Micro Focus: Hanging in There

I have been fairly open about Micro Focus being one of my larger positions and I know I have introduced the idea to a few people, so I wanted to share my thoughts following the company’s strategy update last week.

The market has been extremely underwhelmed by the company following their earnings release mid-year, with the shares down over 40% since June.

For context, I have had three bites at the cherry here- at $14 initially in 2019, then doubling and tripling down at $4.90 and $3.70 last year- for a cost basis of $5.62 (MFGP closed on Friday at $4.56). These purchases roughly sum to 14% of my portfolio time-weighted, although it is now a smaller position due to the lower price and progress in my other holdings.

For my previous writings on the company please see here and here, as I don’t plan to cover too much background in this post, instead focusing on the current outlook.

A Classic Value Trap

Micro Focus has faced declining revenues for several years, following their disastrous takeover of HPE Software in 2018, with the share price down 90% from when it was considered a high-growth, tech roll-up.

A three-year turnaround plan was launched to arrest the revenue situation and although it is early days, this appears to be heading in the right direction. The most recent trading update guided for 5% declines this year, improved from 10% in FYs ‘19 and ‘20.

As seen below from the company’s presentation, the goal is to exit FY23 with flat/increasing revenues and a normalised FCF of $500m annually. This isn’t Hail Mary stuff- the business generated $563m and $511m in FYs ‘19 and ‘20 respectively (although this will be lower this year due to a payout related to a copyright dispute). For reference the current market cap is $1.52b.

If management was plodding along with their heads in the sand, it would be easy to see why the ice cube could simply melt out, but the complete opposite is the case. Over the last year, the company has finally completed the integration of the HPE portfolio and is now operating off a single Enterprise-wide platform, enabling them to laser-focus on costs across the portfolio.

I am wary to take this as gospel, but CFO Matt Ashley identified $400-500m in costs that he believes can be stripped out of the 2021 cost base going forward. Even if this is only partly true, the impact on the financials will be immense.

The main issue weighing on Micro Focus is that Maintenance (by far its largest division) is the one they see the most difficulty in righting. The last few years have been such a mess however, that I do believe there are significant improvements being made and the proof is already out there that the declines are narrowing. Healthy growth in Licence is also a strong portend for Maintenance’s future, as is the transition to SaaS and recurring revenue models across the customer base.

I encourage anyone interested in the company to watch the strategic presentation. I was impressed by Stephen Murdoch’s no-nonsense demeanour and the respect he holds for his customers is obvious. At the end of the day, strong customer relationships and satisfaction will go a long way to growing the business. Improving Net Promoter Scores and retention are already bearing this out.

Overall Impressions and Value Creation

I was pleased with update. There certainly wasn’t a silver bullet, but I think management are mostly doing the right things. They are mandated to hold shares worth two years of their base salary and are awarded bonuses and Long-Term Incentive Plan grants based on revenue, EBITDA, FCF and shareholder returns.

No, you are not going to see Buffett-esque call to go all in on share buybacks, even though they would be incredibly valuable at these prices, but a steady set of hands should be all that’s needed to do well.

A very conservative dividend was reintroduced this year, likely as a nod to any long-term shareholders on the register who had gone without for several years. The policy going forward will be a 20% payout ratio of adjusted earnings and equates to a 5.3% yield at current prices.

The beauty of the company languishing on 4x earnings is a very safe payout can still give a market-beating yield. It also seems logical that management are comfortable with liquidity going forward, to have recommenced payouts when the pandemic excuse to hold-off was still available.

The CFO also gave further detail about surplus FCF going forward, stating the company’s desire to reduce its gearing ratio (Net Debt/ Adj. EBITDA) from 4x to 3x, implying around $1b in debt paydown which will take the next couple of years FCF.

Current Net Debt sits at $4.1b, although this will be reduced by $335m when the sale of Digital Safe closes. I find this commitment to deleveraging extremely comforting, as there would be nothing worse than management spraying money around trying to grow their way out of the current dilemma.

If there won’t be buybacks, a modest dividend and significant debt reduction seems like a very solid way to create value, as debt converts to equity (tax-free) at a constant enterprise value, de-risking the business and freeing up interest repayments for other purposes. I am a huge fan of Dan Rasmussen’s framework on this, as I detailed here.

Strategic Divestitures

One unfortunate note, was management’s commentary on the sale of the Digital Safe business to Smarsh, which came at an excellent price of $375m or 20x pre-tax profit and I was hopeful might be a signal of more strategic sales to come.

Stephen Murdoch stated that Micro Focus is not actively looking to sell any divisions and only acts sparingly when a buyer contacts them and the fit is right for customers and both companies. Essentially the Digital Safe sale was an opportunistic one-off, that would have required significant further investment and made sense with a different owner.

The company has a huge portfolio of assets that the market views as a tangled mess, but some of them would be very valuable to an acquirer, as shown by this latest purchase. I would have thought that selling a few more subs at 20x pre-tax, when the sum-of-the-parts is valued on a 4x PE in the market would be a pretty quick way to reduce leverage and show the market the value in the ranks, but it doesn’t look likely.

The company already has a strong history with this, having bought Attachmate in 2014 and then selling SUSE (only one of the several platforms within Attachmate) for $2.5b in 2018. This capital was returned to shareholders at the time and I would love to see more of it.

One overlooked point of the Smarsh deal, is that Digital Safe came to Micro Focus through the HPE transaction, so it is good to see some value being extracted from the train-wreck. It also seems quite bullish that they getting great prices for the assets they deem to be the problematic ones within their portfolio and would have taken the most resources to fix.

Undervaluation

Today, Micro Focus sells for 4x earnings- an obscene number. Clearly the market is assigning zero terminal value to the company and expects it to rapidly waste to nothing or drastically dilute in a cap raise. Being a UK business and already under pressure before the latest market sell-off has certainly made it a “shoot first, ask questions later” investment.

But using classic Munger inversion, what would have to actually happen for the company to justify the current price?

While the company isn’t widely followed by analysts, there are two broker EPS estimates available for 2021, 2022 and 2023 (I will use the lower of the two) of $1.39, $1.32 and $1.38 respectively. The absurdity seems clear; the Wall St-complex that is pricing Micro Focus to waste away in the near future is also anticipating it to nearly earn its Market Cap in the next three years.

These three years also coincide with a messy turnaround, which will ring-in a much rosier future if successful. Currently, this is a free option in the market. In fact, for an investor to fail to see their capital earned back in quick order, the business would need to drastically undershoot estimates and then melt to nothing within three years, despite a highly incentivised management who have seen fit to reintroduce the dividend this year, as a tell of how they feel about liquidity.

I don’t pretend to know whether the turnaround will be successful, but I am confident Micro Focus is a deeply mispriced bet. Worst case, things deteriorate and I get diluted. But, my hopeful scenario remains multi-bagger upside potential with a modest target of 15x implying a share price around $20, which would arguably be conservative for a cash-generative, high margin software business.

I own shares in Micro Focus.

Guy

As always, this isn’t investment advice. Please do your own due diligence and seek professional advice if you’re unsure about your finances.