OpenText’s Micro Focus Buy To Nearly Double Revenue To $6 Billion

Are acquisitions the best way for a large company to keep growing? Since the majority of acquisitions fail to earn back their cost of capital, the answer is maybe. As I have written, acquisitions can add more than their cost of capital if they pass four tests:

• Is the market in which the acquired company competes large, fast-growing and profitable?
• Will the merged companies gain more market share than if they had remained independent?
• Does the value in present dollars of the merged company’s future cash flow exceed the acquisition price?
• Can the combined firms be integrated to appear seamless to employees, customers, and partners by the time the deal closes?

However, I am rethinking the third test because investors seem to ignore it and focus more on whether a merger yields faster than expected revenue and profit growth.

This comes to mind in considering Waterloo, Ontario-based OpenText, a $3.5 billion provider of information management software and services, that announced in August the $6 billion acquisition of Micro Focus, a $2.7 billion (most recent year’s revenues) UK-based enterprise software company.

This deal does not pass all of my four tests for successful acquisitions. However, if OpenText — whose stock price trades 46% below its September 2021 high — can beat its modest growth expectations, its stock could rise from here.

OpenText’s Business And Financial Performance

OpenText helps companies manage and move information. Its software and services enable companies to collaborate on producing content, manage records, sign documents electronically, archive information, and convert paper and other information into digital content. Its products and services help companies in industries such as “Legal, Automotive, Banking, Healthcare, Life sciences, Public sector, and Oil and Gas,” according to CNBC.

OpenText is barely growing. In the September-ending quarter, OpenText reported slight growth in revenue and a significant loss — compared with a year-before profit. Revenue rose 2.4% to $852 million while its net loss of $116 million compared unfavorably to a year-before profit of $132 million.

OpenText’s outlook for the current quarter is slightly muted. “For the second quarter of fiscal ’23,…in constant currency, we expect cloud revenue up 12% to 14%, total revenues up 4% to 5%. We expect FX to be a revenue headwind of $50 million to $55 million,” CFO Madhu Ranganathan told investors in November.

Earlier in 2022, OpenText’s outlook was more optimistic. CEO Mark Barrenechea told investors in August, “We are raising the bar on our medium-term [constant currency] aspirations which include growth in enterprise cloud bookings of 15% plus, total revenue organic growth between 2% and 4%, increased bookings to drive increased cloud organic revenue growth of 6% to 8%.”

OpenText’s Micro Focus Acquisition

Acquisitions have been a big part of OpenText’s growth strategy. “We have done over 80 acquisitions. We have doubled the size of the company between 2019 and 2022. We look at timing, the quality of the assets, the opportunity for value creation, and return on investment. We try to integrate the acquired company before the deal closes,” Ranganathan told me in a November 30 interview.

So when OpenText announced a deal to acquire UK-based Micro Focus, a business software and consulting firm, for $6 billion, the merger — priced at a 99% premium to its pre-announcement stock price — did not come as a total shock.

The merger came after Micro Focus’s stock had fallen 70% from its 2017 high. As the Telegraph reported, the decline in stock price began following a “troubled merger with Hewlett Packard Enterprise’s HPE Autonomy which HP HPQ acquired for $11 billion in 2011 — ultimately writing down the valuation by $8.8 billion. While Micro Focus picked up parts of that business in 2016 for $8.8 billion, the deal failed to lift Micro Focus.”

Micro Focus and OpenText expressed enthusiasm for this deal. The companies highlighted their large global customer base, wide bundle of enterprise software solutions, and potential to generate $6.2 billion in revenue, reported the Telegraph.

Market Attractiveness: Fail

Can the combined companies pass the four tests for successful acquisitions? In my view, the merger fails the market attractiveness test — that the acquired company competes in a large, fast-growing, profitable industry.

Moody’s Investors Service — which in November lowered OpenText’s debt rating from Ba1 to Ba2 — was particularly unenthusiastic about the industries in which the companies compete. As Moody’s wrote, “Both companies generate a large share of their revenues from declining and mature products and the challenges are compounded by the highly competitive software segments they operate in that are increasingly adopting cloud software solutions.”

