You see a lot of acquisitions come down the pike when you cover enterprise software. Many are pedestrian for the most part, even if they involve large sums of money, but today’s news that OpenText is buying Micro Focus for a total value of $6 billion feels a bit different.
Micro Focus, a British company, built much of its business buying legacy software companies like Borland, Novell and Cobol-IT. Its highest-profile deal was an $8.8 billion agreement in 2016 to partner with HPE on part of its enterprise software portfolio.
Aside from some of the pieces in the HPE portfolio, like the infamous Autonomy deal, most of Micro Focus’ catalog doesn’t align in a direct way with OpenText’s content management roots. That’s because it appears to be a big deal about getting bigger rather than direct synergy with the acquiring company.
“Like a shark that needs to keep swimming, OpenText needs to keep acquiring, since their legacy platforms are all in long, slow decline as licensees eventually exit for more modern platforms.” Tony Byrne, founder, Real Story Group
As for the terms of the acquisition, the total enterprise value of the deal is around $6 billion (£5.1 billion), with an equity value of around $2.1 billion (£1.8 billion). The companies calculated that the per-share price offered, some 532 pence, represents a 98.3% premium to the closing price of Micro Focus before the deal was announced.
Micro Focus, which is neither micro nor focused, has run into hard times in recent years, with declining revenue every year since 2018. Further, its stock price has dropped over 44% this year and more than 89% for the prior five years. This morning, it traded at just $3.15 per share on U.S. markets, leaving it vulnerable to a takeover.
The company dates back to 1976, and over the years has changed its name, changed it back and acquired a slew of companies. Since 1998, it has made a total of 15 transactions, according to Crunchbase, many of the legacy variety. The most recent transaction was ATAR Labs, a security company acquired in 2020 for $15 million.
The deal feels strange because it combines two companies for a lot of money that don’t have a ton of crossover. Do the potential financial gains make it worth the gamble? OpenText thinks so.
Bigger is better philosophy
The acquisition appears to be a bet that getting bigger will help the combined entity become more profitable, making shareholders — and presumably customers — happy.
“Customers of OpenText and Micro Focus will benefit from a partner that can even more effectively help them accelerate their digital transformation efforts by unlocking the full value of their information assets and core systems,” OpenText CEO and CTO Mark Barrenechea said in a statement.
That’s a lot of CEO corporate-speak, but it basically means they have a lot of assets and they are hoping that it gives them more revenue, even if it doesn’t align specifically with their core mission.
Still, Holger Mueller, an analyst at Constellation Research who worked for Barrenechea two decades ago at Oracle, said he has the background to run a company like this one. “Barrenechea has shown he can manage a [broad] offering portfolio during his tenure at CA, so this can write not just the next chapter for OpenText, but will be a completely new book,” Mueller told TechCrunch.
What makes the deal feel even more unusual is that OpenText, ostensibly a software company whose roots are in content management, is behaving more like a private equity firm. Instead of buying a company to fill in a hole in the portfolio or to take a competitor off the board, it’s simply buying it as a revenue generator.
Tony Byrne, founder of the Real Story Group who has been involved in the content management space in one form or another for over two decades, said that OpenText has in fact taken on the qualities of a private equity investor in recent years.
“The key to understanding OpenText is that it is not a tech company in the sense of having a clear R&D strategy. It is a financial construct oriented toward buying and rationalizing post-peak software companies that have sticky solutions with substantial maintenance revenues,” Byrne said.
That sounds a lot like the standard operating procedure for private equity companies at one time, although many firms have moved off that approach and can offer mature software companies a viable exit strategy these days.
He added that buying legacy software forces the company to keep looking for another option, and Micro Focus opens up a whole new swath of revenue opportunities for the company. “Like a shark that needs to keep swimming, OpenText needs to keep acquiring, since their legacy platforms are all in long, slow decline as licensees eventually exit for more modern platforms.”
