Updating Micro Focus After a Strong Run
Today I want to update my thinking on the stock I have had the most feedback on since starting this blog- Micro Focus (MFGP). I first bought it in November 2019 at $14, before doubling down at $4.90 last March and tripling down at $3.70 in September. After bottoming out at $2.70 in October, the company has run to $7.50 today, the rapid comeback propelling it into my largest holding (13% of the portfolio), with a cost basis of $5.62/share.
As I wrote up the company in detail last August, I won't go into its background and the UK/Brexit again today, and instead refer readers to that post. This article will focus on what has changed since the latest full year results were released in February, how I now see the risk/reward, a rebuttal of some of the many bear arguments I have received, regarding MFGP's investment merit, and my updated fair value estimate.
Full Year 2020 Results
The company has recently completed year one of a three year plan, that it aims will stabilise revenues and see consistent free cash flow of $700m annually. Management have admitted that Covid-19 has been an unexpected hit to the turnaround and will delay the timing of these objectives, but I believe there were enough encouraging signs throughout 2020 to give comfort.
The ill-fated acquisition of HPE software in 2017 continues to dominate headline results, with the company writing down goodwill by $2.8b for the period. Not pleasant, of course, but this is a punishment for the sins of the past and has no effect on the cash position for the year. I consider the write-down as the accounts catching up with the equity market's already viciously expressed view of the HPE deal.
Revenues were down 10% over the period, in line with guidance, and the company has said they fell at a slower pace over the second half. The revenue declines remain central to the turnaround attempt and must be successful if the company is to maintain its cash-cow profile. Similarly, adjusted EBITDA fell 13.6% to $1.17b and adjusted EPS fell 21.2% to $1.54.
These results were largely anticipated by the market and the earlier trading updates actually rocketed the share price, as expectations had been running incredibly low until that point. If revenue and EBITDA can stabilise near these levels, the company will be on a normalised 5x PE.
Free Cash Flow remained incredibly strong, at $511m for the full year (down from $563m in 2019, although this figure included four months contribution from the SUSE business, which was divested in that year) and its continued strength is where I see shareholder value on offer at MFGP. Cash flow from operations remained steady at $1.1b, however cash conversion improved remarkably by 17%, due to belt tightening over the year. This exceptional conversion rate is likely not sustainable and the business will need to improve operationally, if it is to thrive going forward.
Leverage levels rose over the year, due to declining adj. EBITDA with the net debt/adj. EBITDA at 3.5x at year end, above the company's stated target of 2.7x. Overall, net debt fell by $450m (after accounting for IFRS 16) due to stable gross debt levels over the period, but higher cash levels from the cancelled dividend and general conservatism.
Under the surface, there were impressive steps taken to improve MFGP's capital position in 2020. An approaching $1.4b maturity was refinanced, leaving the company maturity-free until 2024. None of its term loans have leverage covenants and this removes any near-term financing stress from the company.
$175m that was drawn down from the Revolving Credit Facility pre-emptively in March 2020, was paid back in September and current liquidity sits at $1.1b ($750m cash and $350m RCF available). Covenant restrictions exist on the RCF, if drawn above 35% ($122m), but I have a hard time seeing it being required in the near-term.
In my previous post, I described the dividend cancellation (at the Covid-19 outbreak) as a major contributor to the total capitulation of MFGP's long-term shareholder base. I still believe this was the case and think that the reintroduction of a small dividend is a great sign for the continued turnaround of the business.
A payout of 15c was declared and is a small acknowledgement of the pummelling owners have suffered over the last several years. The company announced its initial intention to pay out 20% of earnings and increase this percentage as the turnaround progresses, indicating a 30c annual dividend (4% yield) that will consume around $100m of FCF.
A recent negative was the awarding, in March, of $172.5m in damages to be paid by MFGP to a Texan claimant (Wapp) for alleged patent infringements. The company will be appealing and claims to have a strong case, but for valuation purposes, we will consider this money gone.
The priority can and must remaining de-leveraging for the next several years, but management is clearly confident with their willingness to recommence dividend payouts, continue small acquisitions and repay and reduce the RCF during the period.
Revisiting the Risk/Reward
When I last wrote-up Micro Focus, the company was trading at half of today's price, so it stands to reason that the opportunity is no longer as attractive. While this is true, it is also important to note that the odds of a positive outcome have risen and that the stock now has momentum behind it. A deep value stock undergoing a change in market perception and gaining momentum is what Grahamian investors dream of!
