Fitch Ratings has affirmed the Long-Term Issuer Default Rating (IDR) for Open Text Corporation (OTEX) and its subsidiaries, Open Text Holdings, Inc. and Open Text ULC at 'BB+'.
The subsidiaries and Open Text Corporation are co-borrowers on the secured revolver, and collectively all three entities are referred to as 'Open Text'. The Rating Outlook remains Negative.
In addition, Fitch has affirmed the 'BBB-'/'RR1' rating on the senior secured debt and the 'BB+'/'RR4' rating on the senior unsecured debt of Open Text Corporation, and the 'BB+'/'RR4' rating on Open Text Holdings, Inc.'s senior unsecured debt. Fitch has also affirmed the 'BBB-'/'RR1' rating on the secured term loan of Open Text Corporation.
The Negative Outlook reflects Fitch's concern for increased leverage as a result of the Micro Focus International plc (Micro Focus) acquisition in January 2023 for total consideration of $5.8 billion, which was largely funded with debt. Fitch expects the combined company to be a significant generator of cash and that leverage should decline over the next several quarters. Should Fitch expect leverage to exceed 3.5x on a sustained basis, Fitch may downgrade the rating by one notch. On the other hand, if Fitch expects leverage to be below 3.5x on a sustained basis, the Outlook may be revised to Stable.
Key Rating Drivers
Deleveraging Expected: The Micro Focus acquisition closed in January 2023 and the company's first fiscal year running as a combined entity will be in FY24. Fitch projects that the combined company will generate significant and growing EBITDA and FCF. Fitch defined leverage is forecasted to be around 4.0x at the end of FY24 and decline to approximately 3.5x at the end of FY25 through EBITDA growth and OTEX's plan to reduce debt by $175 million per quarter until it reaches its net leverage target (as defined by Open Text) to below 3.0x within eight quarters of closing on the Micro Focus transaction. Fitch notes that its definition of gross leverage is defined by Fitch and that OTEX's target is net leverage as defined by the company.
Planned Focus on Margin Expansion: Historically, Open Text has had stronger EBITDA margins and topline growth versus Micro Focus. Open Text will have to continue to make improvements at Micro Focus, which had experienced revenue declines and margin contraction for the last few years leading up to the acquisition. Open Text plans to bring Micro Focus' revenues back to an organic growth trajectory while improving its EBITDA margins and cashflows and thus far, it has been off to a good start.
EBITDA margins should ramp up as OTEX optimizes the Micro Focus business and Fitch believes there is significant opportunity for margin expansion. OTEX calculates its overall adjusted EBITDA margins improved to 34.7% in 1QFY24, up from 31% in 4QFY23. In 4QFY23, OTEX (as a standalone business) had adjusted EBITDA margins of 32.9% while Micro Focus had adjusted EBITDA margins of 28.4%, up from 23.1% in 3QFY23. For FY23, OTEX calculates its total adjusted EBITDA margins were 32.8% and OTEX standalone was 34.7% while Micro Focus was 26.3%. In FY24, OTEX projects its overall adjusted EBITDA margins will be in the range of 36%-38%.
Integration Ahead of Plan: The Micro Focus acquisition is Open Text's largest acquisition to date. Integration is ahead of plan with the company having executed on approximately $260 million of its planned $400 million cost synergies as of the end of FY23. Successful integration must continue if Open Text can achieve its FY26 aspirations of adjusted EBITDA margins in the 38%-40% range. Furthermore, Open Text's debt more than doubled with the acquisition of Micro Focus and as of June 30, 2023, the company had $9 billion of total debt outstanding. While the increase in leverage may be temporary, if OTEX cannot further enhance Micro Focus' operating profile and mitigate potential integration risks, the company could have a weaker credit profile. OTEX must continue to execute on improving Micro Focus which had a portfolio of mature software assets that were in secular decline.
FCF and Capital Allocation: Over the past four years, OTEX has been a significant generator of FCF which averaged around $600 million per year (after dividends) and FCF margins have average nearly 17%. In FY23, FCF and FCF margins were impacted by the Micro Focus acquisition and Fitch believes that FCF margins should return to the mid-teens by FY25. The company projects FCF (before dividends) to be over $1.5 billion in FY26. Once the company hits its net leverage target, Fitch assumes OTEX may once again become acquisitive and/or increase its share repurchase program. It continues to allocate about 20% of the LTM FCF (as defined by the company which is FCF before dividends) to dividends.
