Description

Micro Focus International (MCRO LN)

Micro Focus’ (MCRO) transformational spin-merger with Hewlett Packard Enterprise’s Software Business (HPS) provides us with the opportunity to invest in a compounder that has generated an EPS CAGR of ~26% and annual total shareholder return of ~28% from its IPO in 2005 at 9x normalized earnings, driven primarily by the large margin improvement opportunity at HPS. We are confident in management’s ability to drive better operating performance at HPS and expand EBITDA margins from 21% to above 45%. As (1) the spin-merger closes, (2) technical selling from HPE shareholders passes, (3) management provides details surrounding the margin improvement plan at HPS and pro-forma guidance, and (4) margin expansion continues in the first few quarters following the deal closing, we believe the market will increasingly price the earnings improvement potential. If management executes on their margin plan for HPS, we believe shares have upside in excess of 70% over two years. Several call options exist that may further enhance upside: (1) shares may re-rate above their historical multiple of 13-16x P/E due to better coverage with a US listing, an above $10B market capitalization, and ‘platform value’; (2) additional acquisitions; (3) share repurchases and special dividends.

As public company operators with a private equity-like mindset, management has pursued a strategy of acquiring high switching cost, high recurring revenue, mature software assets and making operational improvements to drive shareholder returns. MCRO has proven itself as a highly disciplined acquirer and manager of a portfolio of mature infrastructure software assets, making eight major acquisitions over the last ten years. The operational improvement opportunities from these deals have driven MCRO’s ~26% EPS CAGR, despite limited organic topline growth. We believe that MCRO’s Executive Chairman, Kevin Loosemore, is among the best software operators and capital allocators, and think he is similar in caliber to Vista and Mark Leonard.

Management is extremely focused on generating 15-20% annualized returns for shareholders, and their performance-based compensation only vests if they meet these targets. MCRO’s compensation structure is unique among public companies, and ensures that management is paid only if shareholders are rewarded. There are three main prongs to management’s compensation package: (1) the company-wide annual bonus scheme is tied to achieving 10% EBITDA growth; (2) the annual executive bonus scheme is paid in stock and based on achieving low double digit EPS growth; and (3) the one-time executive bonus scheme for the HPS deal will comprise several percent of the company’s pro-forma equity – this scheme does not vest below 50% TSR over three years, and will only fully vest at 100% TSR over three years. As such, in order for management to collectively earn a few hundred million dollars, MCRO stock needs to generate a ~70% TSR from current levels. We view this compensation structure as key to MCRO’s exceptional historical performance; since current management took control in April 2011, TSR has been ~40% per year.

We can look to MCRO’s 2014 acquisition of the Attachmate Group (TAG) as an example of management’s ability to dramatically improve the operating performance of acquired assets. MCRO purchased TAG from a private equity consortium which included Francisco, Golden Gate, Thoma Bravo, and Elliott. The TAG acquisition was a transformational purchase for MCRO at the time as it more than tripled revenues from $400mm to $1.4B. Within two years, MCRO improved TAG’s margins from 33% to 45%, in-line with MCRO’s pre-deal margins. The company did this by implementing a very detailed ‘playbook’ consisting of: (1) improving gross margins by exiting negative margin service and SAAS contracts; (2) cutting R&D spending that isn’t specifically tied to revenue generating activities; (3) cutting unnecessary marketing spending; (4) realigning sales force compensation to be based on profits and not bookings; (5) reducing G&A spending by rationalizing the number of office locations and optimizing spending with third party contractors; and lastly, (6) reducing the workforce. Despite the dramatic reduction in costs at TAG, MCRO was also able to improve the acquired business’ revenue growth. When MCRO acquired TAG, the business was experiencing revenue declines of 4% per year; this has subsequently been pared to declines of 1%. The improved revenue performance has occurred both in the mature products in the TAG portfolio, as well as in the high growth enterprise Linux business called SUSE. MCRO has improved SUSE’s revenue growth from 10% to 20% since the acquisition, and presently runs the business at low-30s EBITDA margins; this is faster revenue growth than SUSE’s larger competitor, Red Hat, which operates at mid-20s margins. The performance of TAG highlights management’s ability to significantly improve the operating performance of acquired software assets. While MCRO’s stock only appreciated ~15% in the immediate aftermath of the TAG acquisition announcement, as the company provided additional details on the margin improvement plan and successfully executed the stock appreciated ~100% over the next two years.

