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Will the 346p Micro Focus share price ever go back to 2,697p?

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The Micro Focus International (LSE: MCRO) share price is up by 28% at 346p as I write. Today’s gain was triggered by news that management at the FTSE 250 software company believes profit margins will be higher than expected this year.

The Micro Focus share price has fallen by nearly 90% from its 2017 high of 2,697p, so today’s news is a welcome boost for shareholders.

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Even after today’s gains, Micro Focus shares trade on just 2.5 times forecast earnings. Should I buy into the turnaround story at this large UK tech stock?

Signs of progress?

Chief executive Stephen Murdoch says that revenue is expected to be about $3bn this year, in line with broker forecasts. However, profit margins are now likely to be “towards the upper end of management expectations”. Mr Murdoch expects to report an adjusted EBITDA margin of 39%.

This measure of profit excludes some cash costs, including tax and interest payments. But I think adjusted EBITDA can be a useful measure of the approximate cash profit generated by a company’s operating business.

Based on today’s update, my sums suggest that Micro Focus should generate adjusted EBITDA of around $1,170m for the 2019/20 financial year. That’s about 15% less than last year.

Falling profits are never ideal, but Micro Focus is only nine months into a three-year turnaround plan. Mr Murdoch believes that the group is making good progress and delivering “encouraging early results”.

It’s not all good news

Micro Focus specialises in helping companies adapt legacy computer systems to meet modern requirements. It’s a surprisingly large and important business — behind their flashy websites, many big companies still depend on ageing back office systems.

In past years, the group grew by making regular acquisitions of smaller rivals. Things went well until 2017, when the firm bit off more than it could chew with an £8.8bn deal to buy Hewlett Packard‘s software business.

It’s been downhill since then. The Micro Focus share price crashed in 2018 when management owned up to problems integrating the HP acquisition, which also left the group with a hefty debt burden.

Will the Micro Focus share price bounce back?

I don’t think Micro Focus shares will ever return to 2,000p and above. But I do think they are probably cheap at current levels.

The biggest problem that I can see is that both revenue and profits are falling. Broker forecasts suggests this will continue next year. In my view, Mr Murdoch needs to stop this decline while continuing to reduce the group’s $4.2bn net debt. If he can do this, then a return to dividends may be possible.

Right now, Micro Focus shares are unloved by the market. The stock’s forecast price/earnings ratio of 2.5 is cheap, but I think it’s also a warning.

This business could continue to decline. With so much debt, shareholders could get squeezed out and be left with nothing.

I don’t expect that to happen. I’m feeling more positive about Micro Focus than I have done for a couple of years. I’ve added this stock to my watch list for further research. I might consider a small buy for my portfolio.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Micro Focus. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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