Fairytales vs fundamentals

aksaroya —  8 February 2013 — 1 Comment

By Jane Fuller, former editor of the Financial Times and co-director of the Centre for the Study of Financial Innovation think tank

Out on the cutting edge of the technology sector, the grand corporate ambitions and the eye-popping financial performance are not always built on a foundation of solid accounting stone.

 circuit board


The eyebrow-raising allegations of accounting improprieties levelled at Autonomy by its acquirer, Hewlett-Packard, had me reaching for my ‘spot the dog’ checklist. This refers not so much to signs of financial distress – it’s too late by then – as to the big gap between valuation and reality which sets a company up for a fall.

The trouble starts with good news. Too much of it puts management under pressure. Autonomy, the software founder whose co-founder was chief executive at the time of HP’s $11bn purchase, was a poster child for innovative technology and rapid growth. In early 2003, when the market bottomed after the dotcom bubble, its shares were trading at around £1.20. In late 2011 HP paid £25.50 per share in cash. Between 2006 and 2008, Autonomy’s sales (measured in dollars) had doubled to about $500m and its operating profit margin soared from 27% to 41%. More of the same was clearly expected: its p/e ration at the end of 2008 was about 50.

Fast forward to Autonomy’s 2010 annual report – the last before the takeover. The first thing to note is that it was still a relatively small company with sales of $870m. The second is its astonishingly high operating margin of 45%. Revenue growth had, however, slowed to 18% – and to 16% in the first half of 2011.

As with other software companies, some revenues come from customer support contracts entailing payments in advance. This raises the questions of whether certain sales have been recognised early and also flatters the cash position. The issue of ‘deferred revenue’ is set out in the annual report, audited by Deloitte, via both explanations and line items.

Critics have made much of the accounting for sales through intermediary companies, or resellers. The accounting policy section has a note on the evidence needed to recognise such a sale. It is clear that judgement is involved and collection may be complicated. As for profits, the word ‘adjusted’ should always attract questions. Autonomy is not unusual in excluding amortisation and restructuring costs. However, by the time it has counted out interest on convertible loan notes, the gap  between IFRS pretax profits and its adjusted ones of $379m is nearly $100m. This is racy, but agin the company’s approach is clear.

The most puzzling thing is the issue of the those loan notes in March 2010, raising about $760m. The main aim was a war-chest for acquisitions. But the company had net cash and appeared profitable enough to support net debt of several hundred million dollars. So why raise it at all?

Also, Autonomy’s main source of growth was supposed to be organic. As it happens it had made significant purchases every other year since 2005, leading to nearly $1.4bn of goodwill on its balance sheet. Once again the reality did not match the spin, but this was not difficult to detect.

The same can be said of Autonomy’s corporate governance. Apparently, it was classic  chief executive and FD balanced by five non-executives. But one of the latter was co-founder Richard Gaunt (not claimed as an independent) and another had been around since 1998 and should not have been regarded as independent. That left three relative newcomers to challenge the incumbents if necessary.

Maybe the investigations prompted by HPs $8.8bn write down of the acquisition price will turn up something. It did, however, pay a premium of over 70% to a price already inflated by unrealistic expectations of sales growth, apparently naive acceptance of ‘adjusted’ profit margins, and oblivious to cashflow and balance sheet issues. The technology sector is littered with such dogs and it is not difficult to spot them.  

This post first appeared in Accounting and Business UK, January 2013.


One response to Fairytales vs fundamentals


    Thanks for the interesting article.

    What one should easily spot with the eye, can easily be hidden by one’s own desirous will.

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