When Micro Focus International (LSE: MCRO) issued a profit warning in mid-May, shares in the company collapsed by 50% in a single day. And while the stock has since made a small recovery, it is still trading 60% below the all-time high of just under 2,700p printed in mid-November.
After these declines, at first glance, the stock looks cheap. Indeed, right now shares in Micro Focus are trading at a forward P/E of just 7.4, a substantial discount of 62% to the tech sector median of 19.5. However, despite this extremely attractive valuation, I'm avoiding Micro Focus at all costs.
Micro Focus has built its business buying old, low-growth software assets and improving their profitability.
Some analysts believed this strategy would help the company become the next Arm, the London-listed global technology champion that was brought out by Japanese conglomerate Softbank in 2016, but Micro Focus's acquisition record is mixed.
In 2010, investors dumped the stock after two botched acquisitions -- Borland and a division of Compuware -- resulted in a profit warning. The latest troubles are a result of the unsuccessful purchase of Hewlett Packard Enterprise's software business.
Due to problems stemming from the integration of this business, in January Micro Focus warned that sales across the group were likely to fall between 2% to 4% for the year ending 31 October. Management then downgraded this forecast in mid-March, warning that the sales decline has been "greater than anticipated" and that sales are now more likely to fall between 6% to 9%.
Put simply, this has been a game-changing acquisition for the company, but not in the way management hoped.
The problem is, Micro Focus's options are now limited. Buying the HP business has weakened the group's balance sheet. Net debt is already around three times operating earnings, and the company is paying out most of its free cash flow to shareholders via dividends.
With this being the case, in my opinion, the stock deserves a low valuation. Historically, most of Micro Focus's growth has come from acquisitions, but a weak balance sheet will prevent it from doing any more deals. At the same time, with sales sliding, it looks as if the business won't be able to grow itself out of the problems.
I also believe that the company's dividend is under threat. At the time of writing, the shares support a yield of 6.1%, but as I mentioned above, this distribution is consuming virtually all of the group's free cash flow. For the six months ended 31 October 2017, the firm generated a free cash flow of £28m but paid out £134m in dividends to investors.
If sales continue to slide, at some point management will be forced to cut this payout to free up funds for paying down debt or reinvesting in the business to drive growth.
Considering all of the above, I'm staying away from Micro Focus as there plenty of other cheap income stocks out there with a brighter outlook.
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Rupert Hargreaves owns no share 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.