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magazineMicro Focus a total returns rare breed
Newbury-based Micro Focus (MCRO) is an excellent example of a high returns stock market story. Underpinned by operational excellence that delivers consistently high margins and enormous cash generation. For years it concentrated on earnings quality and cash, but now it has also added growth to the mix.
Micro Focus provides software refresh products and functionality to legacy IT systems. Many large organisations have years of investment stacked up in their IT systems. Ripping them out and starting again is out of the question. This makes adapting this creaking infrastructure to meet technological changes – cloud computing, e-commerce, mobile applications, for example – a high prize. This is where Micro Focus comes in, with its years of expertise in core computing languages, such as COBOL, Linux and the open source SUSE suite.
Financial muscle
In the 12 months to 30 April 2017 the company generated adjusted operating profit of $638.1m on $1.38bn revenue for a 46.2% operating margin. The adjustments strip out software amortisation, acquisitions costs and share-based payments to staff. It generated $452.4m of operating cash flow, easily covering borrowing costs, tax payments and the rough $177.5m of dividends paid out.
Those margins are protected largely by the legacy software licenses and subscriptions (about 44% of revenue) that Micro Focus supplies to a large installed base, plus maintenance fees thereafter (52% of revenue). The rest comes from a small IT consulting unit.
Where management have been particularly effective over the last few years is efficiently managing its very large product portfolio to maximum effect. It has also bought in new product lines, improved operating efficiency and dragged those margins up by the boot straps.
Proven value extractor
This is perfectly illustrated by the acquisition of US IT services peer Attachmate. Bought for $2.35bn in 2014, at the time it was generating 33% margins on an earnings before interest, tax, depreciation and amortisation (EBITDA) basis. These were improved to 46% over the next 18 months.
The company is now facing its biggest growth and integration challenge ever having agreed to merge with the Hewlett Packard Enterprise Services (HPES) business in an $8.8 billion deal. HPES supplies data centre software and hardware across five main areas; IT operations management, application delivery management, cyber security, information management and data analytics, the latter division includes Cambridge-founded Autonomy.
Technically a reverse takeover (HPES shareholders will own 50.1% of the combined entity on completion, existing Micro Focus investors the other 49.9%), the combined business will have revenues of $4.5 billion and $1.4bn of earnings before interest, tax, depreciation and amortisation (EBITDA), before merger cost savings.
Those numbers are based on current HPES EBITDA margins in the low to mid-20s in percentage terms, far below Micro Focus’s 47% last year. If bridging that margin gap sounds like a tough ask, even for Micro Focus, it is worth pondering comments of HPES chairwoman Meg Whitman when the deal was announced, referring to how such margin improvements may stack up.
‘This is what Micro Focus does,’ she simply stated.
The deal was voted through by shareholders in May and will officially complete in early September. HPES is believed to have several institutions on the register with a US-only investment remit, and their exit likely explains why the Micro Focus share price has weakened over the past three months, falling from £26.55 to the current £21.00.
Total returns superstar
Which makes now a great opportunity to get in on one of the UK market’s great total return investments. Combining capital and income. Micro Focus paid out $5.51 per share in dividends since 2011, according to numbers crunched by Stifel analyst George O’Connor. It is due to make an extra $2.13 payout to shareholders once the HPES deal closes, so $7.64, or £5.89 at current exchange rates.
That works out at more than the value of the 566.9p share price at which Micro Focus began 2011. Since then the stock has soared 270%, and that’s after recent declines. Adding these capital returns to the income above gives us the total shareholder return shown in the table, supplied by Stifel’s O’Connor.
Most analysts are waiting for the HPES deal to complete before putting combined entity forecasts into the market although Numis has set the early pace. It anticipates $1.78 of earnings per share for the extended year to 31 October (the year end will change from 30 April), rising to $2.05 in the October 2019 12 months.
The implied price to earnings multiple of 15.3 falling to 13.3 is a far cry from the ratings we have become used to for technology sector companies, which often run to 20, 30-times or higher. By 2019 we wouldn’t be surprised to see a return of surplus cash being returned to investors by way of special dividends too.
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