Significantly Increased Scale: With the acquisition of Micro Focus, the combined company will have an annualized total revenue of over $6.0 billion, delivering on the company's 2021 publicly stated goal of doubling revenues over the next five to seven years. Historically, Open Text has maintained strong recurring revenues consisting of cloud services and subscriptions and customer support (81% recurring revenues in FY23). The company targets pre-dividend free cash flows of $1.5 billion in FY 2026. Fitch expects the acquisition to drive organic growth in the cloud segments as Open Text transitions Micro Focus' customers to Open Text's cloud infrastructure.
Derivation Summary
Open Text's 'BB+' rating reflects its size and scale, which will double with the Micro Focus acquisition. The company's rating is the same as Gen Digital (GEN; BB+/Negative), which has much stronger EBITDA margins of around 50%. Fitch estimates Open Text has EBITDA margins in the low- to mid-30's. GEN differs from Open Text significantly in its strong focus in the consumer market.
From a leverage perspective, there are similarities since both have leverage over 3.5x, which is high for the 'BB+' rating, and they both share a Negative Outlook for that reason. Both are expected to generate significant FCF and reduce leverage. Fitch expects Open Text to have leverage under 4.0x by the end of FY24, and if it successfully increases EBITDA margins, it could be below 3.5x by the end of FY25. For GEN, Fitch forecasts leverage in the 3.5x to 4.0x range by the end of FY24 (FY ends April 1). Should it focus on debt reduction, GEN could also have leverage under 3.5x by the end of FY25.
Fitch rates Open Text Corporation and its subsidiaries, Open Text Holdings, Inc., and Open Text ULC on a consolidated basis, using the weak parent/strong subsidiary approach based on the entities operating as a single enterprise with strong legal and operational ties.
Key Assumptions
Fitch's Key Assumptions Within the Rating Case for the Issuer:
Revenues for Open Text will grow organically in the low single digits until FY26 when Fitch assumes OTEX resumes acquisition activity which boosts topline growth;
After adjusted EBITDA margins of 32.4% in FY23, Fitch assumes that margins expand in FY24 to the mid-30's and further increase after that;
Dividend growth continues around 10%;
Fitch assumes share repurchases resume in FY24 and continue;
Fitch forecasts that cash builds on the balance sheet and is directed to sizeable acquisitions in FY26 and FY27.
RATING SENSITIVITIES
Factors that could, individually or collectively, lead to a Stable Outlook:
Should Fitch anticipate Open Text's leverage falling below 3.5x on a sustained basis, the Outlook could be revised to Stable from Negative.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Fitch's expectation of EBITDA leverage below 2.5x on a sustained basis;
--(CFO-Capex)/Debt above 17.5% on a sustained basis.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
Should Fitch expect leverage to exceed 3.5x on a sustained basis, Fitch may downgrade the rating by one notch;
--(CFO-Capex)/Debt below 10% on a sustained basis;
Evidence of negative organic revenue growth;
Significant debt-financed acquisitions or share repurchases that significantly weaken the company's credit profile for a prolonged period of time.
Liquidity and Debt Structure
Sufficient Liquidity: As of Sept. 30, 2023, Open Text had total liquidity of $1.57 billion consisting of $920 million of cash on the balance sheet and revolver availability of $650 million. In October 2023, OTEX repaid the $100 million balance on the revolver. The $750 million revolver is current and due in October 2024 and Fitch assumes that OTEX can successfully put in place a new revolver. This along with Fitch's expectation for significant FCF also supports Open Text's liquidity.
The company's nearest maturity occurs in May 2025, with $930 million due on the amortizing term loan. In July 2023, Open Text repaid $175 million drawn under the revolver leaving about $100 million drawn.
Issuer Profile
Open Text Corporation (NASDAQ: OTEX) is a public company with a $9.2 billion market cap that offers its customers information management through cloud-based solutions. It also offers licenses, customer support and professional services such as consulting. In FY23 (FY ends June 30), the company generated 62% of its revenues from the Americas, 29% from EMEA, and 9% from Asia Pacific.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG Considerations
The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.
OPEN TEXT CORPORATION 
