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Inside H-P's Missed Chance To Avoid a Disastrous Deal by BEN WORTHEN and JUSTIN SCHECK, BEN WORTHEN, JUSTIN SCHECK Jan

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Inside H-P's Missed Chance To Avoid a Disastrous Deal by BEN WORTHEN and JUSTIN SCHECK, BEN WORTHEN, JUSTIN SCHECK Jan. 21, 2013 Days before Hewlett-Packard Co. dived into an $11 billion software deal it almost instantly regretted, it missed a chance to back away. During a call with an H-P delegation, outside auditors for British software maker Autonomy Corp. mentioned that an executive there had raised an allegation of improper accounting at the firm, according to people familiar with the call, who said the auditors added that the allegation was found to be groundless. The H-P executives never passed this mention on to their board or chief executive, one of the people said. Within days of agreeing to buy Autonomy, in the summer of 2011, H-P was looking for a way to get out of it. Before the deal even closed, H-P canned the CEO who pushed it. Then last fall, H-P wrote down the value of the software firm by $8.8 billion, blaming more than $5 billion of that on what it said was improper accounting at Autonomy designed to inflate its revenue and profit. Autonomy's founder denied any wrong accounting. H-P's Autonomy Deal Read about key events surrounding Hewlett-Packard's purchase of Autonomy. Of a series of H-P fumbles in recent years, the Autonomy acquisition ranks among the costliest. An examination of how the technology giant got into the deal—draining its cash to pay top dollar—finds a confluence of factors: a new chief executive bent on a high-impact acquisition; a refusal by the target firm to provide certain financial data H-P sought; and an H-P board, populated with several new members, that had to wrestle simultaneously with another far-reaching proposal. While weighing the software acquisition, directors also faced a wrenching hardware decision: whether to jettison H-P's $40 billion-a-year personal-computer manufacturing business. To juggle two transformative initiatives at once, the board divided itself into two separate teams and skirted some standard company procedure. Meanwhile, eight of the board's 13 members had served for less than a year and had little experience overseeing the huge company and collaborating with one another. The board set a limit on how much to bid for Autonomy. But with the firm demanding more, and a target date for H-P to announce the deal already set, directors dialed into a conference call and approved a higher price. Recently, H-P has received feelers about buying Autonomy from it but so far isn't interested in selling, The Wall Street Journal reported last week. CEO Meg Whitman conceded H-P overpaid for a company that "turned out to be smaller, slower-growth and somewhat less profitable than we anticipated," but said the idea of the acquisition was correct and "we're still investing in" it. This account of H-P's costly 2011 decision to buy Autonomy is based on conversations with a wide range of people involved with the acquisition and due-diligence process, others familiar with the deliberations of H-P's board, and internal documents reviewed by The Wall Street Journal. The stage was set in 2010 when H-P's board needed a new CEO, following the departure of Mark Hurd amid a flap over whether he had violated standards of business conduct, which he said he hadn't. Cost- cutting had been a big part of Mr. Hurd's formula for raising profits. The company sought a CEO who could mastermind a growth strategy. Its surprise pick was Leo Apotheker, who had headed German software company SAP AG for a short time but was little known in Silicon Valley. H-P simultaneously got a new board chairman, also a software specialist: Ray Lane, a venture capitalist and former president of Oracle Corp. Soon after, four H-P board members didn't stand for re-election, and five new members arrived. Mr. Apotheker proposed buying two midsize software companies. The board's finance committee scotched one, and negotiations to buy the other fell apart over price. A frustrated Mr. Apotheker told Mr. Lane, "I'm running out of software companies," said a person familiar with the conversation. Autonomy, in Cambridge, England, had been on H-P's radar screen for years but was seen as too expensive. Its name came up again at a retreat for H-P executives at the Rosewood Sand Hill hotel in Menlo Park, Calif., a month after Mr. Apotheker arrived. Autonomy's software, which helps businesses find relevant information in text files, video and other corporate documents, was well-positioned, and the firm was reporting steady growth. Mr. Apotheker met with its founder and CEO, Michael Lynch, at H-P headquarters in Palo