Short sellers are extremely smart and courageous investors and a circling of them is a potential red flag, so I was watching the short interest nervously at 4.7% last April. There was a perception that revenues would crater and trigger a capital raise at the time, however as signs improved throughout the back half of 2020, the shorts have retreated to 1.5% of the register.
So why, exactly, have they backed off? Early November to early December saw a scorching doubling of the stock, commencing with the value rip after the vaccine announcements followed by a November 18 trading update that simply reiterated company guidance and expressed cautious optimism about the turnaround plan. Consensus was simply so pessimistic that re-affirmation the company's revenues would "only" fall 10%, as promised, was wildly bullish.
On December 3, Amazon named Micro Focus as an approved partner to help businesses transition into their Amazon Web Services (AWS) ecosystem. A formal partnership was announced in early March, giving Amazon the warrants to take a 5% stake in Micro Focus, at a 20% discount to today's price, in return for providing certain levels of revenue to MFGP that the company defines as "material" throughout the agreement.
While I don't like the dilution associated and think the price will look far too cheap as the partnership ages, it will tip close to $100m into the coffers if fully exercised, and I don't view the downside as material, relative to the value proposition. The most salient point in my view is- will Micro Focus be a going concern in its current state more or less in five years?
If yes, then I believe it is a foregone conclusion that it will be a multi-bagger from today. The combination of a successful turnaround, Brexit closure, a UK recovery and a value rebound would be a spectacular result and to the extent the Amazon deal makes that outcome more likely, I can live with the dilution. It is a scenario where the revenue declines can't be arrested, the debt burden grows and FCF dries up that must be avoided.
It is also clear to me that the extreme bull case I suggested in my last piece was too optimistic, given the short-term desire to deleverage the business. My assumptions allowed for generous buybacks that would have been highly accretive, but aren't in management's vision for now. Debt pay down will, as mentioned above, increase the odds of a great outcome, even though their use over buybacks means my bull case valuation must be lowered. This is partially why I haven't trimmed the position and am confident to maintain it at a high weighting.
Pushback
Given that I have been fairly vocal about Micro Focus, I have had a continual stream of feedback regarding the investment merit of the company- most of it negative! Here I will attempt to respond to some of the criticisms I have received :
Your valuation is stupidly high-
When I calculate a fair value, I am trying to truly think along the Buffett lines of holding the thing for 10 years. Given that Research Affiliates recently named UK value stocks as their "Trade of the Decade", it stands to reason that there are some deeply, deeply undervalued stocks their and I believe Micro Focus is one of them. Add some business stabilisation/improvement, multiple expansion, dividends and a thawing of the toxic market view of the UK (post Brexit) and you can have a very strong result. I have laid out my updated assumptions below, so all feedback is welcome.
Micro Focus is "dead tech"-
I would object to the use of "dead", but happily accept "old" instead. The company is very open about its niche being "bridging old and new" and this is no different now, than when it was the UK's largest IT company at $35, several years ago. Their business lines include Serena, COBOL and Novell, all dating back to the last millennium, but buying software cheaply and integrating it into customer's existing systems is a very cash generative and sticky business.
Further, this claim ignores that the world's most dominant cloud platform (AWS) has just seen fit to partner with Micro Focus, albeit on favourable terms. Also, 70% of revenues are recurring and they are actively targeting raising this and increasing the SaaS proportion of their business (although this is currently only 8%). Internal pivoting is underway too, with the company carrying out its Go-To-Market plan, aiming to fully integrate acquisitions to improve sales efficiency and resource allocation. We will hopefully see these labours bear fruit in the coming years.
Micro Focus is in terminal decline-
This is possible. I am open about the fact that Micro Focus (and many of my investments) are potential value traps, I just think that it's well and truly priced in. When I consider the upside/downside on offer, I see a potential melting ice cube, which may have to raise capital to secure its debt load (the market expectation) vs a turnaround multi-bagger (unexpected, despite positive signs, in my view). I will take this bet all day long, as while dilution would be painful, I don't see my downside as a zero.
Company wide, adj. EBITDA fell 14% to $1.17b in 2020. The bears see this as part of the ongoing structural degradation of the business, but it seems largely pandemic and turnaround driven in my view, which is clear when analysing the company by revenue stream. Of these four segments, Licensing is 22% of revenue, Maintenance 64%, SaaS and Other Recurring 8% and Consulting 6%.
