Primary Preview: Buysiders Considering Micro Focus €442M, $1.1B TLB Highlight Declining Revenue, Legacy-Focused Products; Strengths Include Leading Enterprise Software Position, Solid Cash Generation, Wide Product Range, Recurring Revenue

Buysiders considering U.K.-based listed software company Micro Focus’s €442 million and $1.1 billion senior secured term loan B due in February 2027 highlighted the company’s ongoing revenue decline as a key concern. The group’s largely legacy-focused offering and lack of growth-oriented products is also an issue, they said. Strengths include the company’s global reach, its strong position in the enterprise software sector, robust cash generation and wide product range.

Micro Focus also has about 72% of recurring revenue (based on fiscal 2020 numbers) and fairly diversified revenue streams, prospective lenders noted. The company’s activities are focused on the five areas of cyber resilience, application modernization and connectivity, application delivery management, IT operations management and information management, and governance, each of which contributed between 13% and 28% of revenue in fiscal 2020. During that year, North America accounted for 50% of revenue, APAC and Japan for 12% and the rest of the world for 38%.

Proceeds of the new loan will be used together with $15 million of available cash on the company’s balance sheet to repay the group’s €442 million term loan B and part of its $2.428 billion term loan B, both of which are due in June 2024.

The company’s performance over recent years has been disappointing. Revenue declined about 5% year over year on a constant currency basis to around $2.9 billion for the year ended Oct. 31, 2021. This followed a 10% year-over-year constant currency revenue decline in fiscal 2020. Constant currency adjusted EBITDA fell almost 14% year over year to $1.174 billion in fiscal 2020. For the first half of fiscal 2021, constant currency adjusted EBITDA fell almost 8% year over year to $519 million. EBITDA for the 12 months to October 2021 was $991 million.

Closer analysis also reveals that while constant currency revenue from licenses increased almost 10% year over year to reach $301.7 million in the first half of fiscal 2021, revenue for maintenance, which accounts for about 60% of the company’s topline, and for software-as-a-service, or SaaS, both fell during the same period. Constant currency maintenance revenue fell 8% year over year to $912.5 million, while SaaS constant currency revenue fell 5.4% to $119.8 million.

The company expects fiscal 2021 revenue from maintenance division to decline 9% year over year, SaaS revenue to be flat and license revenue to rise 6%.

This indicates that some of the company’s clients may be gradually spending less on maintenance and support for their Micro Focus software licenses because these are legacy systems that will eventually be phased out, one buysider said. Falling or flat SaaS revenue is also particularly worrying as it goes against the trend seen across the technology sector for increasingly providing software as a service rather than via licensing, he added.

The company expects revenue in the fiscal 2023 to be flat year over year supported by SaaS revenue growth from new offerings and transition and maintenance stabilizing through operational improvements, but lenders have questioned whether revenue will bottom out so soon.

Micro Focus also faces enormous competition from companies including BMC and Service Now, sources said.

The group’s medium term revenue target is underwhelming. Micro Focus aims to reach 1% to 2% revenue growth with its Application Modernisation & Connectivity and Cyber Resilience segments expected to grow by around 5%, offsetting flat growth at Information Management & Governance and as much as 5% declines in its IT Operations Management and Application Delivery Management segments.

However, the company’s liquidity is strong with cash of $560 million as of October 2021 and an undrawn $250 million committed senior secured RCF due 2026. Micro Focus has no significant debt maturities until 2024, when some of its term loans are due.

The company’s cash generation is also fairly robust, which enables the group to continue extending its debt maturities and servicing its debt. However, free cash flow has declined to $511.2 million in fiscal 2020 from $563.3 million in fiscal 2019. First half 2021 FCF more than halved to $139.5 million from $304.9 million a year earlier.

The group is targeting $500 million of adjusted FCF in 2023, supported by cost savings and revenue stabilization. Moody’s previously expected a material improvement in FCF this year, however the ratings agency now expects the overall recovery to be slower because of restructuring charges that will be incurred as the result of a new round of cost savings initiatives combined with a continued decline in EBITDA over the year, as cost reductions are not expected to offset the impact of topline decline.

Micro Focus is targeting between $400 million and $500 million of gross annual recurring cost reductions as it exits fiscal 2023, which it expects to require around $200 million over the two year period to implement.

The company is rated B1 by Moody’s, BB- by S&P and BB- by Fitch. The loan will be rated B1 by Moody’s, BB- by S&P and BB+ by Fitch. On Dec. 9, Moody’s changed the outlook on the all company’s ratings to Negative from Stable because it anticipates the company’s FCF generation to be weaker than previously expected over fiscal 2022 and fiscal 2023 with leverage remaining outside of the levels required for a B1 rating.

Micro Focus said its ratio of net debt to adjusted EBITDA at the end of the first half of fiscal 2021 was 3.6x. Net leverage, based on EBITDA for the 12 months to October, stood at 4.1x. The company is targeting net leverage of 2.7x.

However, Moody’s expects leverage to continue to increase from its estimate of 5x for fiscal 2021 to about 5.4x for fiscal 2022, as lower EBITDA offsets the positive impact from debt repayments to be funded through the company’s recent $375 million sale of its archiving and risk management business Digital Safe and excess cash flows. Leverage should then start to decline in fiscal 2023 driven by EBITDA growth and an expectation of continued debt repayments through excess cash flows, ending the fiscal year at around 4.8x, Moody’s said.

Meanwhile, the group’s strategic decisions, particularly regarding sales and acquisitions, have sometimes been questionable, buysiders noted. In 2018, Micro Focus struggled to integrate its acquisition of Hewlett Packard Enterprise’s software business and burned a lot of cash because of IT and sales problems, which resulted in lowering revenue guidance, one buysider recalled. The company is still carrying negative sentiment in the market because of that, but things seem to have improved since then, he said.

And some disposals have also been mishandled, including the 2018 disposal of Micro Focus’ open-source software provider SUSE to Swedish buyout firm EQT for $2.535 billion, with the spun-out firm going on to be listed on the Frankfurt Stock Exchange in May last year at a market capitalization of about $6 billion.

Micro Focus has a £1.51 billion market capitalization as of today, implying over 2x of equity cushion.

Price talk for the euro portion of Micro Focus’s new loan is between Euribor+400 bps and E+425 bps, with an OID of 99.5 and a 0% floor. Meanwhile, price talk for the dollars is between SOFR+CAS+375 bps and SOFR+CAS+400 bps with an OID of 99 and a 0.5% floor, which is reasonable in terms of relative value in the sector, sources said.

JPMorgan is the sole physical bookrunner. Other bookrunners are HSBC, NatWest, Citi, Bank of America and Goldman Sachs. JPMorgan was contacted but declined to comment.

Commitments are due today by 5 p.m GMT for the euro portion of the loan and at 5 p.m. ET for the dollar portion.

The company’s capital structure is below:
 
– Beatrice Mavroleon, Robert Schach