Alto, Calif., in April 2011 and afterward told H-P chairman Mr. Lane he planned to propose acquiring the firm. "Now you're talking" was the chairman's response, according to someone familiar with the exchange. Mr. Apotheker mentioned the idea to directors the next month and got their OK to look into it. By this time, directors were into other issues. H-P had missed financial projections two quarters in a row. Directors were aware their new CEO was at odds with some of his lieutenants. And the board had a major decision to make. H-P had the largest PC-manufacturing business in the world. Mr. Apotheker wanted to get rid of it. With two major proposals to weigh, involving PCs and Autonomy, the board decided to divide itself up to deal with them. One group focused on a PC-business spinoff or sale, a plan code-named Hermes; the other looked into a possible deal with Autonomy, code-named Tesla. The Tesla team, aided by bankers from Perella Weinberg Partners and Barclays PLC, evaluated ideas ranging from a technology partnership to a full acquisition. Several senior H-P executives expressed reservations. Chief Financial Officer Cathie Lesjak said an acquisition would batter H-P's balance sheet, using up its cash and incurring debt, said people familiar with the conversations. Ms. Lesjak declined to comment through a company spokesman. Because only half of the directors were focused on Autonomy, it became easier to coordinate schedules for meetings with Mr. Apotheker, giving him more opportunities to lobby for a deal, said people familiar with the board's activities. H-P's normal procedures require the board's finance committee to review and approve deal proposals before they reach the full board. That didn't happen with the proposal to acquire Autonomy, said people familiar with how the board proceeded. Whether it would have made a difference is impossible to say. The finance committee chairman was among directors most skeptical of the Autonomy idea, said several people familiar with the board's deliberations, but ultimately he joined in a unanimous vote to buy it. The committee chairman, McKesson Corp. CEO John Hammergren, didn't respond to a request for comment. The full board discussed an acquisition at a meeting July 20. Some members bristled at the likely cost. Others, including Mr. Lane and venture capitalist Marc Andreessen, wanted to push forward, said people familiar with the meeting. These people said the board authorized the CEO to bid up to a maximum of £25 a share, about $40. Autonomy's Michael Lynch The markup, about a 50% premium over the stock at the time, wasn't unusual for a software deal, but Autonomy's valuation was already on the high side. Its market value of about $6 billion was seven times annual revenue and 15 times operating profit. 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. Mr. Apotheker and H-P's strategy chief, Shane Robison, met with Mr. Lynch on July 28. At the meeting, held in Deauville, France, the parties agreed that a deal was possible and H-P should conduct due diligence. In August, the H-P board pegged a coming mid-August earnings report as a target date for announcing the software deal and other sweeping changes. On Aug. 13, with no agreement yet reached and the earnings report days away, H-P's offer had bumped up against the self-imposed cap of £25 a share. Autonomy wanted more. Mr. Lane told Mr. Apotheker to offer an additional 25 pence, or 40 cents, per share, according to people knowledgeable about the talks. Autonomy didn't take it. Mr. Lane arranged a quick conference call of directors. They authorized another 50 pence a share. That got the deal done. "It was a tough negotiation," Mr. Apotheker said in an interview. "We went back and forth. Bankers and everyone else felt it was a fair price." During due diligence, H-P directors were surprised by how little detail about the target firm's finances became available. Autonomy allowed a review of financial statements and about 25 sales contracts. H-P also wanted the "working papers," or original financial material, underlying Autonomy's audits. Autonomy declined to provide them, citing U.K. corporate-takeover rules that require companies to disclose the same documents to all potential suitors. Members of the H-P due-diligence team say it isn't unusual not to get everything sought and said they were reassured, to some extent, by Autonomy's being a public company that had been audited for years. "Any lingering questions were answered," Mr. Apotheker said. Accounting firm KPMG LLP helped H-P with its due diligence. At one point, people from H-P and KPMG spoke by telephone to a group from Autonomy's longtime outside auditor, the U.K. affiliate of Deloitte Touche Tohmatsu. The Deloitte team mentioned that about a year earlier, an Autonomy