For 2020, Licensing saw the biggest hit, declining a massive 19%. This is the main consumer facing side of the business and the segment that must be regularly finding new, incremental customers for its base. That Licensing bore the brunt of a tough year, indicates that the suspension and cancellation of projects, due to the pandemic, was a large factor behind the poor performance. These are the clients who pulled their projects waiting for certainty or to save the budget last year.
By comparison, Maintenance was the lowest relative decliner, as it is a better projection of the recurring revenue side of the business and the least likely to be affected by the pandemic. It is the most material stream by far and I am encouraged that its revenue "only" fell 6% in such a challenging year.
SaaS and OR is still a fledgling part of the business, which saw a 12% decrease over the full year, in line with management expectations. The right mix is still being worked through and management is attempting to reposition the stream for long-term growth, including discontinuing unprofitable operations.
The company seems optimistic that, despite revenues falling 13% last year, the overhaul of the Consulting segment is mostly finished and "it is anticipated that this revenue stream
will stabilise in future financial periods subject to the impact of COVID-19". It will not be a needle mover, but is hoped to add business to Licensing and Maintenance over time.
Upon analysis of these units, I believe there is a high likelihood the pandemic was a one-off negative to 2020 adj. EBITDA and that it, therefore, represents a conservative baseline for valuing the business in future years.
Micro Focus is regularly voted the most hated company in the world by its customers-
This is just wrong and probably reflects historic attitudes. The company drastically improved its Net Promoter Score (NPS) to 45 in 2020, which compares to industry averages of 44 in Enterprise Software and 30 in SaaS.
Valuation
Last August I wrote:
I believe safe fair value today lies at 12x normalised FCF or a market cap of $5.4b (or $16/12GBP per share)- 4x today’s price. This is my base case predicated on the business failing to buy back shares, pay down debt and grow acquisitively going forward. To my mind, this is unlikely as Micro Focus has a history of doing all these things and took advantage of Covid-19 uncertainty to acquire ATAR Labs in July.
My bullish fair value is $33 (25GBP) per share, based on the company achieving $400m in 2020 FCF, then $500m in annual FCF from 2021 onwards. I have modelled the company using $300m to buy back shares (at prices of up to $8 a share) and $100m ($200m from 2021) to pay down debt. If this could be maintained for four years, 2024 financials would show Net Debt of $3.6b, with the $700m in retired debt adding approximately $25m to annual FCF after tax.
The combined $1.2b of buybacks, at prices up to twice current levels, would retire 150m shares, leaving 188m on the register as the divisor to $525m in FCF for 2024 FCF per share of $2.79 (12x$2.79=$33.48 per share).
On review, I have altered my fair value to allow for higher debt pay down and lower buybacks, ultimately making the business safer, despite bumping down the magnitude of the upside. I assumed $400m in FCF for 2020, which came in at $511, but I will continue to err lower in my assumptions, as 2020's cash conversion was exceptionally high.
To reach a full-cycle fair value estimate, I have assumed $227.5m of FCF for 2021 (affected by the Wapp pay out), then $400m annually until 2023, with $500m onwards. I am assuming that all FCF (after divs) will be used to pay down debt and I will give management the benefit of the doubt that any (likely small) acquisitions they do will, at least, not be value destructive.
My aim is to account for several years of lower FCF during the turnaround and have settled on a much more conservative ongoing number than the company's normalised goal of $700-800m/year. On these estimates, Micro Focus can achieve $1.5b of de-leveraging and pay $500m of dividends over the next five years, leaving net debt (including leases) at $2.65b (well under the company's leverage target).
Using 2020's Covid-hit adj. EBITDA as a baseline, if Micro Focus trades at a very reasonable software multiple of 10x EV/EBITDA in 2025, the enterprise value of $11.7b would indicate an equity value of $9b. This market cap would reflect a realistic 5.5% FCF yield on my conservative $500m or 8.3% on the mid-range of the business' stated goal.
Lastly, in finalising my bull case, I have adjusted for the Amazon dilution, without subtracting the price paid from net debt, to arrive at my bull case fair value of $25/share.
To form a probabilistic return on the investment, I estimate a 70% chance that the turnaround will work (something like the above) and a 30% chance of its failure leading to a dilutive capital raise and a 50% loss from today's price to $3.75/share. Handicapping these odds, arrives at an expected value of $18.50/share- 2.5x today's price.
Given that there will be dividends paid along the way and I consider my assumptions conservative, I obviously remain very bullish on the company.
All feedback welcome.
Guy
Please don’t take this as financial advice. Do your own due diligence and consult a professional advisor, if unsure about your finances.