The importance of due diligence

Hewlett-Packard is learning that due diligence in buying another company is important. An $8.8 billion lesson is hardly one that shareholders like to learn; they sent the stock tumbling 12 percent on Tuesday.

Here are a few details from the Wall Street Journal story:

Hewlett-Packard Co. surprised investors Tuesday when it claimed it had been duped into overpaying for one of its largest acquisitions, a U.K. software maker, that will result in an $8.8 billion charge.

The technology giant, whose board has faced withering criticism for its handling of past two CEO ousters, said an internal investigation revealed “serious accounting improprieties” and “outright misrepresentations” with Autonomy, which H-P acquired for $11.1 billion in October 2011.

The write-down—H-P’s second straight quarterly multibillion-dollar charge—resulted in a nearly $7 billion loss for the Palo Alto, Calif., company.

H-P said Autonomy—before it was acquired—mischaracterized some sales of low-margin hardware as software and recognized some deals with partners as revenue even when a customer never bought the product.

Here’s more on the financial state and what happened at the tech giant from the New York Times:

Hewlett-Packard bought Autonomy in the summer of 2011 in an attempt to bolster its presence in the enterprise software market and catch up with rivals like I.B.M. The takeover was the brainchild of Léo Apotheker, H.P.’s chief executive at the time, and was criticized within Silicon Valley as a hugely expensive blunder.

Mr. Apotheker resigned a month later. The management shake-up came about one year after Mark Hurd was forced to step down as the head of H.P. after questions were raised about his relationship with a female contract employee.

In the previous fiscal quarter, the company announced that it would take an $8 billion charge related to its 2008 acquisition of Electronic Data Systems, as well as added costs related to layoffs. Then Ms. Whitman told Wall Street analysts in October that revenue and profit would be significantly lower, adding that it would take several years to complete a turnaround.

“We have much more work to do,” Ms. Whitman said at the time.

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.

To say the company is faltering would seem like and understatement. There are also some pretty serious allegations flying around in the press. Check this one out from the Bloomberg story:

Hewlett-Packard began investigating Autonomy’s finances after a senior executive at Autonomy came forward after founder Mike Lynch, 47, departed in May, Hewlett-Packard said. The company said it has referred the matter to U.S. and U.K. securities regulators and will also pursue civil litigation.

“The board relied on audited financials — audited by Deloitte — not Brand X accounting firm but Deloitte,” Whitman said today on a conference call with investors. “The CEO at the time and the head of strategy who led this deal are both gone — Leo Apotheker and Shane Robison.”

Autonomy’s former top management team said allegations by Hewlett-Packard are “false,” according to Vanessa Colomar, a spokeswoman for Lynch.

Lynch, in an interview with the Wall Street Journal, said Hewlett-Packard has mismanaged the Autonomy deal and that the company is “trying to cover it up with this big writeoff.”

Apotheker said he’s “stunned and disappointed” by the alleged improprieties and that he did thorough due diligence on the acquisition. He agreed to buy Autonomy, the second-largest U.K. software maker, for $10.3 billion to expand in cloud- computing and add software that searches a broad range of data, including e-mails, music, videos and posts on social networks such as Facebook Inc.

Autonomy misrepresented its gross profit margin and also falsely created or miscategorized more than $200 million in revenue over a two-year period starting in 2009, John Schultz, Hewlett-Packard’s general counsel, said in an interview. Autonomy was reselling Dell Inc. (DELL) computers and counting those sales as software revenue, he said. Some sales were also fabricated through resellers.

“You have active concealment,” Schultz said. Deloitte “obviously didn’t catch these issues at the time. It was difficult, if not impossible for HP to catch them.”

So its basic defense is one of “well, it wasn’t our job to check the financials.” Can you imagine if JPMorgan Chase said that about Bear Stearns or Bank of America said it about Countrywide?

Obviously, people screwed up. They didn’t catch what they were supposed to, and the deal is going south. But the real losers are investors. Not only did they overpay for the original acquisition, but also now they’re paying for the lack of due diligence.

To top that off, investors have to content with the loss of confidence in HP’s ability. I know the executives who did the deal are gone, but I imagine that the accountants and bankers who helped are still working with and for the company. Doesn’t give you much confidence in the firm or its ability to manage.