Micro Focus International (MCRO)

Micro Focus' new chief executive, Stephen Kelly, has also proven to be a shrewd manager of expectations and analysts have upgraded their forecasts three times since his appointment. But delivering on those raised expectations looks likely to get tougher – Micro Focus operates in a slow-growth market and there seems to be little room left to cut costs further.

The company sells software for mainframe computers: big, old machines that sit stubbornly at the heart of many large companies' IT systems. Though unwieldy when compared with today's standard data-centre kit, mainframes are so engrained in many companies' processes that they cannot easily be replaced. But while Micro Focus currently holds a 27 per cent share of this $620m (£310m) market, it's also one of IT's slowest-growing sectors – 1-2 per cent annually at best. With 70 per cent of Micro Focus' revenues coming from this market, Mr Kelly's revenue growth target of "close to 20 per cent" does not look easily reached, especially as last year's results were set against lower comparables.

Mr Kelly says that acquisitions will make up part of the difference. May's acquisition of Accucorp, which sells to small and mid-sized companies, is progressing well, but November's purchase of HAL Knowledge Solutions isn't going so smoothly. HAL adds to Micro Focus' application portfolio management tools operation and is important to the company's attempts to sign bigger overall contracts. But this is also a competitive marketplace and HAL failed to meet Mr Kelly's break-even target by the end of the year.

After these acquisitions, Micro Focus still has net cash of more than $40m left to spend on further deals that might better boost earnings. But Mr Kelly has emphasised that his "primary focus is on organic growth". However, achieving decent revenue growth looks dependent upon a recovery in the US, where sales execution was disappointing last year. A new US management team was installed in February, but there's no guarantee that Micro Focus can pull-off the same speedy turnaround that it managed in Europe.

Looking further out, the prospects for mainframe software don't improve much either. Micro Focus' modernisation tools can prolong the life of existing hardware investments, but the longer-term trend is towards a new set-up, known as "service-oriented architecture", which better enables different technologies (including mainframes) to interconnect and work together.

Many of the software companies that resell Micro Focus' technology – including IBM and Oracle – are also pushing this competing technology. In addition, there is lingering uncertainty over a cause of previous profit warnings: the strength of its other partnerships with systems integrators, such as EDS and Accenture.

"It is our view that the systems integrator channel must be cracked in order for Micro Focus to access a significant proportion of larger projects and this can only be achieved over a prolonged period of time," say analysts at broker Jefferies International. "It is not clear to us that these timescales are consistent with the growth expectations implied by current valuation metrics." This adds another level of risk as securing larger customers through a reseller channel makes for a slower purchasing process, creating irregular revenue flows.

Yet, Micro Focus' shares have more than doubled in the last year and now trade on 21 times broker Cazenove's forecast adjusted earnings for 2008. Indeed, private-equity backers Golden Gate have just sold 7 per cent of the share capital, providing an effective ceiling at the placing price of 260p. Given the pedestrian growth outlook, the toppy rating leaves Micro Focus's turnaround looking more than factored-in, while any future disappointments could put the shares under pressure. Sell.

BEAR POINTS

• Slow growth in Micro Focus' core mainframe market

• Uncertain routes to market

• Risk from recent acquisitions

• Irregular revenue flows

BULL POINTS

• Recent forecast upgrades

• Strong cash reserves