What Should The Software Testing Industry Watch For as the HPE–Micro Focus Merger Plays Out?

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With HPE’s decision to spin off and sell its software assets, Micro Focus has continued on its consolidation spree and built upon where it left off with the acquisition of Serena Software in March 2016.

The transaction is particularly interesting to keep an eye for from a software industry’s perspective not just because HP holds the majority of the market share, but also because, from a revenue perspective, HPE is far bigger than Micro Focus. As a result, the challenge of integrating two separate business units becomes far greater for Micro Focus.

The merger is set to close by Q3 2017. And as this merger goes through normal closing conditions, including anti-trust clearances and shareholder approval, it is crucial to see how it plays out for the software testing industry in general as well as for the current customer base of HP. Especially at a time when the core competency of Micro Focus remains managing mature software assets and improving profit margins through consolidation, rather than actively pursuing new product development.

Other interesting points to keep an eye out for include how Micro Focus goes about achieving the following:

Balance Between Cost Consolidation and Active Product Development

The HP Enterprise sale brings a plethora of software products to the Micro Focus portfolio. The products however can be primarily categorized in two main segments: mature more stable tools that have been acting as a cash cow for HP Enterprise. The products in this category include assets like Unified Functional Testing (UFT), Quality Center (QC), LoadRunner etc.

On the other hand, the second segment comprises of tools that are fast-growing, but with lower margins. HP Autonomy and Fortify in fast-growing verticals like data analytics and security would traditionally fall into this category.

Similar product segmentation can be found across Micro Focus as well, with the first Micro Focus portfolio consisting of highly-profitable mature software assets focusing on areas such as COBOL development, identity and access management, and application delivery and testing.

Unlike this mature business, the SUSE portfolio, which Micro Focus gained access to through Attachmate acquisition couple of years ago, provides slimmer margins but better growth.

The plan of Micro Focus seems to be consolidating mature slow-growth software business of HP Enterprise and increase operating income margin of this business by 20 percentage points to around 45 percent.The other part of the plan includes using HP tools in fast-growing verticals such as analytics and security for growth and building preferred partnerships with HP on the fast growing SUSE portfolio to further leverage the growth SUSE has been experiencing.

Such a plan looks really good for investors. And probably that’s the reason why the stock prices of both HP and Micro Focus soared when the news was disclosed to the market. However, while the transaction sounds great play for investors, it would be interesting to see how Micro Focus tries to balance investor commitments with customer needs.

Specifically how Micro Focus tries to build a profitable franchise out of HPE’s mature software business, while balancing active new product development for trends like Agile, Continuous delivery, and Microservices. Such a balance becomes even trickier to achieve when the software business unit of HP Enterprise has continued to shrink over the past three quarters.

The Case of Overlapping Assets

The $8.8 billion deal of HP Enterprise with Micro Focus comes with a lot of overlapping software assets, resulting in a repetitive portfolio for Micro Focus. Take the following as an example. Automated Testing tools from Micro Focus such as Silk Test and Silk Central Connect overlap with HP Unified Functional Testing (UFT), while Micro Focus Connect serves the same purpose as Quality Center. Similar overlaps can be found across performance testing space as well.

Such a horizontal merger can cause two specific challenges from a HP Enterprise customer point of view.

First and foremost, it increases concentration and reduces competition, and as a result the consolidated business (in this case Micro Focus) can raise prices more easily without having to worry about losing and alienating customers. More information about this can be found in the other post I wrote recently. This particularly doesn’t sound great for HPE customers who are already spending a large portion of portion of their IT budgets on HP tools. To remedy the problem caused by such a horizontal merger, the overlapping assets may often need to be divested.

Take the example of Verizon’s acquisition of Alltel Corp where it had to dump overlapping assets post of Department of Justice inquiry.

The second challenge comes from the aspect of purely managing such overlapping assets, primarily because it means duplicate product development, sales and marketing, general overhead, and administrative support. One way of overcoming this is consolidating business under one roof.

However, while this consolidation happens and jobs are lost, there is large period where feature development takes a backseat for enterprise uses of HPE. HPE enterprise customers thereby have a lot to figure out in this department over the new few months.

Execution Risk

Micro Focus has been involved in a series of acquisitions since 2006.  This includes its decision to acquire NetManage for close to $73 Million in 2008 and then buying Borland Software for $75 million in 2009. Its 2014 merger with Attachmate Group for $2.5bn was the biggest to date. However, the acquisition of HPE is much different than anything Micro Focus has attempted or had experience with in the past.

HPE Software not just happens to be larger in size than Micro Focus, but with annual revenues of around $4.5 billion, the new Micro Focus post this acquisition would be approximately three times the size of the current Micro Focus. As a result, the challenge of integrating disparate businesses units as well as achieving promised synergies through cost reductions in the promised timeline becomes more difficult.

Concerns Regarding Growing Debt Levels

The acquisition of Hewlett Packard Enterprise’s software group has resulted in Micro Focus giving up roughly half of its equity along of $5.5 billion of debt financing. The concerns regarding growing debt obligations of Micro Focus have in fact promoted a review for downgrade from Moody’s. It would thereby interesting to see with integration costs planned over the next two years, whether Micro Focus can reduce debt levels to reduce the Moody’s adjusted leverage (debt/EBITDA) from present 4.0 X to 2.5 X.

With its origins from COBOL Development and having performed numerous acquisitions over the past few years, Micro Focus has had good experience in improving margins of mature software products. However, often that has come at the cost of new feature development. As a result, it remains to be seen, if it can hold onto the enterprise user base of HPE, while improving the margins by 20 points and not precisely looking to develop new features or products.

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