“In investing, what is comfortable is rarely what is profitable” Robert Arnott
Business description: Micro Focus (MCRO- LN) is a UK based pure enterprise software Company, the 7th largest in the world. The company targets the mature segments of the enterprise software market which is a unique niche. MCRO has grown primarily through M&A (26 acquisitions) with HPE Software and The Attachmate Group deals, been their largest.
The HPE Software deal: Sep. 2017, MCRO completed its largest acquisition to date (merger-spin). The price tag was $8.8bn, financed through equity (50%) and cash ($2.5bn). As a result, MCRO had to borrow to finance the deal. Net debt stands at 3.3x EBITDA above what they historically guided for (2.7x EBITDA).
The Attachmate Group deal: $2.5 bn price tag ($1.5bn in stock). The deal closed in November of 2014, added $956 mm in revenue. The transaction brought in some interesting assets to the product mix, including Linux SUSE.
Recommendation: Buy. Micro Focus is a good business selling at a great price. The stock trades at $17.5/share (8x 2018 earnings) vs. P/E of 12x for comps with low organic growth. The business is cheap by every valuation measure and worth a probability weighted share price of $27.50, an upside of 50+%. I used a sum of the part model to get to a $2.2 2020 EPS, which implies a 2020 P/E multiple of 12.5x.
Why this opportunity exist? Micro Focus announced two revenue warnings (2 months apart!) and its CEO departed. The stock fell by 46% on March 16th and traded sideways since. The current bearish consensus is a good entry point to building a small position and add to it as the integration of HPE shows evidence of improvement.
Why I think this is NOT a value trap: When a company loses half of its market value in one day, there are three possibilities:
Earnings manipulation or possibly fraud: I don’t think this is another Valeant playing sleight of hand accounting games. Although, when evaluating earnings quality, the M&A growth model muddies the water. My reasons for dismissing earnings management include:
- Revenue recognition methodology is in line with peers. The cash from operations closely tracking net income over time.
- They don’t report related party transactions, so can’t really opine much on that. No-off balance sheet items.
- DSO doubling since the HPE acquisition. I believe this to be a result of IT integration issues post the HPE deal. I spoke to a former HPE employee and he mentioned that the sales force was not able to properly invoice to customers because of the integration of the CRM system.
- The business is terminally impaired. Micro Focus is synonymous to a senior home for enterprise software. They purchases software related assets late into the maturity cycle, and then seeks to optimize the acquisition for cash flow. The cost savings they can achieve directly hit EBITDA and free cash flow (low CapEx, low R&D). If no deals are available, then cash is redistributed back to shareholders via buybacks or dividends. So the business really boils down to management and execution.
- Market overreacted. The current market value is below goodwill which essentially tells me that the market is writing off HPE software assets and assigning a negative value to COBOL and SUSE. This is a value bargain by any stretch of imagination. Fear is the only reason I can think of to justify the company’s shares trading in oversold territory. I spoke to a number of mutual fund managers who have owned HPE shares pre-acquisition. Some have sold their stub immediately after the completion of the transaction either because Micro Focus business model (cutting cost and milking the cow) doesn’t fit their investment criteria or simply didn’t understand or care about what MCRO does. The ones who remained indiscriminately sold their positions after the negative news (more akin to an institutional investor only allowed to hold investment grade issues selling a bond after it was downgraded with no regard to fundamentals).
I will address the mispricing by leaning on the latest management earnings call and provide a variant perspective to each item of concern that seems to be keeping consensus bearish at this point in time.
The company issued revised FY constant currency revenue guidance decline of (6-9%) y/y vs prior guidance (2-4%). CFO’s response to what’s causing the problems: “We believe that the revenue decline issues are mainly due to one off transitional effects relating to the combination of HPE Software. Those key transitionary factors are the IT system…implantation issues have impact the efficiency of our sales team, and our ability to transact with partners and customers and our cash collection. We have had higher sales force attrition, particularly in North America.”
In my opinion, consensus simply underestimated the market tolerance for poor execution. Micro Focus was channeling all their sales team invoices through one CRM. Sales people are coin operators. As issues with misinvoicing emerged, they couldn’t get paid because customers were getting a bill sent to the wrong address. This explains the DSO and partly the sales team turnover.
As with any integration, integration soft issues typically emerge that management find difficult to handle. In speaking to an HPE former employee, HPE sales force, for a lack of a better word, were accustomed to a lazy environment. HPE sales team had their comp tied to hitting their sales target. Once they reached it, they weren’t motivated to sell more. The new Micro Focus model essentially has changed that: The sky is the limit. You sell more, you get paid more. Comp is also heavily tilted towards sales turnover. Many didn’t like this model, hence the sales force turnover issues. This is fixable.
Where can I be wrong? The revenue decline is terminal. I looked at the renewal rates for all Micro Focus products including HPE software. They stopped reporting them in 2014. Renewal rates for comps. Average 90 to 92%. Since last time they have reported them, they were in their mid-80 to low 90’s. The lack of disclosure is concerning, but tracking the % change of maintenance and license fee revenue (first derivative for renewals) corroborate the CFO claim that this is a short-term issue due to integration challenges and not a terminal decline in the business itself.
“$600 mn EBITDA improvement over the next three years is expected to be mitigated by the progress made in the cost reduction program which is currently tracking ahead of schedule”. Consensus thinks this is not achievable. I disagree. Micro Focus product Mix (COBOL, SUSE, HPE Software) is very sticky. The maintenance vs license fee mix is around 60/40 so an aggressive experience sales force selling mature enterprise software with a high switching cost should have no impact on their SG&A.
