The Art of the Bad Deal

Wall street’s disproportionate sway over the U.S. economy has caused big problems in recent years, from the subprime crisis to high-frequency-trading debacles. But here’s one you may not have noticed: it’s crippling innovation.

To understand how, look at the latest victim, the once mighty Hewlett-Packard. It’s hard to think of a company that’s been as loved and, more recently, loathed. The godfather of high-tech firms, HP was started in a garage in 1939 by two engineers and came to symbolize the Silicon Valley culture of creativity and collaboration. But that was then. For more than a decade, HP has been plagued by management flameouts, layoffs and slumping profit margins. Now the company is reeling from its Nov. 20 announcement that it is taking a massive write-down on Autonomy, a software company it paid $11 billion for in 2011. HP is erasing $8.8 billion of Autonomy’s value from its books amid allegations of accounting improprieties and disclosure failures. And HP’s stock chart is looking like a downward slope on one of the mountains near its headquarters.

HP’s real problem–it is one that also troubles the rest of corporate America–is an addiction to buying short-term growth at the expense of long-term innovation that can produce profit and jobs. Executives are still rewarded on the basis of stock price and behave accordingly. Many have come to resemble financial institutions, running their balance sheets like portfolios to hedge short-term bets while failing to invest in their future. Over the past three decades, companies that have sacrificed long-term growth for short-term gain have included Kodak and Merck. Suffice it to say the list is long and, thanks to ever shorter investor time horizons, growing.

In the case of HP, buying Autonomy, which made search and analysis software, was supposed to boost the company’s stock price by moving its focus away from computer hardware and printers, which are under increasing pressure from competitors’ cheaper products. Yet integration plans were unclear, and investors felt the deal was overpriced. As fund manager Pat Becker of Becker Capital Management, who sold his HP shares when the buy was announced, puts it, “Acquisition at any price is a bad strategy.”

But one of the reasons HP was shopping for a software company in the first place was that it had lost the ability to innovate from within, in part by discarding its engineer-driven culture for a sales orientation. Kimberly Elsbach, a professor at the University of California at Davis who co-authored last year’s paper titled “The Building of Employee Distrust: A Case Study of Hewlett-Packard from 1995–2010,” traces the beginning of the end to the appointment of CEO Carly Fiorina, an outsider who downgraded techies and upgraded herself, centralizing corporate control and even starring in an ad campaign. She also began a series of layoffs–ramped up after a merger with Compaq in 2001–that took the company further away from its original culture.

That merger, say Elsbach and other experts, reflected a broader shift in corporate leadership that favored financial engineering over the real sort. It became common in the 1980s, when top executives increasingly began to be plucked from finance rather than from industry and manufacturing. It took a long while for this shift to reach Silicon Valley, but eventually it did. At HP, that led not only to the Fiorina era but also to brutal cost cutting under her successor Mark Hurd, who okayed another merger, with the ailing technology-service company EDS. In the view of veteran tech analyst Rob Cihra at Evercore Partners, that merger’s chief goal was to boost HP’s stock price by increasing the size of the company, then dramatically cutting jobs. “There was no attempt to integrate the two firms. Cost cutting as a result of the EDS merger became the biggest driver of earnings growth for the next few years,” says Cihra. “But HP wasn’t building value. They were destroying it.” Once the easy gains were had, the stock fell precipitously.

It’s worth noting that firms that are the most successful over the long haul truly value innovation. IBM pours twice as much per year into R&D as HP does and develops as much proprietary technology as possible. Apple is all about blue-skying the best technology, then investing as much money as it takes to build it. Both have share prices and market valuations that dwarf HP’s. And it’s unlikely that either will ever have to worry about fending off the buyout vultures that have begun hovering around a once great company.