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The ‘butts’ and the ifs

The guys at technology group Micro Focus (MCRO) have been doing the corporate equivalent of cigar-butt investing for many years; buying the sort of IT company that other industry leaders shift to their recycling bin. It wasn’t sexy, but eking extra profit out of those discarded stubs turned Micro Focus shares into a Davidoff Nicaragua of a performer. From the end of 2005 through to mid-2017, their price was a 14-bagger (up 1,440 per cent), while the FTSE All-Share index was as exciting as five Woodbines – up 40 per cent (a 0.4-bagger).

However, success brings its own challenges and that formula – dubbed ‘click and repeat’ by its just-departed executive chairman Kevin Loosemore – has become increasingly difficult to maintain. As the metaphorical cigars needed to get bigger and fatter to get the nicotine through to earnings, Mr Loosemore’s team could only find old stogies – and expensive ones at that.

None was more costly – nor more damaging – than the most recent, the 2017 reverse takeover of the software arm of Hewlett Packard Enterprise (US:HPE). Micro Focus might have been forewarned. The deal transformed its size – taking it from $1bn a year in revenue to $3bn-plus – but came with much of the Autonomy software that the US company’s predecessor had bought for $10bn in 2011, rapidly written down to less than $2bn and followed up with fraud proceedings against Autonomy’s boss, Mike Lynch, that trundle on.

Now the misery has spread to Micro Focus, as its results so clearly show. Basic pre-tax profits, which nudged $150m in 2015-16, have fallen four years running and ended in a $34m loss in 2018-19. Sure, some gloss can be put on that. Excluding unusual items – which are starting to look depressingly usual – pre-tax profit was $260m, down 32 per cent on 2017-18. More flattering – and the bosses’ favoured measure of profits – ‘adjusted’ pre-tax was down just 8 per cent at $985m (this adds back amortisation of intangible assets and $294m exceptional costs, which chiefly relate to sorting out the HPE business).

Basically, however, Micro Focus looks a mess and its bosses earn brownie points by being unusually candid about that. Peppering the results announcement are phrases such as “inconsistent approach to customer engagement”, “reduced productivity” and “elevated levels of staff attrition”. Then they throw in “siloed development of product development”, “disconnected strategies” and “systems not fit for purpose”.

Yet ‘mea culpa’ does not get Micro Focus out of its hole. True, it should help that it has stopped digging. In other words, acquisitions are pretty well on hold – the only deal Micro Focus did last year was $89m for a cyber-threat software business. Management also acknowledges that the business software market has moved on, while Micro Focus has not been at all focused. But it’s not a given that the group can get back on the ball. Sure, management has its plan – bosses always do. In conventional management speak, they tell us how they have restructured the operating model to “drive collaboration and the leverage of innovation across portfolios both to strengthen existing offerings” and so on – and on.

What that boils down to is promising that 'from now on, we’ll try really, really hard'. Which isn’t as dumb as it sounds. Anyone who has worked at a big company in the throes of reorganisation will tell you that, among the confusion, the real progress is likely to come from axing the ridiculous projects (there are always some), filling gaping holes in the structure and avoiding the crass mistakes.

That’s another way of suggesting that in the coming years Micro Focus’s performance is likely to regress towards its mean. For a group whose average underlying profit margin of the past five years is 23 per cent, compared with last year’s 6 per cent after exceptional costs, that would be welcome indeed. Not that one should expect its margins to return to anything like their historic best if only because business software and IT services are increasingly being turned into commodities.

However, margins back into double figures should be feasible. In which case, do investors anticipate that and see the shares as a recovery play? That might be a leap too soon. That said, there remains the matter of the dividend and the 11.3 per cent yield it offers with the share price at 792p; even the final payout, which is available until 13 April, offers 5.7 per cent.

A yield of those dimensions tells us the market expects a cut in the payout. With net debt still hanging at over $4bn and running at 3.2 times operating cash profits, a cut must be a real possibility. If any recovery falters, if the unforeseen comes along and lands another blow, the dividend would be the first cash cost under scrutiny. But don’t underestimate the power of mean regression. So with a bit of momentum in their price, the shares would be tempting.