CEO Chris Hsu stepping down. The market might have been spooked by this but I’m not reading too much into it. If this was the CFO stepping down, I would have been more concerned as it can indicate accounting manipulations of some sort.
15-20% annual shareholder return target is uncertain. This target return has historically depended on management execution. Management has the experience of running mature enterprise software assets. That is all they do. Certainly, there can be hiccups along the way as they complete large transactions such as HPE software, but I’m inclined not to dismiss their track record by simply focusing on FY 18.
No M&A deals in the mid-term. Chairman Kevin Loosemore (unfortunate name), said“In regard to M&A, clearly, our focus at the moment is on the operational performance of the business. We need to get the operational performance of the business. So we don’t need the distraction of further M&A at this point in time”.This is in line with their original four phase plan and it makes sense. Currently they are experiencing issues at phase 2 (integration) and still have to show progress to investors before stabilization (phase 3) takes place. The company is guiding for growth through M&A (phase 4) in FY 2020. CapEx as % of proforma sales of $4.2 bn (6% currently) should trend lower as M&A is now off the table.
DSOs could be high for a while, and there could be even higher restructuring charges putting pressure on FCF and slowing down the deleveraging process. DSO issue is fixable because it is not related to customers unable to pay but an invoicing IT issue. The business remains profitable and highly cash flow generative with net debt to EBITDA at 3.3x. They should be able comfortably to reduce leverage below 3x. With an adjusted proforma EBITDA of $1.4 billion and low CapEx and R&D (4% of proforma sales) and assuming a 2x current provisions for restructuring charges ($108mn instead of $54mn), Micro Focus should be able to comfortably meet its short-term obligations. The only covenant relates to the revolving credit facility, which is currently undrawn.
Spinning off of the SUSE business. Here is what Kevin Loosemore said in the latest earnings call: “We have consistently said that our job is not to own assets, our job is to get value from assets. We believe that we can create incremental value by operating the SUSE business successfully, and I think the last 3 years, that would probably be agreed to be the case.”
Elliot Management, an activist investor in Micro Focus, might agree with the former (managing but not owning assets) and disagree with the latter (SUSE is best used as part of Micro Focus portfolio). I share the same view with Elliot Advisors. SUSE’s management has been given complete autonomy to run the business as they see fit, but still constrained by how much R&D they can spend to grow the business. It’s currently a distance second to Red Hat and growing EBITDA at 10-12%. I think SUSE’s Linux business in the context of increased enterprise demand for big data needs significant R&D to grow market share and hence is less valuable to current Micro Focus shareholders. Elliott’s CEO, Paul Singer, has been recently vocal about the need for Micro Focus to sell SUSE. Judging by Elliot’s CEO record I believe he might be successful in forcing a SUSE spin off. A move that can be very accretive to Micro Focus shareholders.
At this level of low sentiment, any OK news is great news. If Micro Focus is able to fix their IT glitches and ramp up their integration of HPE, which I think they can, the 6-9% guidance of declining revenue (86% renewal rate) should be adjusted upward. Assuming a base renewal rate of 88% (2% below their historical average), this should bring revenue decline to 5 to 7% for FY 18.
Earnings management or fraud. Probability of 5%. In this scenario, equity investors might end up getting nothing after the company assets are liquidated and the debt is paid. This scenario is not my base but still probable. Given no related party transactions disclosure and my lack of familiarity with the software business, I can still be missing something.
Revenue decline is greater than historical average guidance of 0-2%. (Probability of 20%). If that is the case, the stock’s current multiple of 12x EBITDA is justified. If Micro Focus is unable to sustain a sensible cost cutting approach without driving revenue further south, this will impact margins and their annual shareholder returns of 15-20% will simply not be achievable. The stickiness of their products (COBOL is a great example) is a mitigating factor so it all boils down to execution.
SUSE: Growth profile different than the rest of Micro Focus products (EBITDA margin of 30%, 10-12% historical revenue growth). SUSE is a distant second to Red Hat which trades at an EV to EBITDA multiple of 51 (EBITDA margin of 15%, revenue growth of 18%). I assigned an EBITDA multiple of 10 to 15 to SUSE, in line with low growth software companies. Based on an EBITDA of $100mn, a 60% long-term retention rate and an opportunity cost of 10% (long-term S&P 500 returns+200bps), SUSE is worth $2.5bn to $3bn.
Micro Focus excluding SUSE & HPE: If you strip out SUSE and HPE software, COBOL remains a very cash generative and profitable business with low CapEx and R&D. Assuming no growth, an EBITDA of $500mm which is conservative, given that mainframe COBOL has been growing at 2%, and using BMC and Computer Assoc. as peers (10x EBITDA), the Micro Focus ex SUSE and HPE is worth $5bn.
At the current equity market value, the company is priced at $7.8bn. Essentially, we are getting HPE Software, a business generating a proforma 2018 EBITDA of $1.5bn for FREE. Pricing HPE Software business at the low end of peers’ EV/EBITDA multiple and reducing it by the debt on the balance sheet (mostly HPE related), we get an EBITDA multiple of 7. HPE, in my estimate, is worth $10.5bn. Adding it all together, the company’s enterprise value is $18bn. Subtracting net debt of 4.1bn, gives us an equity market value of $14bn, implying a stock price of $32 a share.
Expected value then becomes = (0.75x32) + (0.2x17.5) + (0.05x0) = $27.50/share.
Important dates: Next earnings call schedule July, 11 2018
Disclosure: I am/we are long MFGP.