S&P: U. K.-Based Software Company Micro Focus 'BB-' Rating Affirmed On Proposed Acquisition Of HPE Software; Outlook Stable
At the same time, we affirmed our 'BB-' issue rating on the company's existing senior secured term loans, including a revolving credit facility (RCF). The recovery rating remains at '3', indicating our expectation of recovery in the higher half of the 50%-70% range in the event of a default.
The affirmation reflects our balanced view of Micro Focus' announcement to acquire HPE Software. In our view, the acquisition entails some benefits including a potential improvement in Micro Focus' scale, and we think that the combined group will be able to generate strong margins after integration. However, we see short-term risks arising from the large integration process and current weaker performance of HPE Software. This is despite Micro Focus' good track record of integrating acquired companies, including Attachmate Corp., which it acquired in November 2014. In our view, the increase in leverage due to the acquisition of HPE Software remains reasonable thanks to the usage of equity. Furthermore, we think Micro Focus will gradually reduce its leverage post-closing, owing to potential cost savings and positive cash flow generation. This is also supported by the company's financial policy.
Micro Focus and HPE announced on Sept. 7, 2016, that Micro Focus will acquire HPE Software for $8.8 billion. The transaction is mainly financed by an issuance of new Micro Focus shares to HPE's shareholders. Micro Focus also has commitments for a total of $5.5 billion debt financing, including a $500 million revolving credit facility (RCF). The new debt will be used to fund a $2.5 billion cash payment to HPE, $400 million distribution to Micro Focus' current shareholders before completion of the acquisition, transactions cost, and to refinance Micro Focus' current indebtedness. We understand HPE Software will be acquired on a debt-free basis. Micro Focus estimates its pro forma company adjusted net leverage will be approximately 3.3x when the transaction closes, which is expected to occur in the third calendar quarter of 2017.
Micro Focus' business risk continues to reflect its narrow revenue base from mature infrastructure software with limited growth prospects. With annual revenues of $3.2 billion, HPE Software will meaningfully increase Micro Focus' scale. However, about 80% of HPE Software's revenues come from legacy infrastructure software with ongoing declining revenues. Likewise, only 18% of Micro Focus' current revenues--pro forma Serena Software Inc. (Serena) acquisition, completed on May 2, 2016--come from SUSE product portfolio (enterprise Linux business), which is its only growing segment. The remaining revenues are derived from COBOL (a software programming language) and mainframe solutions (18%), host connectivity (14%), identity, access, and security solutions (16%), development and IT operations management (23%), and collaboration and networking (11%). In COBOL, the company operates in the distributed segment of this market, where customers can use their own applications written in COBOL across multiple platforms. Micro Focus also operates in the mainframe segment, but to a much smaller extent. Furthermore, the group competes with much larger players, including IBM, Microsoft, and Oracle, and with niche software providers such as Red Hat Inc. and newer entrants in the cloud space.
These weaknesses are partly offset by Micro Focus' solid profitability. The S&P Global Ratings-adjusted EBITDA margin improved to 43% from an already strong 38.2% in fiscal 2016, ending in April 2016. Micro Focus has been successful in operating mature, non-growing businesses and in the integration of Attachmate. We think Micro Focus can replicate this success with HPE Software. HPE Software currently reports about 21% EBITDA margin. Micro Focus believes it can improve this margin to about 46% within the mature product portfolio of HPE Software by the end of the third full fiscal year post-closing. In our view, there should be reasonable operational efficiencies derived from running the target as a pure software company rather than as part of a larger hardware-focused company. Furthermore, limiting the research and development and sales and marketing spending on declining segments should provide cost savings.
Other strengths include:A high proportion of recurring revenues (more than 70% of Micro Focus' and about 59% of HPE Software's revenues), supported by mission-critical software in many segments;Leading positions in some segments like off-mainframe COBOL, host connectivity and enterprise Linux markets, and enhanced market position in segments like IT operations management post-closing; andSome diversification, operating in different segments within the infrastructure software market, and Micro Focus and HPE Software globally serving more than 20,000 and 50,000 customers, respectively. We forecast that the HPE Software acquisition could push Micro Focus' pro forma S&P Global Ratings-adjusted leverage to just above our rating threshold of 4x. However, we believe the group's robust free cash flow and cost savings potential preserve adjusted leverage at about 3.5x within a year of closing the acquisition. That said, we expect that Micro Focus will remain acquisitive and continue meaningful shareholder distributions. Micro Focus targets a company-adjusted leverage of 2.5x (which corresponds to our adjusted leverage of about 3x), to be achieved again two years post closure of the HPE Software acquisition. In our view, Micro Focus has a good track record of delevering, as witnessed by the usage of equity in recent acquisitions and repayments of debt, together with growing EBITDA.
Compared with other software providers we rate, Micro Focus has weaker growth prospects, in our view. Moreover, we continue to see execution risks with the integration of HPE Software after the integration of Attachmate, which could result in lower revenues or delays in achieving cost reductions.
Our base case assumes: A low-single-digit organic revenue decline in fiscals 2017–2019. We expect revenue in all segments, including the acquired Serena and HPE Software, to decline or remain flat. The only exception is SUSE, for which we anticipate continued solid annual growth. Modest restructuring costs relating to the Serena acquisition and remaining integration of Attachmate in fiscals 2017 and 2018. Significant integration and restructuring costs in fiscals 2018 and 2019 relating to the HPE Software acquisition. We expect about $300 million-$400 million annual expenses. We include these costs in our EBITDA calculation. Micro Focus and Serena to maintain or slightly improve their margins in fiscals 2017-2019 on the back of completed restructurings. In our view, there is meaningful cost savings potential from integrating HPE Software. We assume HPE Software's unadjusted EBITDA margin to gradually improve from the current 21% to above 30% in fiscal 2020.Increasing dividend and shareholder distributions, or additional acquisitions, to keep company adjusted leverage at around 2.5x. Based on these assumptions, we arrive at the following S&P Global Ratings-adjusted credit measures: EBITDA margin of 43%-44% in fiscal 2017, compared with 43% in fiscal 2016. On a pro forma basis, 22%-27% and 28%-31% in fiscals 2018 and 2019, respectively. Positive FOCF and break-even DCF after cash restructuring outlays in fiscal 2018, FOCF rising to $500 million-$700 million in fiscal 2019.Debt to EBITDA of below 3x in fiscal 2017. On a pro forma basis, about 4x-4.5x in fiscal 2018 and about 3.5x in fiscal 2019.FFO to debt about 30% in fiscal 2017. On a pro forma basis, less than 20% in fiscal 2018, but improving back to above 20% in fiscal 2019.The stable outlook reflects our anticipation that Micro Focus' S&P Global Ratings-adjusted debt-to-EBITDA ratio could peak above 4x pro forma after the HPE Software acquisition closes, but it will decline to about 3.5x in one year after closing and further strengthen sustainably below 3.5x after two years. We also assume Micro Focus will maintain above 30% average S&P Global Ratings-adjusted EBITDA margins.
We could lower the rating if we assess that it is unlikely that Micro Focus will improve its debt to EBITDA and FFO-to-debt to less than 3.5x and more than 20%, respectively, in the 24 months after the acquisition closes. We think this could result from operational problems, notably from integration issues leading to higher restructuring costs or lower cost savings, or if revenues declined more than we expect, especially within HPE Software.
Rating upside is currently limited due to the expected significant integration of HPE Software and the increased leverage at closing of the acquisition. We could raise the rating in the longer term once the integration of HPE Software has been successfully completed and organic revenues have at least stabilized. In addition, gradually stronger metrics in line with our base case would support an upgrade.