This company has been doing all the small things right since ousting its previous CEO after a shock profits warning in February 2006. In fact, this has been one of the best turnaround stories of the past two years; the stock has leapt more than fourfold since its nadir of 72p. But should jubilant shareholders take their gains now or wait for more?
Micro Focus (MCRO), tipped as a BUY by The Independent
Chartists point out that the “trend is your friend” and advise buying simply on the basis that the stock is ramping, in the vain hope that it will continue to rise. But this strategy ignores intrinsic value and often goes wrong when a company is already overbought – which I believe is the case with Micro Focus.
Micro Focus is a software developer that specialises in helping large organisations adapt their old IT systems (such as COBOL-based systems) into newer internet and Windows operating environments, such as Java and XML. Although core functions don’t change, the old systems become easier to use and, above all, avoid the disruption and resources required to swap to an entirely new application, such as SAP or Oracle. Micro Focus’s software is used by around 90 of the Fortune top 100 companies, including General Motors, Citibank, Unilever, Vodafone and Pfizer.
However, the key point for investors is that, regardless of short-term market dynamics, these legacy systems are in a slow, terminal decline and will eventually become extinct. Due to their age, they are substantially more expensive, inflexible and inefficient to run than newer applications. As such, their demise will eventually burn a huge hole in Micro Focus’s revenues, unless it diversifies into other areas.
Despite that fact, the picture has been surprisingly rosy recently. Last week, the company issued an upbeat trading statement and upgraded its guidance on the back of bumper US sales and the benefit of acquisitions. First half turnover at $107m is now expected to come in ahead of City expectations. No mention was made of organic growth rates, but the board had previously indicated a range of 6% to 8% for this year.
So what’s causing this temporary spike in sales? It looks as if there are two main factors at work. First, there is better sales execution by the management team. However, this effect is likely to diminish once historical comparables become more challenging and IT spending weakens. Secondly, I believe the recent mergers and acquisitions (M&A) boom has artificially boosted Micro Focus’s markets by forcing the delay of large-scale technology changeovers while deals are being executed, which has lead to more temporary IT fixes. With M&A activity slowing, these blockages should be lifted, removing the short-term stimulus.
In valuation terms, the City appears to be pricing the stock to perfection. At 322.75p, the shares trade on current year p/e and sales multiples of 25 and 6.5 respectively. I would value Micro on 15-times earnings – or around 190p per share – particularly as many of its peers are trading on p/es of eight to 12. Lastly, at 38% Micro Focus’s operating profit margins look unsustainable in the long term. Coupled with a weakening dollar (representing 40% of turnover), I would suggest selling the stock.
Recommendation: SELL at 322.75p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments