The big deal last week (announced on 7/9/2016) was undoubtedly the acquisition by Micro Focus International (MCRO) of the software business of Hewlett Packard Enterprise (HPE). This is a deal valued at US$8.8 billion which will result in HPE shareholders owning 50.1% of the company and hence it is a reverse takeover. But the on-going business will be managed by Kevin Loosemore as Executive Chairman of Micro Focus and it will of course be registered and listed in the UK. It will become one of the largest technology businesses in the FTSE, effectively replacing ARM following the acquisition of that business.
Does this herald a renaissance of the UK’s high technology sector? Micro Focus is primarily a software business and its original focus was on COBOL development tools (COBOL being a computer language this writer used in his early career on mainframes which later went out of fashion). I also incidentally did quite a lot of business later with Hewlett Packard and its customers in software so I probably have some knowledge on which to base comments. Subsequently Micro Focus acquired a number of other software businesses selling “tools” of various kinds. I have never held Micro Focus shares mainly because I considered that they simply owned a ragbag of software products which were in decline. But Mr Loosemore has undoubtedly done a fantastic job of maximising profits and cash flow from these businesses.
One might ask why software products of the kind Micro Focus sell live on so long? The answer is that businesses are often reliant on very old applications and the software code in them where millions of dollars might have been spent over the years building these applications and their supporting infrastructure. If those products can be maintained so that they remain live and robust, why rewrite them? In effect maintaining “legacy” applications and products can be very profitable business but the dynamics of most software companies mean that the entrepreneurs who establish and grow them never know when to stop building an empire and concentrate on the financials and operational efficiency.
The Hewlett Packard (HPE) software business being transferred includes the Autonomy products which they acquired at a high valuation. The grounds for the amount they paid for that company were later alleged by HP to have been based on false accounting which is the subject of an on-going law suit. HP wrote off $8.8 billion subsequently (they paid $11 billion cash for it).
Readers need to understand that HP never seemed able to make a success of software businesses, so this was simply the latest in a serious of management failures. Indeed Mike Lynch the former CEO of Autonomy was highly critical of how HP was run and its impact on the Autonomy business. He should have looked into history and seen that selling a software business to HP was a sure way to kill it. It’s partly to do with culture. For example, one of the oldest jokes about HP was that “if HP sold sushi, they would market it as cold, dead fish” (source possibly Steve Jobs). They traditionally developed great products by great engineers but sales and marketing was never as sharp as say at IBM. Selling software, an intangible product where customers cannot easily see what is in it before they buy, requires a very different approach to selling a catalogue of hardware items. Software businesses are also best developed by independent dynamic companies not by bureaucracies.
The recent sales and profit trends for the HPE software business show stable or declining figures, so it would seem that Meg Whitman, CEO of HPE, has accepted that they cannot make a success of that business. One can see exactly why it would be an attractive deal for HP to exit at 11.4 times EBITDA with a pre-completion payment of $2.5 billion.
For Micro Focus shareholders the attractiveness of the deal depends on confidence in Mr Loosemore continuing to repeat his trick of turning mature software businesses into cash generating machines. In this case he is tripling the size of the company and taking on a large amount of debt to pay for it, so this is the biggest bet to date. But the real pay off will come if he can raise the margins in the HP software business from the current 21% to the 40% plus margins achieved in Micro Focus over the next few years.
But it is surely the case that the HPE software products have now found a better home. And the share price of Micro Focus jumped 15% on the day the deal was announced, which no doubts reflect the confidence of investors in the long term outcome and their faith in Mr Loosemore.