover, board controversy and waning profits. The company, which previously rivaled the likes of I.B.M., Cisco and SAP, has watched the value of its stock erode sharply.

Even before the accounting problems, the Autonomy acquisition looked troubled. Within weeks, the deal contributed to the downfall of the chief executive at H.P. and led to squabbles among company's directors, including Ms. Whitman, who took over in September 2011.

In the latest quarter, the company reported a $6.9 billion loss, dragged down by the Autonomy mess and continuing problems in the business that resulted in an overall charge of $8.8 billion. On Tuesday, the stock continued falling, dropping 12 percent to less than $12, its lowest point since 2002. "We intend to be very aggressive in recovering value for our shareholders," said John Schultz, H.P.'s chief counsel. Individuals will be examined as well as accounting firms, he said, adding, "we're not limiting it to Autonomy."

Autonomy's founder, Mike Lynch, rejected Hewlett-Packard's claims, denying that his former company committed any accounting chicanery or misled anyone about its financial information. He indicated that the company's practices were in line with international accounting standards. "It's completely and utterly wrong," Mr. Lynch said.

The deal was criticized at the outset.

In August 2011, H.P.'s chief executive at the time, Léo Apotheker, shifted strategy unexpectedly. All in the same announcement, Mr. Apotheker disclosed plans to buy Autonomy, killed two major products and publicly mused about selling the company's personal computing business.

While many Wall Street analysts said H.P. was overpaying for Autonomy, Mr. Apotheker believed that H.P., which sells printers and computer servers as well as PCs, needed to move more aggressively into software. In buying Autonomy, he was buying into one of the biggest trends in tech, the analysis of voluminous data.

(Read More: Hewlett-Packard Walloped by Charge Relating to Fraud)

Autonomy specializes in finding patterns among so-called unstructured data, like e-mails, online video, or web surfing. Mr. Lynch is a Cambridge-trained Ph.D. in signal processing who previously founded a company that searched for fingerprint patterns. He made a reported $800 million from the sale of Autonomy. A brilliant man known for a brutish office manner, he bonded with Mr. Apotheker, a multilingual German software executive.

But within weeks of striking the deal, Mr. Apotheker was out, and Ms. Whitman was named to the top spot. During the deal negotiations, she had complained about the Autonomy price to other board members, according to several people briefed on the matter. Mr. Lynch's other close ally at H.P. during the sale of Autonomy, a chief technology officer named Shane Robison, left H.P. toward the end of 2011.

Early in her tenure, Ms. Whitman resolved to increase Autonomy's customer base with existing H.P. clients, and to look for ways to put the software inside H.P. products. Ms. Whitman and other executives gushed about the opportunities, describing ways Autonomy's number-crunching technology could take on I.B.M. in data analysis, and Amazon.com in cloud computing services.

Behind the scenes, the situation was less sunny.

After securing the deal, Mr. Lynch tried to keep Autonomy far from H.P.'s bureaucracy. He mostly worked in London, and initially kept Autonomy's main office in a San Francisco high-rise decorated with pictures of famous theoretical mathematicians, and not at H.P.'s Palo Alto headquarters.

"He told his people, Meg, anyone who'd listen, that H.P. should not get involved with Autonomy," said an executive who worked with both companies who asked not to be named to preserve professional relations. "Meg figured we should leave them alone, so they could stay entrepreneurial."

The lack of cooperation between the two companies quickly became evident. At a going-away party, an H.P. lawyer presented Mr. Lynch with a sweatshirt with the word "integration" and a line through it.

Autonomy, too, was facing challenges after years of fast growth but poor customer relations, according to Leslie Owens, an analyst with Forrester Research. "They didn't invest in R&D; they didn't have regular software releases; they weren't transparent with a road map of where they were going; they didn't seek customer feedback," she said. "Customers complained, but the promise of managing all their information and making better decisions was so attractive. They bought more."

Soon after the H.P. acquisition, Ms. Owens said, Autonomy announced a new version of its core product. "We asked for a demo," she said, and "we're still waiting."

Sales plummeted soon after Autonomy became part of H.P. Ms. Whitman said she initially thought this was because of Mr. Lynch's lack of experience running a big company. In hindsight, however, she ascribed it to Autonomy conforming to H.P.'s rules.

According to H.P., Autonomy sold hardware like servers, but the company booked these as software sales in some instances, thus underplaying expenses and inflating the margins. "They used low-end hardware sales, but put out that it was a pure software company," said Mr. Schultz. Computer hardware typically has a much smaller profit margin than software. "They put this into their growth calculation."

An H.P. official, who spoke on the condition of anonymity because of continuing inquiries by regulators, said the hardware was sold at a 10 percent loss. But the loss was disguised as a marketing expense.

The amount registered as a marketing expense appeared to increase over time, the official said. This was notable, because H.P. was reviewing a period in which Mr. Lynch appeared to be shopping Autonomy to H.P. and other companies.

"It was a willful effort by some company executives to mislead investors and potential buyers," Ms. Whitman said.

H.P. also contended that Autonomy relied on value-added resellers, middlemen who sold software on behalf of the company. Those middlemen, which the H.P. official characterized as "small companies that relied on Autonomy products for the majority of their sales," reported sales to customers that didn't actually exist.

H.P. also claimed that Autonomy was taking licensing revenue upfront, before receiving the money. That improper assignment of sales inflated the company's gross profit margins.

H.P. said it discovered the problems only after Mr. Lynch's departure. Soon after he was fired, several senior Autonomy executives also resigned from H.P. Mr. Lynch said he has started another company, and expected these executives to join him.

Now, H.P. is dealing with the fallout. Last week, H.P. passed along its findings to the Securities and Exchange Commission and the Serious Fraud Office in Britain.

The problems complicate an already difficult turnaround effort, as Hewlett-Packard continues to face weakness in its core businesses. Revenue for the full fiscal year dropped 5 percent, to $120.4 billion, with the personal computer, printing, enterprise and service businesses all losing ground. Earnings dropped 23 percent, to $8 billion, over the same period.

"I knew H.P. was going to be a challenge," said Ms. Whitman. "I've been around long enough to know you have to play the hand you're dealt."

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