OpenText views acquisitions as a means to expand the size of its total addressable market. “Acquisitions have increased our total addressable market from $90 billion to $170 billion and will increase our revenues to over $5 billion,” Ranganathan told me.

Moody’s analysis makes me assign a low probability to the possibility that the industries in which Micro Focus competes will grow and become profitable. That does not mean it would be impossible for the combined company to accelerate revenue growth.

It does suggest to me that in order to achieve that, Open Text will need to swim hard against the tide.

Better Off: Possible Pass

What does it take for a merger to make the combined firm better off? In my view, an acquisition passes this test if the combined companies can increase their market share above the level that each would have enjoyed had they remained independent.

This is difficult to measure; however, I think firms will gain market share if they can do two things:

• Provide a value proposition that consumers view as far superior to the one that competitors provide.
• Perform critical activities — such as product development, marketing, sales, and human resources management — more effectively than do rivals.

It is possible that the merger between OpenText and MicroFocus will make the combined companies better off. But in order for that to happen, there is much work to be done. That’s because “organic growth at both companies has significantly lagged the growth of the enterprise software industry,” according to Moody’s.

Moody’s analysis is based on its expectations that Open Text’s organic growth will increase by around 2% in the next two years “driven by growth in its cloud portfolio” while MicroFocus shrinks at about 5% a year over the next two to three years.

OpenText says that the combined companies will achieve meaningful expansion of their cloud revenues, adjusted EBITDA and cash flows in fiscal 2024. This will be achieved through $400 million in cost savings,” according to the company.

OpenText expects a considerable revenue boost from MicroFocus. Barrenechea estimated that MicroFocus would increase revenue by more than 40%, according to TechTarget. He explained that OpenText’s five years of experienced selling in the public cloud would help make cloud Micro Focus’s largest business.

That cloud marketing experience could benefit Micro Focus’s customers. However, it remains to be seen whether the combined companies will be able to build products that customers perceive as providing greater benefits for the price than do rivals’.

NPV > 0: Unclear

The financial test for a merger’s success is whether the value of its future cash flows in today’s dollars exceeds the acquisition price.

It is unclear to me whether OpenText’s merger with Micro Focus will pass this test. However, by adding $4.6 billion to its debt, the company is taking on high financial risk. “Open Text’s gross leverage was high at 3.6x (Moody’s adjusted) prior to the acquisition and Moody’s expects it to increase to mid 4x, pro forma for the acquisition,” according to Moody’s.

To be fair, Moody’s set a stable outlook for its rating. The rating agency accepts OpenText’s assertion that it will “prioritize debt reduction and reduce net debt to EBITDA toward its target of less than 3x within eight quarters of closing the acquisition of Micro Focus.”

While OpenText is clearly optimistic, I could not find a forecast of the cash flows from the merger over the next 10 years — which I would find useful for assessing whether the deal passes this third test for successful acquisitions.

Integration: To Be Determined

In my view, mergers should be integrated between the time a merger is announced and the day that deal closes. In that way, the combined companies will operate seamlessly for employees, customers, and partners once the merger is official.

The longer that integration is delayed, the more vulnerable companies are to rivals who hire their best people and pick off their customers. In general, OpenText attempts to do this. “We try to integrate the acquired company before the deal closes,” Ranganathan told me.

By integration, I mean that the companies decide who is in charge of each function, draw clear reporting lines, complete all cost reduction quickly, and make sure that all employees, customers, and partners are using the same systems to interact with the company.

OpenText began the integration process after it announced the deal in August. As Ranganathan told me in a January 3 interview, “The OpenText and Micro Focus operating teams began coordinating in August and our sales forces will be ready to go after new opportunities when the deal closes.”

Eighteen months after that, Open Text expects “to have Micro Focus on our operating model,” Barrenechea said. As Ranganathan told me — citing an August 2022 presentation to investors — this means that Micro Focus’s business model will be “uplifted to the cloud” and the companies will achieve adjusted EBITDA in the 37% to 39% range and “upper quartile” free cash flow of at least 20% of revenue.

If you think Open Text and Micro Focus will be able to compete more effectively once combined and achieve these ambitious financial targets by fiscal 2025, now would be a good time to buy the stock.