finance executive had alleged improper accounting at Autonomy, according to people familiar with the call. Three of these people said Deloitte mentioned the issue briefly and added that a review had found the allegation to be baseless. The H-P team didn't investigate further, one of the people said, and didn't share the information with either Mr. Apotheker or H-P's board. Neither Mr. Apotheker nor the directors ever heard such an allegation during negotiations, according to several people either close to the CEO or knowledgeable about the board. Said one: "There were zero red flags raised about this company during the whole process." KPMG said that all information disclosed to it "in this limited engagement" was "equally disclosed to H-P." Deloitte declined to comment. In November, following H-P's accusation of shady accounting at Autonomy, Deloitte said that it "categorically denies that it had any knowledge of any accounting improprieties or misrepresentations in Autonomy's financial statements." It cited client confidentiality for declining to discuss the matter further. Autonomy's Mr. Lynch, who declined to be interviewed for this article, has repeatedly said that all of Autonomy's large deals were audited and that any accounting discrepancies H-P claims stem from differences between U.S. accounting rules and the international standards Autonomy followed. The H-P board met by conference call Aug. 17, 2011, to consider giving final approval to the acquisition. Directors heard Ms. Lesjak, the CFO, reiterate her position that H-P couldn't afford it, said a number of people familiar with the call, who added that other executives, such as the then-strategy chief Mr. Robison, were in favor. Mr. Robison didn't return calls seeking comment. Mr. Apotheker pushed for the deal. "I tried to explain to the board that in light of the strategy this was the path forward," he said. "I never told the board there were no other options…. I was convinced of the logic of the deal. I defended it." The board approved the deal unanimously. The next day yielded a wide palette of news about H-P. The company was lowering its 2011 earnings outlook; it was killing its just-introduced smartphone and tablet; it intended to split off its huge PC business; and it was making a $10 billion-plus bet on software. The day after that, the stock fell 20%. Mr. Lane spoke with some large H-P investors and found nearly all disliked the Autonomy deal. He learned that many invested in the dividend-paying company more for stability than for growth. 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 Mr. Lynch about how his firm recognized revenue, receiving answers and documents that allayed concern, said H-P General Counsel John Schultz. With the stock in a swoon, Mr. Lane asked H-P's advisers if his company could back out of the software deal, people familiar with the matter said. He was told U.K. takeover rules made that impossible unless H-P could show financial impropriety. Mr. Lane spoke to senior H-P executives and found a near-universal view that their CEO wasn't right for the job. In late September, 35 days after the agreement to buy Autonomy and 11 months into Mr. Apotheker's tenure, the board dismissed him. "We had concrete and ambitious plans on how to integrate and leverage the Autonomy acquisition," Mr. Apotheker said. "But I was gone by the time the deal closed." The closing was Oct. 3. Autonomy's Mr. Lynch stayed on to run the software firm as a unit of H-P. Within weeks, Mr. Lynch told the new H-P CEO, Ms. Whitman, in an email that when he discussed with H-P's server unit the idea of selling Autonomy software along with H-P hardware, he received a "very negative response." Autonomy started missing revenue targets, according to emails and PowerPoint presentations. Early in May 2012, Ms. Whitman and other H-P executives visited Autonomy offices in Britain to figure out what was wrong. Two weeks later, H-P fired Mr. Lynch. Within weeks of his dismissal, H-P has said, the company heard an allegation from an Autonomy executive that Autonomy manipulated its numbers. That set in train the process that led to H-P's November writedown and allegation of improper accounting by the software firm. The Justice Department, the Securities and Exchange Commission and the U.K.'s Serious Fraud Office all began investigating the allegation, H-P has confirmed. Mr. Lynch said late last year that he hadn't been contacted by regulators and that the allegation was false. "We continue to reject these allegations in the strongest possible terms," he said. —Joann S. Lublin contributed to this article. A version of this article appeared January 21, 2013, on page A1 in the U.S. edition of The Wall Street Journal, with the headline: Inside H-P's Missed Chance To Avoid a Disastrous Deal.