Interactive Investor

Stockwatch: a tech stock back on its historic roller-coaster ride?

Shares in this software company have doubled from last November – and there could be more to come.

26th February 2021 14:06

Edmond Jackson from interactive investor

Shares in this software company have doubled from last November – and there could be more to come.

The mid-cap shares in global infrastructure software company Micro Focus International (LSE:MCRO) have doubled from a circa 210p low early last November, along with plenty of other stocks perceived as higher risk/reward.

But compare this with the 2007 to 2009 period for Micro Focus, after which the stock enjoyed a long-term bull market with a high of nearly £27 in October 2017. I recall a similar hairy chart around the late 1990s to early 2000s tech-boom. 

Having previously seen Micro Focus rally hard, in August 2012 I set out a bull case at 540p when the forward price-to-earnings (PE) ratio was a modest 10x and the yield a useful 6% covered 1.6x.

After two profit warnings and a change of management, a new executive chairman proclaimed “Micro Focus is an excellent business capable of providing outstanding returns”.

Investment value with a volatile history 

A virtue of this stock – compared with much else in the technology space – is being a well-established company, at times on a cheap PE and even offering a meaningful yield.

Founded in 1976, Micro Focus is a British multinational company – reporting in US dollars - headquartered in Newbury, that first made its name in Common Business Oriented Language (COBOL) programming software.  

A key reason for its roller-coaster chart is playing to the stock market’s love of vigorous growth by acquisitions. They invigorate earnings per share (EPS) and provide exciting news flow, but they can also lead to managerial over-stretch – distracting from businesses already owned – also a balance sheet swollen with goodwill (the premium paid in takeovers, above tangible asset values) and debt.  

If a company makes a long-term serial habit of this, it explains a cheap PE and relatively high yield: the market pricing the stock for higher risk. Moreover, software can be fast-moving where managers need to be on the ball – re-positioning the business – and research & development (R&D) takes a decent slice of cash flow, just to stay competitive.  

With all that in mind, the 20 years (and above) chart for Micro Focus shows there are still opportune times for enterprising investors in its stock.  

Back in 1998, there was the $534 million (£382.3 million) acquisition of Intersolv Inc – with a parent name-change to Merant plc – which appeared not to work out, as the original Micro Focus was demerged and re-listed in 2005.

Acquisitions continued globally, such as applications lifecycle manager Borland in 2009 and Attachmate Group Inc for $1.2 billion in shares in 2014. The market cheered such action and the stock soared to more than £25 by mid-2017. 

But the price plunged to about £25 in March 2018 after a profit warning and departure of the CEO. Recovery buyers drove it back over £20 by June 2019, but its bear market was renewed by a revenue warning that August – with weak sales hastening a strategic review.  

Year one of a three-year turnaround plan 

Latest preliminary results to end-October 2020 showed revenue numbers down 10% (both in actual and constant currency terms), though it is tricky to decipher the extent of headwind from the pandemic.

The first half saw an 11% decline, and the second was not much better, down 9%. Yet the current CEO – who worked his way up after joining in 2012 – proclaims the business remains resilient, with high levels of recurring revenues and long-term customer relationships. 

This claim seems somewhat contradicted by a turnaround aim to re-position into software-as-a-service for better security of revenues. Moreover, I cannot help feel ‘SaaS’ has been around for years, i.e. Micro Focus is just catching up.  

The adjusted margin of earnings before interest, tax, depreciation and amortisation is proclaimed at 39.1%, slightly easier than 40.7% in the October 2019 year. That said, the income statement still has a slew of costs – including just over $500 million annual R&D expenses – such that the operating margin (before exceptionals) was 11.7%.

This was a reduction on 15.4% in the October 2019 year albeit chiefly due to revenue slipping than rising costs. Taxation swallowed the $71 million pre-tax profit. 

The narrative typifies the early stage of turnaround – “improvements in operational effectiveness…but much remains to be done”. The income statement says further cost-cutting is essential, plus renewed top-line growth if Micro Focus is to gain a PE over 20x – as typically associated with well-honed IT stocks. 

Yet if confidence rises in the recovery plan, the stock can quite easily gain a high PE in anticipation.  