In September 2016, HPE announced that it would be spinning-off HPS to MCRO for total consideration of $8.8B ($2.5B cash and 50.1% of MCRO stock) or 11.4x EV/EBITDA. The transaction will roughly triple MCRO’s revenue base from $1.4B to $4.5B and create one of the largest infrastructure software companies with over 300 individual products and 65% recurring revenues. Management believes they can grow pro-forma EBITDA of $1.4B on $4.5B revenue to $2B by taking HPS’s mature business (80% of HPS revenues) from 24% margins to 46% (MCRO: $640mm EBITDA on $1.4B revenue, 46% margin; HPS: $750mm EBITDA on $3.1B revenue, 24% margin [HPS EBITDA excludes $90mm of corporate costs that will not transfer]). Despite management’s phenomenal track record of improving margins at under-managed mature software assets, the market has not priced in any of the potential operational upside at HPS. Given (1) management’s track record, (2) the significant excess costs that existed at HPS, and (3) the substantial margin improvement that has already been made at HPS prior to the deal closing, we believe it is highly likely that management will achieve their targets and improve pro-forma EBITDA from $1.4B to $2B+ over the next two years. We view this situation as analogous to DXC, where yet again we have a highly skilled management team taking over a bloated asset from HPE, and a stock that is valued at a low multiple of normalized earnings.

Based on the improvements that have been made at HPS over the last several quarters, we estimate that the company will have run-rate EBITDA of close to $1.7B and EPS of $2.25 at the time of deal close, driven by HPS EBITDA of $1-1.1B (we estimate LTM EBITDA of $1.5B and EPS of $1.90). We believe that the ultimate earnings power of the pro-forma business is in excess of $2.70 per share, and could exceed $3.00 when normalizing for the temporarily elevated 30% tax rate and the potential for margins in the mature HPS business to reach the current 50% margin in the mature MCRO business. We also see the possibility of further margin upside beyond 50% based on recent management commentary that when Vista looked at the core MCRO business in 2013, they thought 60% margins were achievable. See Appendix C for summary financials of the pro-forma business.

As Meg Whitman said when describing the rationale for the transaction: “This is what Micro Focus does. They are a pure-play software company who is expert at managing mature software assets. And as Micro Focus will tell you, most people who work in the software business in Silicon Valley want to grow assets. And actually some of these assets should actually be maintained on a stable platform that extends the value for customers. And it’s actually not what we do, it is what they do. But then you come to the question of why we did a spin-merge as opposed to sell the whole business. And the reason is because our shareholders will be able to ride the upside of what Micro Focus does. Remember, our shareholders will own 50% of the new company. And by the way, I will be a shareholder of that new company given my vested options and my vested RSUs in HPE. And I can tell you, I will be holding those shares because I think they're going to do very, very well.”

Besides acquiring the HPS assets, MCRO will also be ‘acquiring’ a new CEO once the deal closes at the beginning of September – Chris Hsu. Chris joined HP in 2014 as Senior Vice President of Organizational Performance to drive operational improvement initiatives across the company. He led the separation of HP into two companies (HPE and HP Inc.), and designed both the spin-merger of CSC with HP Enterprise Services and MCRO with HPS. Since the announcement of the MCRO deal, Chris has taken over running the HPS business and begun implementing the MCRO ‘playbook’. Prior to joining HP, Chris was a Managing Director at KKR and a leader in the KKR Capstone operating group. The feedback that we have received on Chris has been nothing short of outstanding, and we believe that he will substantially bolster MCRO’s management team. Kevin Loosemore, the current Executive Chairman of MCRO and architect of the company’s business plan, will remain Executive Chairman of the enlarged group.

Since Chris took over the HPS business at the end of 2016, he has been implementing the MCRO ‘playbook’ and has dramatically improved the margins of the business. In the three quarters Chris has been running HPS, year over year margins have improved by 200bps, 400bps, and 1,000bps (HPE’s Fiscal Q4 2016, Q1 2017, and Q2 2017). In Q2 2017, despite a 9% revenue decline driven primarily by a 28% drop in license sales, margins improved from 16% to 26% and EBIT grew 45% year over year; had license sales not declined to that extent, margins would have been up well over 1,000bps. We estimate that on a run-rate basis, HPS margins are already in the mid 30s; we believe margins could be even higher by the time the deal closes in September (see Appendix C). Current run-rate margins at HPS exceed the margins that many sell-side analysts are modeling in several years from now. The market has seemingly ignored the improvements Chris has made at HPS while the deal is pending, and instead is overly focused on weak license sales. Significant license sales declines are typical during acquisitions of enterprise software companies by private equity; customers are unsure of what products will be maintained and the level of future product investment (see TIBCO and Riverbed as examples of this). Additionally, recent turnover in the HPS sales force, combined with the inability of the MCRO sales force to begin selling HPS products, has further hindered license sales. As product plans are finalized and a few quarters elapse following the acquisition, license sales are likely to rebound and make-up for the sales deferral that has occurred in recent periods. The market’s obsession with weak license sales at HPS has masked the fact that the business will join MCRO with substantially higher margins and EBITDA than was the case when the deal was announced.

