Deep Value in Micro Focus International

Micro Focus International is a high cash generative business currently on the ropes following a transformative merger that did not pan out as expected

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Praveen Chawla
Sep 11, 2020
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Micro Focus International, PLC (

LSE:MCRO, Financial) (MFGP, Financial) is a UK-based developer and marketer of enterprise-level software applications. It specializes in acquring infrastructure software from larger companies who want to focus on other strategic priorities.

Infrastructure software is a type of enterprise software or program specifically designed to help business organizations perform basic tasks such as workforce support, business transactions and internal services and processes. Companies including banks and airlines pay Micro Focus to extend the life of the computers they use to run their businesses, manage data, etc. This allows companies to avoid spending on newer computer systems.

Micro Focus's expertise is to acquire these products and improve the profitability of them. Until some time ago it did a lucrative business in this niche, but in 2017, that changed when it acquired the software business of Hewlett Packard Enterprise Co (HPE). Micro Focus paid $2.5 billion in cash to Hewlett Packard and then proceeded to merge with its software business. The transformative deal together with debt and equity was valued at over $8 Billion. After the transaction, Hewlett Packard shareholders owned 50.1% of the combined company.

However, it became clear pretty soon to the stock market that the integration of the Hewlett Packard assets was not going according to plan. Revenue and profits of the combined company were not meeting forecasts. It looked like Micro Focus had bitten off much more than it could digest. Investors lost confidence and the stock crashed and kept on crashing.

77023eaa1f32ede62828c6874b1f11d4.pngIncome statement

The following is a graphic showing the income statement of Micro Focus. The company is dual-listed in the UK and the U.S. The income statement charted below is in British pounds. As is typical in the UK, it reports bi-annually. In its latest report, it took a big loss due to impairment. In March, it suspended its dividend to preserve cash following the onslaught of the pandemic.

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The following waterfall chart shows the bridge between Micro Focus's "net income from continuing operations," "Operating Cash Flow" and "Free Cashflow." The company took an impairment charge of £600 million ($767 million) (shown under Cash Flow from Others). Even though the company reported a net loss of £774 million, the Free Cash Flow of the company was £402 million. While not great, it is still pretty good. This makes me think that perhaps the market has over-reacted in its pessimism.

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A company that can generate £402 million in free cash flow and is being valued by the market at only about £975 million is, in my opinion, being mispriced. This is a free cash yield of over 40%.

Balance sheet

A quick look at the company's balance sheet reveals that the company has about £3.77 billion in long term debt. While the market is understandably worried about it, and Gurufocus ranks the company's financial strength as 3 out of 10, it should be noted that Micro Focus has recently managed to refinance its debt. The company announced on May 29 that is has secured two tranches of dollar and euro denoted funding worth $650 million and €600 million ($710 million), respectively. Micro Focus said that has secured its financing needs out to 2024, so it has a good three years of breathing room to hopefully pay down its debt. The management objective is to bring leverage down to 2.7 times Ebitda, which it says it is comfortable with as ongoing leverage.

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Given the asset impairment charge, I think we should be looking at the debt through a cash flow lens and not an earnings lens. Cash flow remains quite good and the company is in no danger of bankruptcy in the near term. The main near term issue facing the company is to slow and then arrest the revenue decline. We should note that the company still has a lot of intangible assets on its books. It is very likely that more asset writedowns will occur in the future as the company struggles to integrate and rationalize its product lines.

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Valuation

I think the best way to get an idea of valuation is to look at the median justified price to cash flow price. The chart below indicates that the company is very undervalued compared to its normalized operating cash flow valuation.

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Conclusion

While Micro Focus is facing huge challenges due to its continuing difficulty in integrating the Hewlett Packard assets and collapsing top-line, it's a high cash generative business. With a huge free cash flow yield and decent credit position, it has some time to get its act together.

If it does, the stock could be a multi-bagger. If it does not, the company could be an attractive acquisition target. The stock is selling at a very low valuation. Fund manager Dodge & Cox, known for their long term perspective, own over 15% of the outstanding stock with an estimated cost basis of over $30. They seem to be holding firm even in the face of massive paper losses. Causeway Capital Management LLC (run by

Sarah Ketterer (Trades, Portfolio)) owns over 5%, though they seem to be cutting back their position.

I think it is worth taking a chance on this stock, even though the Gurufocus system does warn that the stock could be a possible value trap given its history.

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Disclosure: The author is long Micro Focus stock.

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