If forecasts are fair, a PE of 4x and near 6% yield 

Consensus – probably guided by the company – looks for just over $480 million net profit in the current year to end-October, with a flat scenario for 2022. This may well, however, reflect a ‘wait-and-see’ view on the turnaround. It is a median scenario of recent years’ earning power, if tricky to assume much about past performance when a business group is transitioning. 

But if only vaguely realistic, it represents a forward PE barely over 4x, whereas having followed Micro Focus periodically for over 20 years a mean ratio would be in double-digits.    

Confidence in the projection is somewhat bolstered by the decision to reinstate a 15.5 cents per share dividend after being dropped in respect of 2019. Consensus looks for about 35 cents going forward if well down on around 100 cents previously. 

With the stock currently 433p, that implies a 5.8% prospective yield, which, if realistic, does constitute support. 

It is possible to visualise the early stage of a medium-term bullish risk/reward profile from the current price level, on the basis of such a payout and the operations’ narrative improving. 

Near $3 billion reported annual loss is goodwill impairment 

Management justifies this as “driven by changes in the group’s trading performance and overall environment when compared to original projections made at the HPE software acquisition”. 

It is so typical of an acquisitions spree that later hits a more challenged environment. The current CEO has been in place from early 2016 (previously chief operating officer) and the Hewlett Packard Enterprise software acquisition was September 2017, so he rather owns it – although an executive chairman of 15 years departed in February 2020. 

HPE proved difficult to integrate and generated a total of $960 million exceptional charges, $715 million by early 2020. 

The $9.2 billion goodwill and intangibles are nearly 3x the $3.2 billion net asset position. This halved over 12 months due to goodwill write-down. 

Overall traction is yet to kick in, for revenue growth 

There is management-speak about “re-engineering our Go-To-Market approach” and sharpening product innovation in support of clients’ digital transformation.

You would think it a promising area, if tricky to gauge exactly how competitive the various (acquired) elements of Micro Focus are. Aspects of the operations review are encouraging, but as yet, it is mixed. 

It is the kind of situation where the market is likely to await evidence by way of numbers – but you could also regard this as priced-in, at a possible long-term turning point. Certainly it is versus richly-priced technology stocks that are exposed to rising inflation. 

Micro Focus International - financial summary
Year ended 31 Oct

  2015 2016 2017 2018 2019 2020
Turnover - $ million 835 1,245 1,077 4,754 3,348 3,001
Operating margin - % 17.4 23.7 21.1 7.9 6.6 -88.7
Operating profit - $m 145 295 227 377 222 -2,661
Net profit - $m 102 163 158 784 1,469 -2,969
Reported EPS - cents 73.8 93.2 63.1 4.1 -4.9 -886
Normalised EPS - c 127 105 119 200 88.3 22.6
Operating cash flow/share - c 174 163 230 278 175 202
Capital expenditure/share - c 19.0 25.6 21.9 39.9 22.6 25.9
Free cash flow/share - c 155 137 208 238 152 176
Dividend/share - c 62.1 92.6 116.0 70.3 0 15.5
Earnings cover - x 1.2 1.0 0.5 0.1 0 -57.2
Cash - $m 241 667 151 621 356 737
Net debt - $m 1,459 1,108 1,411 4,253 4,339 4,154
Net assets/share - c 765 906 846 2,200 1,882 960

Source: historic company REFS and company accounts

£4.6 billion debt remains quite a millstone 

The cash flow statement has a better profile, with net cash from operations up 3% to $678 million. It appears to show around $1.5 billion churn in bank debt, although the balance sheet has such debt – virtually all long-term – stable around $4.6 billion, versus $737 million cash.

This generated a $279 million net interest charge that swallowed 80% of operating profit. 

Frankly, debt must reduce to mitigate stock volatility, which is doubtful if the board intends to restore dividends. But disposals could help, and there is substance. At 433p a share, this is a £1.5 billion company. 

Significantly, I feel Micro Focus has re-rated since early November due to a liberal attitude towards indebted companies. Aston Martin Lagonda has similarly doubled, in the “pending turnaround” category. Risk appetite has sharpened for these stocks amid the belief central banks and governments will maintain stimulus. 

Yet, of interest to enterprising investors 

My conclusion is that taking a small initial position is justified, then monitoring developments and trading accordingly. Despite the extent of debt, it could prove manageable (down) over time. ‘Buy’. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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