Is Micro Focus International plc still a buy after $8.8bn deal?

Software firm Micro Focus International (LSE: MCRO) stunned investors this morning by announcing an $8.8bn deal to acquire the software division of Hewlett-Packard’s Enterprise business.

Shares in Micro Focus hit an all-time high of 2,400p following the news and are up 18% at 2,300p at the time of writing. The deal will be transformational for Micro Focus, which currently has a market cap of just £5.3bn ($7bn).

What’s the deal?

The business being acquired is known as HPE Software and is described as a leading global infrastructure software provider. It provides IT operations, data analytics, security and other software services to more than 50,000 customers, including 94 of the companies in the US Fortune 100.

HPE Software generated revenue of $3.2bn over the year to 30 April. Excluding certain costs that won’t transfer to Micro Focus, adjusted EBITDA was $738m. The $8.8bn price tag represents a valuation multiple of 11.4 times adjusted EBITDA. I’d say that’s full, but not excessive.

Payment will be through $2.5bn of new borrowings and the issue of $6.3bn worth of new Micro Focus shares to HPE shareholders. This will give HPE shareholders a 50.1% stake in the combined company.

It’s possible that some Micro Focus shareholders won’t be happy about this level of dilution. To keep investors happy, Micro Focus will be making a $400m return of capital to shareholders before the HP deal goes ahead. That’s about 126p per share.

What’s the attraction?

Micro Focus believes it can squeeze much bigger profits from the operations of its new purchase. According to today’s announcement, HPE Software currently has an adjusted EBITDA profit margin of 21%. The equivalent figure for Micro Focus is 46%.

Within three years, Micro Focus expects to increase the margins on 80% of HPE Software’s revenue to that 46% level. This should result in a business with rising earnings, strong free cash flow and the potential to provide an attractive dividend income.

What could go wrong?

One risk is that Micro Focus will fail to achieve the hoped-for gains in profitability. The other risk relates to debt.

Micro Focus expects to have a net debt-to-EBITDA ratio of 3.3 times following the acquisition. The group hopes to reduce this key lending ratio to 2.5 times within two years. These are relatively high levels of debt, but Micro Focus has a history of high profit margins and strong cash generation.

Overall, I don’t think this level of borrowing is a particularly big risk.

Is Micro Focus still a buy?

Last year’s figures for the two firms suggest that HPE Software will generate enough additional earnings to justify the dilution caused by the issue of new shares. This means that if Micro Focus can deliver the expected improvement to profit margins, earnings per share and the dividend could grow strongly over the next few years.

Large acquisitions of this kind aren’t always successful. But I’m tempted to back Micro Focus management, who have done a very good job in recent years. Overall, I rate Micro Focus as a buy following today’s news.

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Roland Head has no position in any shares mentioned. The Motley Fool UK has recommended Micro Focus. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.