Sunday, November 25, 2012

Mind the GAAP

When William Hewlett filed U.S. Patent 2,268,872 for the HP200A resistance-capacitance audio oscillator, he and his buddy David Packard unwittingly set in motion one America's most powerful illusions.  There's no small irony in the fact that it was Walt Disney's Fantasia that put HP on the map and World War II communications that provided the fuel for the "rocket" that Hewlett would describe in the following manner.

"We just happened to be on top of the rocket when it took off.  We were here with electronic products when electronics became a big thing.  We went up with it.  We don't deserve one damn bit of credit for the success of Hewlett-Packard."

The garage-to-icon myth is one of the most told, most misrepresented, stories of our modern economy.  RCA's David Sarnoff saw the value in Hewlett's technology and integrated it into Walt Disney's epic visual orgy set in motion in late 1930s.  But it was the war, and more precisely, MIT's microwave signal engineers which moved the duo out of the Palo Alto garage and solidified a government procurement cash-flow that would go on to support the enterprise.  It was 30 years between the garage and the first calculator in 1968, the HP9100A.  Hardly the 'overnight' entrepreneurial success that so many have chased into the Silicon Valley mirage.  So, this week when Illusionist-In-Chief Meg Whitman announced the nearly $8.8 billion charge-off, she was doing a lot more than swallowing the ipecac of the misguided Autonomy acquisition.  At the end of day, she was further indicting an economic model that she and her predecessors, though lauding at every turn, have failed to rationalize.  Growth, for its own sake, is to corporations what malignancy is to cancer.  While radical therapy can, on occasion, save the organism, this latest erasure of 'asset' value is but a whisper in light of the nearly $75 billion of market capitalization that has been vaporized in just the past few years from this once unassailable behemoth.  Ms. Whitman is probably correct in writing off Autonomy - itself an illusion created by a myriad ofcompliance and 'big data' noise - because it really wasn’t worth what HP and its investors paid.  But to blame the multi-billion crater on the impact of an accounting discrepancy (true or not) is still an illusion of gargantuan proportion.

What Meg (to say nothing of her unhappy colleagues like Ben Verwaayen at Alcatel and Stephen Elop at Nokia) doesn't get is that it's not GAAP accounting that is the enemy.  Revenue recognition audited by PricewaterhouseCoopers may be aggressive and wrong in the Autonomy deal.  But let's face it, the board (including Meg) should have been independent and inquisitive long before pen ever hit paper on the deal - not now that the target's name has become one of the greatest Icarian jokes of all times.  For Autonomy to work, it requires a bunch of dependencies!  HP, Alcatel, Nokia and others have the short term governance pathology of boards and management who live in the echo chamber of the past 30 years of public market lies.  Being at the top of the equity food-chain, growth through acquisition is favored above organic innovation.  Ironically, HP killed much of its true innovation about the time it adopted the "Invent" brand campaign.   And, when faced with the looming specter of presiding over the death of iconic brands, the same markets that celebrated the growth orgy stand more than willing to indebt the organ donor for one last gasp at profiteering.

For a bit of a digression, consider this week's announcement that Lloyd Blankfein's Goldman Sachs is looking at financing Alcatel in its hour of need.  Generous?  A real corporate citizen helping out another ailing giant?  Not so fast!  According to the press, Goldman is seeking to "stabilize" Alcatel's balance sheet.  This coming on the heels of Verwaayen's announcement that he's looking at selling many of Alcatel's patents to the Sherman Act-testing RPX.  Is Goldman's deal a stability play, an intellectual property collateral land grab, or a bit of both?  Does Goldman, RPX, or Verwaayen know the value of the assets once built in another innovation icon - Bell Labs?  Out of the firm's combined nearly 64,000 patents, slightly under 25% would stand up to validity challenges.  With over $150 billion in revenue generated by parties who are likely infringing a few thousand of the firm's legitimate IP, neither Alcatel nor its investors have any visibility into the assets of consequence.  Having one "too-big-to-fail" bank step into finance a "too-big-to-fail" company isn't going to shed more light on the matter.  However, if Blankfein plays his cards right, he'll get nearly $7 billion worth of collateral for a few hundred million.  And, like the HP story, investors will have their collective pockets picked by a system that has failed.

After 1999, 2001, and 2008, aren't we supposed to be more transparent, more informed?  Don't we have accounting and reporting requirements that are supposed to protect investors from these colossal blunders?  Don't we have oversight from the SEC, L’ Agence Nationale de la Sécurité des Systèmes d'Information, Committee on Foreign Investment in the United States, the UK Serious Fraud Office, and other agencies who are watching out for the stated interests of States and their citizens?  Haven't we learned our lessons about assuming that someone, somewhere is actually paying attention so we don't have to do so?  If this week's news is any indication, the answer is an unequivocal "No".

But let's get back to the GAAP.   In our fervor for consolidating small enterprises into cumbersome polyphemes we do grave harm to the economy and rend our social fabric.  In the Small War Plants Corporation Congressional Act of 1942, we once acknowledged that agile small businesses were vital to employ the population and innovate in times of need.  Justified by an innovation-filled war machine in the Third Reich, the U.S. recognized that tactical response to economic, social, and technological demands required a fertile infrastructure to support the formation of new enterprises.  However, in less than a decade, this impulse had been infected with tax and debt incentives that favored a view that small enterprises were, in the end, part of a food-chain ending with the very large corporations they were formed to out-maneuver.  The utility of enterprise - including the gainful employment of millions - when it comes to merger frenzied financial predation - is seen as an inefficiency.  Efficiencies of scale erase livelihoods in the name of profit.  GAAP doesn't cost-account for the social burden of unemployment and underemployment, of failed cities and towns, of lost spirit of enterprise.  After all, those are masked by tax advantaged corporate practices which domicile costs in one jurisdiction and shield profits in another.

What the G-20 need is a peacetime version of the SWPC of 1942.  And, to be sure, failure to address this will cost us more than iconic names like HP, Nokia, and Alcatel.  When the Glencore Xstrata merger actually closes (which looks like it may finally happen), the resulting over $200 billion revenue entity will loom far above the GDP of many of the countries from which the combined firms extract minerals and other resources.  And, like BHP, Vale, and Rio Tinto, this powerful size will attract new challenges.  In a world where being large has run into powerful social and practical headwinds, the ecosystem upon which titans depend is becoming more fragile.  When the industrial incumbents weaken, opportunistic impulses surface.  Nationalization of assets occurs on the margins.  Trade barriers are built explicitly and implicitly.  And in the end, we see fragmentation.  We can either preside over, and participate with, it in an orderly fashion or allow it to happen to us.  The former requires genuine accounting for the things that we value.  The latter will allow us to wax nostalgic for values we failed to explicitly acknowledge.  We could benefit from the recognition that innovation and enterprise is a pathway for purposeful engagement - not an inefficiency from which capitalist pressures should extract every dime.  We benefit from William and David's first impulse - not Meg's last one.  We benefit from a wire stretched between two rooms which made remote communication possible - not from Goldman's final leverage.  It's time that we revisit our myths and divine the truth that they've masked.  We've been weighed in the balance sheet and have been found wanting.  It's time that we mind this integrity gap.

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Thank you for your comment. I look forward to considering this in the expanding dialogue. Dave