We generally like mature infrastructure software assets as they are incredibly sticky and generate strong free cash flows, owing to the ‘captive’ existing customer base that requires minimal costs to continue servicing. Given the extent to which these software products are integrated into the technology systems of large enterprises, these companies are usually unwilling to attempt rapid re-writes of existing systems given the business risks of a failure. We believe that legacy infrastructure software, if positioned properly, will continue to exist in a hybrid cloud environment which incorporates both legacy on-premises systems and software on the public cloud. As an example of the stickiness of these assets, MCRO’s COBOL product has grown significantly since the early 2000s despite predictions that COBOL would cease to exist by the mid-2000s; in fact, in FY 2017, COBOL delivered 3% revenue growth owing to a new product which enables COBOL systems to function in a cloud environment. We view the acquired HPS products as being of superior quality to the non-SUSE MCRO products, and believe the HPS portfolio should ultimately deliver low single digit revenue growth, an improvement from its 1% growth in FY 2016. In particular, HPS’s ArcSight security product, Mercury application testing product, and Autonomy/Vertica ‘big data’ products are all sector-leading offerings. The HPS portfolio, when combined with a slightly declining to flat MCRO portfolio, should lead the pro-forma company to deliver modest organic revenue growth once management has finished exiting value-destructive revenue streams.

Looking past the HPS deal, we believe MCRO will continue being a structurally advantaged acquirer of mature infrastructure software assets. With private equity firms like Vista and Thoma Bravo focused on higher growth software, along with other software acquirers like Constellation Software, MCRO is unique in being the primary acquirer for under-managed mature software companies. Since it is difficult to IPO software companies with flat or negative revenue growth, MCRO is well positioned to buy private equity portfolio companies. With a proven ability to run mature infrastructure software assets at 50% EBITDA margins and many companies running at substantially lower margins due to value-destroying spending to chase growth, the acquisition opportunity set for MCRO is quite large. To name a few specific targets, we believe BMC, Quest / SonicWall (former Dell Software Group), Compuware, CA, Progress Software, Software AG, MicroStrategy, and IBM’s legacy software revenues are all potential acquisition candidates. With management’s credibility further bolstered by executing on the HPS operational improvement opportunity, a pro-forma business that delivers modest organic revenue growth, and a long runway as a structurally advantaged acquirer, we believe MCRO could re-rate above its 15-16x P/E multiple prior to the HPS announcement. We view Constellation Software and OpenText as relevant comparable companies, not poorly managed mature software companies like CA.

As a result of (1) MCRO being a relatively small, underfollowed company, (2) the lack of familiarity of HPE holders with MCRO’s track record, (3) investors who are long the HPE stub shorting MCRO, (4) lack of details on the HPS margin expansion plan, and (5) the time until deal closure, the market is offering us the opportunity to buy a compounder at 9x P/E. We believe it is highly likely that management will successfully execute on their plan to improve HPS margins, and expect MCRO equity to generate returns in excess of 70%.

Appendix A: HPS Margins

Note: Margins below are based on segment operating income (EBIT) for HPS, and do not exclude ~$90mm of corporate costs that will not transfer to the pro-forma company.

Note 2: The reported margin for HPS in FY Q2 2016 of 24.8% was significantly distorted by a gain recognized from the TippingPoint divestiture. The true margin was ~16% (see HPE FY Q2 2017 conference call, and the MCRO press release from June 1st).

Appendix B: MCRO Margins

Note: FY 2017 margin was 46.4%, comprised of 50.3% for core MCRO and 32.6% for SUSE.

Appendix C: Financials

Note: HPS financials below do not exclude ~$90mm of corporate costs that will not transfer to the pro-forma company.

Disclaimer:

The author makes no representation as to the accuracy or correctness of the information contained herein and expressly disclaims any liability to any person from relying on such information.  The information and views contained herein are provided as of the date this summary was posted and present the views of an investment firm that currently holds a net long position in the company’s securities.  The author has no obligation to update any of the information provided herein.

Catalyst

1) Deal closes 9/1;

2) HPS/HPE Fiscal Q3 earnings 9/5;

3) Investor day 9/7;

4) Management provides more details surrounding margin improvement plan at HPS;

5) Execution of operational improvement plan at HPS;

6) Additional acquisitions