Micro Focus begins to get to grips with HPE integration plan

Software product group Micro Focus International issued its interim results to 30 April on Wednesday - the second interims for its 18-month reporting period to 31 October - with a pro forma constant currency revenue decline of 8.0% to $1.97bn.

For the latest six month period, Micro Focus saw further improvement in its pro forma adjusted EBITDA margin to 36.0% from 31.8%, and expected that to increase to about 37% for the full year, at the midpoint of its revenue guidance. Adjusted EBITDA itself was up 6.4% to $710.5m.

Back in March, less than six months after completing the reverse takeover of assets that included parts of HP's disastrous acquisition of Autonomy, Micro Focus issues a profit warned due to a rate of revenue decline that was "greater than anticipated".

On Wednesday the FTSE 100 group reiterated the full year guidance given back in March, for an expected 6-9% revenue decline and underlying operating profit margin of 37%, saying that due to initial challenges in the integration of HP Enterprise's software arm, the process was running a year behind schedule. Management now expects to stabilise revenue declines and margins to climb well above 40% by 2020.

There was also “strong” free cash flow of $213.4m, despite elevated trade receivables as a result of IT systems issues.

The company’s twice-covered dividend policy remained unchanged, with a 58.33 cent second interim dividend for the 18-month accounting period declared.

Micro Focus said its cost management programmes were progressing well, with the group targeting a further $300m of annualised cost savings by end of the 2020 financial year.

It also reported progress on its integration with IT systems as “stabilising”, with the business being simplified, and the sales organisation re-aligned and refocused.

Additional resources were required to stabilize then remediate the ‘FAST’ platform, which was said to be driving an increase in exceptional costs - now expected to be $960m, compared to the $750m previously flagged.

Micro Focus said 70% of revenues were recurring, which reflected “deep and business critical” customer relationships.

“I am pleased to report that since March there has been an improved momentum in the HPE Software integration process and a slowdown in the rate of revenue decline,” sais executive chairman Kevin Loosemore. “This has led to revenues for the period being at the better end of management guidance.

“The Micro Focus strategy and proven operating model has seen us successfully acquire and integrate a number of transactions over recent years.”

Loosemore said the firm’s management was now applying the Micro Focus operating model across the enlarged group “fully and robustly”, after an initial period where the application had been inconsistent/

On 2 July, the group announced a proposal to sell SUSE for a total cash consideration of $2.535bn.

Loosemore said the sale, at a multiple of approximately 7.9x revenue and 26.7x adjusted operating profit for the 12 months to 31 October 2017, reflects an "excellent return on the investments" since it was acquired in 2014.

The disposal should generate approximately $2.1bn in cash, the substantial majority of which he said would be available to deliver as returns to shareholders.

Following the sale of SUSE, the Micro Focus business would continue to focus on the opportunity presented by the consolidation of the mature infrastructure software market, Loosemore added, with the business generating in excess of $1bn a year in operating cash flow.

“This in turn underpins the ability of the business to achieve its target of 15-20% total shareholder returns. In addition, by maintaining an appropriate debt profile, we will have the capability to fund either further significant returns of value to shareholders or fund additional accretive acquisitions.”

Due to initial challenges in the integration of the HPE Software assets, Loosemore said the board believed that it was running about one year behind its original plan, and as communicated in March it expected that on exiting the current financial year, revenues would be “substantially lower” than anticipated at the time of the transaction.

“By the year ending 31 October 2020, we expect the business excluding SUSE to have stabilised revenue declines and be delivering adjusted EBITDA margins in the mid-40 percentage points.

“Incremental cost savings required to deliver the above can be accomplished with only a $30m increase to the $600m estimated in September 2016.”

Loosemore said the new IT systems implemented in HPE Software had now been stabilised, the cost of which and the anticipated further necessary remediation would incur an additional $180m in exceptional charges on top of the $150m estimated in September 2016.

The company’s changed year-end meant that it was announcing a second interim dividend of 58.33 cents, the same as last year's final dividend, Loosemore explained, and would propose a final dividend at the full year results in January. “To avoid undue disruption we have decided to pay the 18-month dividend as a smaller first interim followed by a larger second interim dividend and then a broadly similar final dividend.”

Shares in Micro Focus fell more than 10% on Wednesday, undoing most of the rally since March.

Broker Canaccord said the adjusted EBITDA was 7% ahead of consensus forecasts on a 5.9% decline in revenues versus consensus that was looking for a fall of 9.3%. Net debt of $4337m was broadly in line with expectations.

"We note an increase in exceptionals to $960m from $750m to cover the cost of stabilising and then remediating the FAST programme. Cost management programmes are said to be ‘progressing well’ and management is targeting a further $300m of annualised cost savings by end of FY20. We understand that this is $200m more than the $600m anticipated when the HPE deal was announced.

"We believe the market has yet to price in the recently announced accretive disposal of the SUSE open source business for $2.5bln in Q1 next year.

"Chairman Kevin Loosemore commented that since March there had been an improvement in momentum in the HPE integration process and a slowdown in the rate of revenue decline. We believe that this progress, together with the recently announced disposal of SUSE, mean that Micro Focus is back on track with its longstanding and consistent strategy of 'managing, optimising and consolidating mature infrastructure software businesses'."

Analysts at JPMorgan Cazenove noted that Micro Focus was trading on 8.1x calendarised 2019 forecast ratio of EV/EBITDA versus the global software sector that averaged 17x, "with much of the differential due to lower revenue growth prospects, higher debt ratios, as well as recent volatility".Cazenove