Open Text Q2 Earnings: Guidance Too Visible, Too Strong (OTEX)

Although Open Text Corporation (NASDAQ:OTEX) has participated in the unfavorable conditions associated with high-growth tech companies, falling from its 2-year high of approximately $55.00 per share on August 30, 2021, to a 52-week low of $24.91 on October 13, 2022, it has held up fairly well considering the economic environment it operated in.

After rebounding off its low, OTEX stock has traded in a range of about $25.50 per share to $31.00 per share. After what appeared to be a decent earnings report, it has failed to gain momentum, even after management gave some long-term guidance that reflected what I consider to be an unimpeded best-case scenario.

The other major element covered in the earnings call was the acquisition of Micro Focus, which closed on January 31, 2023. That means the next couple of earnings reports will be important in order to show what the contribution from the new acquisition will be on the overall numbers of OTEX, taking into consideration the next report will only have two months included in the total because of the closing date.

In this article, we’ll look at some of its recent numbers, the company’s guidance, and the challenges and potential that comes with Micro Focus.

Some of the numbers

Revenue in the second fiscal quarter of 2023 was $897.00 million, compared to revenue of $877.00 million in the second fiscal quarter of 2022. Revenue in the first six months of fiscal 2023 was $1.75 billion, compared to revenue of $1.7 billion in the first six months of fiscal 2022.

Breaking down the revenue streams, Cloud services and subscriptions accounted for $409.00 million; Customer support $317.00 million; License $108.00 million; and Professional service and other, $64.3 million.

Annual recurring revenue (ARR) was $725.00 million, up 3.6 percent year-over-year.

Net income in the reporting period was $259.00 million, or $0.96 per diluted share, compared to net income of $88.3 million, or $0.32 per diluted share in the second fiscal quarter of 2022.

Net income for the first six months of fiscal 2023 was $141.5 million, or $0.52 per diluted share, compared to revenue of $220.00 million, or $0.81 per diluted share, in the first six months of fiscal 2022.

It should be noted that improvement in net income was primarily from a non-cash mark-to-market benefit from derivatives associated with Micro Focus, and lower costs related to debt reduction.

Adjusted EBITDA in the quarter was $341.00 million, with an adjusted EBITDA margin of 38 percent.

OTEX had free cash flow of $163.00 million in the reporting period.

The company held cash and cash equivalents of $2.82 billion at the end of the second fiscal quarter, compared to cash and cash equivalents of $1.69 billion as of June 30, 2022.

At the end of the second fiscal quarter of 2023 the company had long-term debt of $5.2 billion, compared to long-term debt of $1.47 billion at the end of June 30, 2022.

Company guidance

While I think the four-year guidance given by OTEX management is somewhat unreliable because of the enormous number of things that could happen during that time which could disrupt the performance of the company, I do see its guidance for 2023 having more merit, based upon the increase in numbers that will come from the contribution of Micro Focus.

Having said that, these numbers could have the potential to disappoint if a recession hits that has a strong impact on business spend in the sector OTEX competes in.

With that in mind, management guided for revenue for full year, fiscal 2023 to jump to $4.47 billion to $4.55 billion, reflecting gains of 28 percent to 30 percent. Of that, Micro Focus is projected to contribute from $870.00 million to $920.00 million to the total.

Adjusted EBITDA for fiscal 2023 is projected to be in a range of $1.46 billion to $1.52 billion, with an adjusted EBITDA margin of 32.5 percent to 33.5 percent.

Free cash flow is expected to be from $500 million to $600 million for full year 2023.

While the company already has the first six months of fiscal 2023 under its belt, I think the reason it has the $100 million differential in its cash flow is because of the integration costs and cuts it’s making at Micro Focus, which are probably somewhat fluid at this time.

Moving on to guidance for full year 2024, the company projects that revenue will be from $5.7 billion to $5.9 billion, up by 33 percent to 35 percent from 2023.

Adjusted EBITDA for all of 2024 is guided to be between $2.1 billion to $2.24 billion, which represents a gain of 36 percent to 38 percent.

Free cash flow is projected to be from $800 million to $900 million for full year 2024.

For full year fiscal 2026, management projects organic revenue growth from two percent to four percent, an expansion of EBITDA margin from 38 percent to 40 percent, and free cash flow of approximately $1.5 billion.

How the company plans on meeting guidance

My view is OTEX is basing guidance on a best-case scenario that isn’t going to be disrupted in any way over the next several years. I think the biggest risk to the company’s outlook is a probable recession in 2023, which would, at best, push out its guidance numbers further out, and at worst, put longer-term pressure on the performance of the company over the next couple of years at least.

On the other hand, if the Fed pivots sometime in the second half of 2023 and there is no recession or a mild recession, OTEX could surprise to the upside as its customer base would loosen their purse strings further while the market would likely invest heavily in the rebounding tech sector under that scenario.

As for things under the company’s control, it’s looking for ongoing growth in its cloud business, returning Micro Focus to organic growth by 2025, and completing integration and cost reductions associated with the Micro Focus acquisition.

On the cost reduction side of things, management is looking to cut approximately $400 million in combined company costs over the next 18 months or so. It plans on doing so by automating some of the work, shrinking overlapping work, getting rid of inefficiencies, and removing redundant facilities.

An area it’s looking to improve with Micro Focus is in regard to its renewal rate. OpenText has had a renewal rate of about 95 percent recently, while the renewal rate of Micro Focus has been in the low 80 percent. The company wants to bring the renewal rate of Micro Focus up to the 95 percent level by no later than fiscal 2025.

Based upon geopolitical and economic weakness, OTEX believes its products and services are positioned well to help its customers operate in an increasingly complicated world. Among the challenges are inflation, FX, rising energy costs, supply chain constraints, high interest rates, the war between Russia and Ukraine, China, and shortage of skilled workers. OTEX’s management considers these challenges to be opportunities, and they definitely could be. But in the short term they could also be considered negative catalysts that slow down economic growth and have a detrimental impact on the performance of OTEX, which would disrupt its guidance by slowing down its pace of expected growth.

OTEX looks at it from a glass half full perspective and sees digitalization as the major answer to the challenges facing companies, and that plays into the strengths of OTEX if its customers are convinced that the company is the answer to their problems.

Conclusion

I have no doubt that, over time, companies will continue to increase their technology budgets. Citing IDC, management stated in 2023 alone expectations are Software-as-a-Service spend will be up 15 percent, software by 8 percent, and IT spend will increase by 5 percent.

As mentioned earlier, that doesn’t mean these projections will be met if the global economy falters and we enter into a deep and prolonged recession. Even a modest recession that lasts for a while would cause a number of companies to spend less than they would under more optimal economic conditions.

I want to see how Micro Focus does through the remainder of 2023. If the company is able to successfully integrate it while lowering costs, and is moving toward it stabilizing in 2024 before returning to organic growth in 2025, then it has a chance to meet guidance, assuming a mild recession for a short period of time.

It of course also assumes its existing cloud business continues to grow at a steady pace.

Over the long haul I think OTEX is likely to do very well, but within the parameters of its guidance, I think its expectations are based upon an assumed visibility that simply isn’t or can’t be there because of the uncertain economic conditions we face, and the lack of clarity concerning when the Federal Reserve will finally pivot.

With its share price up over $10.00 per share since October 13, 2022, I think it’s getting expensive, with much of its performance and guidance already priced in.

For that reason, I would wait for a significant correction in its share price and confirmation it is able to successfully integrate Micro Focus while cutting costs.