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Six Autonomy Red Flags That HP Missed

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In 2011, Hewlett Packard (HPQ) bought big data software maker, Autonomy, for $10 billion and last week it wrote off $8.8 billion of that. Since Meg Whitman, who spent $140 million of her own money on a failed gubernatorial bid in 2010, took over at HP's CEO on September 21, 2011, its stock has lost 46% of its value to $12.44 -- 84% below its April 2000 all-time high of $77.

After writing about how HP's Autonomy deal failed most of the four tests of a successful acquisition, I received emails from two people who highlighted six red flags that should have warned HP away from buying Autonomy.

1. Autonomy CEO, Mike Lynch, would be out of HP fast.

It is quite common for an acquiring company to adopt a conqueror's mentality -- meaning that HP would have wanted to get rid of all the top people at Autonomy and replace them with HP people. But in so doing, there is a question about whether it would have been losing the people who made Autonomy worth $10 billion.

That's why HP should have paid more attention to whether Lynch would stick around. A venture capitalist who contacted me said that when the Autonomy deal was announced, he told the CEO of one of his portfolio companies, "I doubt Mike Lynch will remain at HP more than 6-9 months.  Sure enough, within 9 months he was out."

The venture capitalist also noted: “Talk about a culture class. The HP Way and Mike Lynch's Way (CEO of Autonomy) couldn't be any more different.”

2. Track record of destroying acquired companies.

Lynch has been widely quoted as saying that HP destroyed Autonomy. That's something the venture capitalist who contact me found the most ironic. As he wrote, "What is really funny to me is the fact that Mike Lynch and all of these ex-Autonomy executives are stating how HP destroyed Autonomy."

The venture capitalist gave me an example of a company that Autonomy bought and then destroyed. He noted, "As my friend, Brian Baird, who sold his company Meridio to Autonomy, told me 12 months after his acquisition, Autonomy lost almost every executive from every company they acquired (including his) because of Autonomy’s slash and burn style of dealing with acquisitions."

3. Amazing revenue growth that's really artificial.

The venture capitalist sent me a quote noting that “Autonomy's amazing revenue growth (55% YoY) has largely been a result of acquisitions rather than organic growth.”

He also told me that Autonomy's growth looked to him like it was too good to be true. He pointed out that "Endeca, one of the stars of the Boston enterprise software technology ecosystem, was always whiter than white with its accounting and business practices."

And yet an Endeca competitor, Fast Search and Transfer (FAST), was growing much faster. As the venture capitalist wrote, "We couldn’t understand why FAST grew as much as it did and then was bought in 2008 for $1.2 billion by Microsoft (MSFT), until the news came out about fraud accounting for as much as 1/3 of FAST’s revenue."

The venture capitalist had a similar view on Autonomy. As he said, "We similarly could not believe the Autonomy numbers that the UK stock analysts (other than 1-2 true analysts) accepted without question."

This venture capitalist has a dim view of Autonomy and HP. As he wrote, "There will be a big PR battle over the next few weeks on this, and those who are Autonomy fans will rightly point out that HP overall had poor results, but Autonomy itself was in my view a case of perpetual low-level fraud on the UK investing public where management had hoped an HP sale would prevent an eventual disclosure and stock crash of their own."

 4. Low deferred income and high accounts receivable.

Jon Tseng of Uneasy Empires is an analyst who did not drink the Autonomy Kool-Aid. Tseng pointed out that Autonomy's cash collection and accounting policies were unusual.

Most software companies have high deferred revenues -- money received for services not yet rendered and booked as revenue -- and low accounts receivable -- money owed for services already rendered and booked as revenue.

That's because most software companies -- like Leo Apotheker's pre-HP employer, SAP -- get paid up front for their licenses (thus low receivables) and collect cash upfront for maintenance and support that the company has not yet delivered (high deferred revenue).

But Autonomy was just the opposite -- it had high accounts receivable and low deferred revenue -- something that should have smelled funny to Apotheker who pushed the Autonomy deal.

5. Unusually high margins.

Tseng also pointed out that at "40%+" Autonomy had unusually high operating margins for such a fast-growing company. He notes that "20-30% operating margins [are] no sweat" for a fast-growing software company but 40% "[operating margins are normal] only in mature businesses with large cash-cow installed bases and lower marketing costs like Microsoft."

6. A persecution complex with analysts.

Tseng linked to a 2009 article in The Daily Telegraph that highlighted many instances of Autonomy blocking questions from analysts who had a negative opinion on its stock. It reported that "The Daily Telegraph understands that no analysts with a sell rating on the stock were apparently able to ask a public question after the company presented its third-quarter results [on October 19, 2009]. Several analysts claimed they are often prevented from asking Mike Lynch, Autonomy's chief executive, and Sushovan Hussain, finance director, difficult questions."

All these red flags -- and HP's outraged write-off -- have not stopped Lynch from mouthing off to the press. As he told the New York Times, Deloitte and a bevy of highly paid lawyers reviewed Autonomy's books before the merger. And after the deal closed, HP proceeded to drive out Autonomy's top 100 executives while rewarding HP sales people for selling competing products.

Lynch has $800 million worth of "take a hike" money from the HP deal. But for those of us who do not have Cambridge University doctorates, the lesson of this debacle is clear -- even the highest and mightiest among us are subject to basic laws of economics and justice.

That's because Lynch may end up much poorer after he pays lawyers to defend himself from HP's legal onslaught. And HP shareholders are probably hoping its stock now has nowhere to go but up.