When Micro Focus International (MFGP) posted weak first-half year results, investors voted by selling off shares. MFGP stock finally bottomed in early November at $2.78. Two strong volume days last month suggest bottom fishers are betting on the business turning around or the company getting bought out.
Given the inconsistent performance, why should investors continue holding this stock?
In the first half of 2020, Micro Focus posted steady performance and high cash generation from its application modernization and connectivity unit. Conversely, its application delivery management performance is inconsistent. The unit lacked strong sales execution, hurting results. The company said it is taking corrective actions as part of its organizational transformation. Ahead of 2H/2020 results, speculators are betting that MFGP will post improving results.
As shown below, buying volume surged and lifted the stock:
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Similarly, its ITOM Platform underperformed in the first half. Again, management is taking corrective actions to improve portfolio performance. For example, it will focus primarily on maintenance renewals. Furthermore, it will assess ways of stabilizing revenue in this segment.
On Nov. 19, Fitch recognized Micro Focus demonstrating “improved operating trends and early signs of stabilization in strategic execution following the various challenges stemming from the 2017 acquisition of Hewlett Packard Enterprise Co.’s (HPE) software unit carve-out.” Although the acquisition is weighed down by macro demand weakness, MFGP will post better license sales and renewals.
A strong 2H/2020 report would lift investor confidence in the management’s ability to post better operating leverage and profitability. And although licensing revenue fell by 21.3% in 1H/2020, this was due to new customer project delays. If MFGP posts those delayed revenues in the next report, then the stock price could continue rising from here.
MFGP also cited Covid-19 causing delays in various projects where it needed physical access to customer sites. Consulting revenue, which fell by 14.8% in the first half, could also recover after easing lockdowns in the summer allowed staff to resume work. And since much of the work was broadly complete in the last reporting period, MFGP may recognize and collect the revenue stream in the next reporting period. Chief Financial Officer Brian McArthur-Muscroft said, “We have reacted quickly to largely mitigate the COVID-19 negative revenue impact at the adjusted EBITDA level. This has been achieved primarily due to the close management of variable and discretionary costs.” The praise is not well-earned. In the period, Micro Focus took a massive $922.2 million impairment charge due to the coronavirus pandemic. With the pandemic worsening again, management may take another charge in anticipation of disruptions in early 2021.
Delays in renewals for maintenance contracts soured Micro Focus’ expectations. Covid-19 also added uncertainties for its customers earlier this year. In the first half, MFGP changed its overall sales structure and the leadership team. With more discipline in the way it nurtured its pipeline, investors should expect the maintenance segment to rebound for the rest of the year. As 2021 approaches, the company is well-positioned to post better results in its North American segment.
In a 5-year discounted cash flow growth exit model, Micro Focus has a low hurdle to surpass to justify a stock price in the low double-digit range. Assume the following metrics:
Model courtesy of finbox
At a discount rate of 11% and a low perpetuity growth rate, the stock is worth $13.69. Building in a scenario of revenue decline in the next two fiscal years still suggests the stock is deeply undervalued:
Optimistic investors may open the model by clicking on the above link and raising the growth rate. Adjusting the annual revenue growth rate and EBITDA as a percentage of revenue would accomplish the same result. Instead of guessing that revenue recovers, input the company’s guidance in the forecast, as soon as it is available.
My above model assumptions already account for management turning around the businesses slightly. Chances are good that its customers will renew their contracts, especially for maintenance and security. When that happens, Micro Focus stock will continue its bounce from the all-time lows reached in recent weeks.
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Disclosure: I am/we are long MFGP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.