The Micro Focus Buy-Out: Vindication?

After banging the drum on Micro Focus for several years, a suitor has arrived, with Canadian software firm OpenText offering to acquire the company for an Enterprise Value of $6b or $6.30 (532p)/share. I have mixed emotions here and will try to sum up my thinking since the deal was announced (announcement here).

Of course, it’s hard to be upset when one of your holdings doubles overnight. The deal represents a near 100% premium to the pre-announcement price and a bird in the hand is possibly worth two in the bush. There are a lot of attractive opportunities to recycle those funds into right now.

But this is somewhat tempered by the opportunistic nature of the bid. Micro Focus shares have suffered along with most of the tech-space and were priced near Covid-lows. While the premium is large, it represents a discount to the $8/share reached in mid-2021, and values the company at 6.3x EBITDA- an extraordinarily low multiple for a software firm.

While I believe the price is too cheap, it does put the company in play and I am hopeful of a rival bidder, given the value Micro Focus would have to other strategic buyers. Consider that Micro Focus sold Digital Safe, one of its troubled divisions from the HP acquisition, for 12x EBITDA in late 2021.

This was a product management had no desire to spend the resources to improve, and yet, if its deal multiple were applied to the whole business, would suggest a $25 share price ($1b in EBITDA x12, $12b-$3.6b net debt for an $8.4b market cap). Digital Safe’s revenues were falling faster than those of the group as whole.

Micro Focus has a portfolio of dozens of products, some draconian such as COBOL and Novell, but many successful and functional, for example Attachmate, Serena and NetIQ. Their Enterprise Suite is used to launch client systems onto AWS (Amazon Web Services). A strategic seller, with the time to sell some of these pieces one-at-a-time, would have a field day and dwarf OpenText’s $6b.

The gem is their Big Data offering Vertica, which drove strong growth in Information Management & Governance licencing in FY21 and recently launched its managed, service subscription Accelerator. I believe Vertica could sell for a good chunk of $6b on its own in the right environment, as its peers include nose-bleed cloud businesses, such as Snowflake.

So why are they doing it?

I generally only pay prices that imply management aren’t exactly Outsiders material and Micro Focus is no exception. While reintroducing the dividend last year was a nice show of confidence in the company’s cash generation, it was far from optimal for a company with too much debt and a very cheap share price.

However, managment appear to be staying on with OpenText and their share incentives are being rolled over. This may have given them the rare opportunity to act in the interests of shareholders, without sacrificing their jobs- the great dilemma that has scuttled far too many corporate deals.

From the documents:

The Micro Focus Directors did not solicit an offer for Micro Focus. However, the Micro Focus Directors regularly consider all options for driving and improving shareholder value. The initial unsolicited proposals received from OpenText at 478 pence and 514 pence per Micro Focus Share were not at a level the Micro Focus Directors felt adequately reflected an appropriate valuation of Micro Focus and its future prospects. After OpenText’s third proposal reached a level of 532 pence per Micro Focus Share in cash, the Micro Focus Board determined that the offer from OpenText was at a level that they would be willing to recommend to Micro Focus Shareholders.

So management didn’t seek out a bid, but felt compelled when the premium got large enough. They go on to reiterate macro-concerns outlined in their most recent results and discuss the certainty of a hard-cash offer against the uncertainty of their turnaround delivering future value.

This can be taken two ways, in good faith or as an admission that the turnaround is failing to gain traction. While I am fairly neutral on Micro Focus’s leadership, the fact that the largest shareholder (respected, traditional value managers) Dodge & Cox have backed the deal, leads me to think the latter may be part of the story, in which case, this bid may be a lucky escape of sorts.

What would have happened to the share price if at the next results, the company had reported that revenue declines had accelerated again to 15%, due to higher labour costs and competition in the software sector? It doesn’t bear thinking about!

Chances of a higher bid

The irrevocable undertakings taken by management and Dodge & Cox all lapse in the scenario of a competing offer. I believe there is a real chance of this and will be holding my shares for now.

This isn’t inconsistent with my above performance concerns, as Micro Focus’s tight timeframe to stabilise revenues exists largely from allowing itself to become far to leveraged. While the assets may have substantial value, each period that revenues fall tightens the noose a little in a fixed cost business, but a cashed-up acquirer can use any capital structure they choose.

I would suggest a savvy one would use debt generously, but immediately carve off assets similarly to the Digital Safe deal and delever the investment to a suitable level, using the companies readily avaliable latent value (an approach I wish management had been more ready to take themselves).

Without this leverage stress, the time pressure to improve operations would be diminished and take the time required. For any number of competing software firms, this would be a simple way to bolt on revenue at a bargain price.

Amazon

In March 2021, the company signed a commercial agreement with Amazon to help large clients integrate their networks onto AWS. As part of the agreement, Amazon was issued 15m warrants to buy micro Focus shares at 446.6p each (4.4% of the company).

If Amazon is indeed seeing value through the partnership and likes the economics of the company, now just may be the time to step in, as there is already a natural compliment between their related products (while 4.4% of Micro Focus is almost inconsequential to Amazon, so is its whole Enterprise Value). Of course, Amazon has a vast number of commercial partnerships, so this may be wishful thinking.

Summary

Micro Focus has been a brutal ride for this weary shareholder. After buying MFGP at $14 pre-Covid and averaging down at $4.90 and $3.70 since, my cost basis is around $5.62/share.

After having weathered so much grief due to the turnaround, it would have been nice to have reaped the rewards, if it is indeed near complete. A Micro Focus growing revenues again would be worth far more than the $6.30/share offered in this deal. But this is of course uncertain, as management have themselves stated.

In my opinion, the shares now represent a cash-like profile, with a free option on a higher offer. Given the turmoil we are witnessing in the wider market, to sit tight in a special situation like this is an easy decision.

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.