As Growth Stalls, Micro Focus Gets Takeover Attention

May 4, 2011 Alex Woodie

A private equity firm is rumored to be eyeing Micro Focus International as an acquisition target. The British software company, which is suffering from flat sales and a rash of executive departures, last week confirmed speculation in the press that it has been approached about selling the company, but declined to provide specifics. Micro Focus owns the popular RUMBA emulator, but most of its revenue comes from COBOL tools for mainframes.

Micro Focus was the subject of takeover speculation in early March, when IBM and SAP were rumored to be looking at the company. Micro Focus denied the rumors, even as they caused the company’s share price to jump considerably.

This time around, the speculation is that one of the big private equity firms is taking a gander at Micro Focus. The pairing could be a good fit, the thinking goes, because Micro Focus has a lucrative revenue stream from maintenance contracts and royalties, and everybody knows that private equity firms just love maintenance and royalty streams from proprietary software that they can milk like a long-term annuity.

In a note on its investor’s Web site, Micro Focus confirmed that it received “a very preliminary, non-binding approach in relation to a possible offer for the company.” It also added that its board of directors “is currently considering its response to the approach.” The company also suspended its stock buyback program as a result of the, er, whispers of a hint of a possible offer.

When the news hit last Tuesday, traders didn’t buy in to the haziness that Micro Focus was attempting to cast on the events, and started buying MCRO until it was up 6.5 percent for the day, to about 360 pence. The stock, which is traded on the London Stock Exchange, is 33 percent off its June 2010 high of 540 pence. (Stocks on the LSE are traded in pence sterling, or GBX, which is 1/100 of a pound sterling, or GBR.)

Last Thursday, the Financial Times reported that the private equity firm Bain Capital was preparing an offer for Micro Focus for between 425 pence and 450 pence per share, or £890 million ($1.4 billion).

Much of the drop in Micro Focus’ stock came in February after it warned of a revenue drop for the second half of its fiscal year, which ended April 30 (the company will report its financial results soon). The company said full year revenues would be in the $432 million to $442 million range, which represents a decline of $11 million to $21 million over its earlier guidance. (Micro Focus had $432 million in revenues for fiscal 2010, which was a 58 percent increase from 2009). The company also warned that adjusted core earnings would be off by about $12 to $20 million. Its stock dropped to the 250 pence level following the warning.

Micro Focus executives blamed the drop in business on mainframe modernization deals that didn’t go through, primarily among governmental agencies in the United States and large financial services firms on the East Coast. North America represents more than half of Micro Focus’ fiscal 2010 revenues.

The poor execution is thought to have led Nigel Clifford to resign from the chief executive officer’s position in early April. The CEO job has been given to Kevin Loosemore, the company’s non-executive chairman since 2005.

Some analysts wanted to give Clifford, who had been with Micro Focus for just 11 months, a break, saying he inherited a tough position, with lots of churn in the managerial ranks (including the departures of the two top executives, CFO Nick Bray and CEO Stephen Kelly, in June 2010) and many recent acquisitions to digest. However, others say there just isn’t as much demand for COBOL tools for mainframes, which still makes up the majority of the company’s revenue, thereby hurting its growth potential.

Micro Focus, which is based in Newbury, England, made a string of big acquisitions between 2006 and 2009 as it sought to corner the market for COBOL language compilers and other tools, and then diversify beyond COBOL, which is predominantly used on IBM mainframe computers.

First it spent $3.5 million for HAL Knowledge Solutions, an Italian developer of application portfolio management software, in November 2006. It followed that up with the $40.7 million purchase of rival COBOL tool developer Acucorp in May 2007. A year later, it snapped up NetManage, the developer of the RUMBA and OnWeb emulation and modernization tools, which are mostly used by IBM i shops, for $73.3 million. In July 2008, it bought Liant, which made COBOL and PL/I Tools. In December 2008, it acquired application modernization vendor Relativity. And in May 2009, it spent $155 million for Borland Software and the testing tool division of Compuware.

About half of the $433 million in revenue for fiscal year 2010 came from maintenance revenue, the company says in its fiscal 2010 report. That is a large percentage for a software company. About 42 percent of the company’s 2010 revenues came from license fees; just under a quarter of that amount came from royalties from OEM deals with other ISVs.

The fact that Micro Focus has nearly $260 million in revenues coming in from maintenance and royalties has undoubtedly been noticed by potential suitors. These are relatively low-cost revenues that don’t require much more than manning the technical support desk, fixing bugs, and responding to minor feature requests. It’s basically an annuity, and doesn’t require maintaining an expensive international sales force or dropping big bucks researching and developing new products.

Micro Focus’ market capitalization is £712 million, or about $1.175 billion, based on a per-share value of £3.60, or $5.94, across 198 million outstanding shares as of last week.

Consider that Lawson Software just accepted the takeover offer from Infor/Golden Gate, which valued Lawson at about two and a half times trailing 12-month revenues, or nearly $2 billion. Assuming a similar valuation, Micro Focus is worth somewhere around $1 billion. When one figures that a purchaser would get an annuity stream equal to 25 percent of that purchase price, it’s a safe bet that somebody (perhaps multiple somebodies) is looking real hard at making Micro Focus a real offer.