NOVEMBER 30, 2018 

By: Jamie Powell

Alphaville was at the Sohn conference on Thursday, listening to fund managers pitch their best ideas. Here's two we wrote up earlier.

Micro Focus, the £6.7bn enterprise software company, has had a difficult year. Since January, investors have seen their holdings of the FTSE 100 business decline in value by 39 per cent. At one point, it was down almost 60 per cent:

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But all is not lost, said Andrew Dickson of Albert Bridge Capital at the Sohn Conference Thursday. In fact, he thinks it could at least double from here.

So what's the story?

First, a bit of background. Micro Focus is not your traditional tech company in that it has no interest in growing, Dickson said. Sure, we hear you say, that's what all melting ice cubes tell their investors. But Micro Focus has always made its strategy clear: it buys legacy software companies with sticky products, improves the margins and then watches the cash flow in. For a long time, it worked. Its operating cash flow ballooned from $35m in 2006 to $452m in 2017. To no one's surprise, its share price followed suit:

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In May 2017, it completed its biggest deal to date, paying $8.8bn in cash and stock for HP's enterprise software businesses. According to Dickson it was a steal: HP had spent $20bn acquiring the assets over the years, and due to pressures on then chief executive of HP Enterprise Meg Whitman, was a forced seller. Further, there were no buyers bar Micro Focus, said Dickson.

Here's the relevant slide, complete with a screenshot from Ferris Bueller's Day Off (Dickson has good taste in films, we can report):

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Now integrating a huge new business was always going to be painful. Cultural changes are not easy, even for small firms, and Micro Focus needed to realise those margin improving savings in HP's units to satiate investors in good time. It didn't happen.

Disappointing half-year results in January sent its shares down 17 per cent, but a profit warning in March proved the coup de grace: the shares collapsed 50 per cent. Dickson was bemused, he told us on the phone: “we fully expected the shares to fall 7-10 per cent on the news, but not 50 per cent!". When asked why the reaction was so extreme, he said “there was already some negative bias in the market towards the company, and it seemed to set off a feedback loop — the machines [algorithmic trading] didn't help either”.

Yet for Dickson, the story hadn't changed: Micro Focus' management had a two decade track record of hitting its targets after swallowing software companies, and there was little to reason to doubt them this time around, even if there were a few more bumps in the road.

In other words, Mr Market was, and is, wrong: Micro Focus is cheap as chips, trading at just 9.4 times 2019 estimated earnings, and those estimates are probably too bearish:

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Indeed the market, and the media, still seem down on its ability to embed the HP assets successfully. 9.7 per cent of the shares are sold short, according to Markit data, and of the dozen analysts with ratings on the stock, 6 have hold or sell ratings.

So there's room for sentiment to change, and if it does, there should be a significant re-rating of the stock. Apart from margin improvement, Dickson sees one catalyst in the short term: the planned sale of SUSE for $2.5bn, with $2.1bn being distributed to shareholders via a special dividend. Net this cash windfall off the current share price, and it looks even cheaper. If that doesn't change the game, then significant margin improvement from 2019 onwards should.

But what's it worth? Handily, Dickson provided a valuation slide to round things off:

At pixel, Micro Focus was trading at £15.57, down 1.02 per cent.

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At pixel, Micro Focus was trading at £15.57, down 1.02 per cent.