It is not usual that a FTSE100 company loses billions of pounds of its market cap, but that’s what has happened to Micro Focus International (LON:MCRO). Already facing a downturn in revenues, the company has revised its guidance even further, and the share price has tumbled as a result:
Profit warnings from very large companies are relatively rarer, and before today the largest ones covered were Royal Mail and TUI Group. Micro Focus does have some form in this regard, however and issued a similar profit warning just over a year ago which saw the immediate departure of the then CEO. On that occasion, the share price reaction was even more violent, but in retrospect that proved to be a good entry point as the share made up most of the losses over the next year and a half.
Micro Focus could be still considered a great British success story. Originating as a small start-up specialising in software for microcomputers, it has grown mainly by making a series of acquisitions of various other software companies. In 2017 a really big move came when it merged with Hewlett Packard’s business enterprise segment.
The scale of this acquisition was a poisoned chalice. Revenues would jump over four-fold off the back of it. But integrating a much larger company into existing operations proved to be a bit of a problem, and these issues were behind the profit warning last year.
The warning comes in the dreaded RNS which mentions a strategic review.
We pull no punches at the start:
The Board has concluded that recent trading means that the Group does not expect to meet the constant currency revenue guidance of minus 4% to minus 6%, for the full year to 31 October 2019, compared to the 12 months ended 31 October 2018.
Full-year guidance was re-iterated as late as July 9, so things must have taken a downturn quite recently. What are the reasons for this?
Weak sales execution has been compounded by a deteriorating macro environment resulting in more conservatism and longer decision making cycles within our customer base. There remains a significant pipeline of business opportunity being pursued but to be within the current guidance range a highly challenging percentage of this pipeline would need to close prior to year end.
Weak salesforce has been a common feature here and was mentioned in the last profit warning. The guidance reads:
As such the board considers it appropriate to revise the guidance range for the year ending 31 October 2019 to minus 6% to minus 8%.
This doesn’t sound too bad on its own. At best, it’s ‘broadly within guidance’, at worse, another 4% missed.
One thing to be suspicious of is the directors deals. The share traded on an undemanding P/E prior to this profit warning, and with interim results holding guidance, this was the reaction:
Massive, co-ordinated sales here, which in retrospect looks like they knew what was coming and as such got great prices for their shares. It also should be pointed out that these guys are not short of cash either, and are on multi-million pound salaries. The company is heavily in debt, although this was alleviated last year by the sale of one of its divisions.
However, more cash has left the company in the form of share buy-backs, and this at a time when the executives saw no reason to hold on to their own shares. A bad destruction of shareholder value has gone on here, as the share count has gradually increased in order to help pay for the acquisitions. Shareholders have every right to be annoyed with this, as on paper this looks like a classic case of empire building rather than careful management.
Analysing the accounts could be said to be meaningless as the company has changed beyond recognition since the latest acquisition. The most recent results are filled with adjustments relating to this, and there are a lot of moving parts to the company which make it difficult to analyse on a quick skim.
Unsurprisingly for this type of company, the balance sheet is weak, and always has been. Tangible net asset value is negative, and most of its assets comprise goodwill and intangibles. However, operating cashflow is strong because of depreciation is a major item. With the sale of one of its divisions and no more acquisitions it could be seen that quite a lot of cash is generated, and a good chunk of this is being returned to shareholders in the form of dividends, although as seen before the buy-back has proven to be a waste of time.
Whilst it is difficult to value intangible assets, certainly in this case they own many valuable brand names and licences. From this aspect whilst tangible net assets are negative, I don’t believe it represents a dangerous situation although we would like debt to be lower. There would be several options that a strategic review promises, either expansion is put on hold and debt i is paid down with existing cashflow, another division can be sold, or more equity can be raised. The last seems doubtful at the share price.
The upcoming strategic review could make for unpleasant reading. This profit warning was scant on reasons as to exactly where it is going wrong, but an impairment to the value of investments could have poor implications for the share price.
Stockopedia rates this stock highly, giving it a score of 89. However, a skim through of the RNS of the past does not make for pleasant reading, as it seems that the company have gone through many warnings on profit, and as such these type of things may feature prominently in the future. For the money earned management seem to represent quite poor value, and the selling out of stock in such amounts indicates a bit of a red flag.
On some aspects it may offer good value for money. The projected profits in future mean that if you are prepared to accept it, the company does seem compelling. The price to book value discount is large, although the price probably factors in that the value of the assets are not as large as the company makes out.
At the moment I can’t say I feel quite confident that everything will work out. 2/5