Both Mueller and Byrne said that OpenText has been trying to shed its content management origins, and this deal is going to take it in new directions. Micro Focus certainly does that for the company. “OpenText has tried to leave the document management space for a while, an area that the vendor has continuously expanded to dominate, but now its relevance goes way beyond [that] with the arsenal of offerings Micro Focus brings,” Mueller said.
Byrne agreed, saying the company shifted focus long ago. “OT left their search/content management roots some time ago. They have a specific operating model and since they do very little actual software development, the type of tech firm they absorb is less important than the prospect of future maintenance streams.”
But given that shift in philosophy toward an acquisitive strategy, does this deal make sense from a financial perspective?
A closer look at the deal
Micro Focus has not had a good time as a public company. Since going public in 2017, it has seen nearly all of its value evaporate. Its U.S. shares traded in the low $30s during its opening quarters of public life. It bounced around a share price in the teens and low 20s for some years until, in 2020, its share price fell under the $10 mark; Micro Focus set a 52-week low of $3.03 per share most recently.
Given that steady erosion of value since its IPO, you can imagine that its investors are likely content to see it exit for roughly double its pre-deal share price. (If you held the company’s stock from IPO, the premium that OpenText is offering will amount to thin comfort.)
Why did Micro Focus lose so much value over the last few years? Because it is a company in decline. In its fiscal 2020, Micro Focus reported $3.06 billion worth of revenue. In its fiscal 2021, that fell to $2.9 billion, a 5.3% decline. Adjusted EBITDA over the same time frame fell 12.4%. The trend has continued, with the company reporting $1.3 billion worth of H1 2022 revenue, down from $1.4 billion in the year-ago period. Once again, Micro Focus’s adjusted profitability also ticked lower.
A company in decline is only worth so much. A company in decline that also has more debt than it has market cap is worth a bit less. That’s why Micro Focus, with $437 million worth of adjusted EBITDA in the first half of its current fiscal year, is selling for 2.2x its revenues recorded in the 12 months ending this April, per a company calculation.
So if the market doesn’t want Micro Focus, why does OpenText? There are a few possibilities. First, that adjusted profitability number. Adjusted EBITDA at OpenText was $314 million in its most recent quarter. Given Micro Focus’ more than $400 million in half-year adjusted EBITDA, we can infer that the deal will greatly expand OpenText’s aggregate profitability post-closing.
There’s more. OpenText is barely growing, as we noted above. Indeed, in its fiscal fourth quarter — the three-month period ending June 30, 2022 — it posted revenue growth of 1.0%, a deceleration from the 3.2% it posted for the full fiscal year. Profitability boosters and a huge slug of revenue must appeal to OpenText leadership.
And from a purely financial perspective, there’s enough cash in motion for the cost of the deal to be managed. Per OpenText, it intends to use $4.6 billion worth of “new debt,” along with $1.3 billion in cash and $600 million extracted from an extant revolving credit facility for the transaction. It’s a lot of money. But while Micro Focus has been shrinking, its efforts to cut costs have actually bolstered its operating and free cash flow to $485 million and $190 million, respectively, from $468 million and $140 million in the year-ago half-year periods. Throw in the fact that OpenText had operating cash flow of $252 million and free cash flow of $214 in its most recent quarter, and the debt load could be more than serviceable.
If you are willing to infer synergistic cost cutting, and perhaps some cross-selling to distinct — though we presume partially overlapping — customer bases, then the deal appears plausibly intelligent. Though as with all engineered financial-esque deals, nothing is certain. (Excessive cleverness usually fails, etc.)
Investors are certainly spooked by the transaction. Shares of OpenText were off around 13% today on the news. It appears that spending around $6 billion to buy a shrinking company that, yes, kicks off cash and adjusted profit, in the name of growth is not something that Wall Street is ready to cheer. Indeed, today’s dramatic loss of value at OpenText is not too far off the equity value of Micro Focus; there’s irony in those numbers.
While most companies grow organically through internal innovation or by acquiring missing pieces in the platform, OpenText appears to be buying a company strictly as a way to feed its revenue engine and find a way back to modest growth. It’s one way to go about it, but it’s growth by brute force rather than offering customers any kind of new approaches or differentiated offerings.