Micro Focus has been doing all the small things right since ousting its CEO after a shock profits warning in February 2006. It’s been a star performer in the past three years, with the shares up five-fold since its nadir of 72p. But I believe its winning streak is set to end.
The group specialises in helping large firms convert old IT systems into newer internet/Windows operating systems. The old system becomes easier to use and the upgrade avoids the disruption of shifting to a whole new platform. That’s good news for thrifty customers (such as General Motors and Citibank) and Micro has delivered recession-busting double-digit growth since 2007.
But this is a ‘late-cycle’ industry, and the pace of new licence wins and contract renewals will slow next year. This is already happening, as a recent profit warning from Compuware, a leading US player in Cobol software, shows.
Micro Focus (LSE: MCRO), rated a BUY by Bank of America
And growth in Micro’s largest region – North America, which accounts for 50% of turnover – slowed in the first half. With the weakening dollar, this could knock 2010 guidance when preliminaries are released on 25 June. Also, due to the 2006/2007 mergers and acquisitions boom, the firm had much modernisation work, which is now starting to dry up.
The long-term outlook isn’t good. Age and inflexibility make legacy systems far costlier to run than newer ones. So they’re in terminal decline, which will eventually affect Micro Focus’ fortunes. The board recognises this and last month agreed to buy two US firms for a total of $133m in order to move into the automated software testing sector, where it will compete with HP and IBM. This move grows Micro’s addressable market, but I suspect it could also be a high-risk bet placed at the top of the cycle.
In May, SQS Software, the world’s largest independent software testing consultancy, issued a shock profits warning as sales declined. And the City seems to be pricing Micro Focus to perfection. At 370p, the shares are on heady 2009 sales and p/e multiples of four and 13.8 times respectively. These ratings assume it can defend its 37% profit margins, which looks unlikely, given the global recession. I’d value it on a ten-times through-cycle EBITA multiple (assuming sustainable margins of 30%), or around 280p a share.
Recommendation: SELL at 370p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments