Earnings Call Transcript - OTEX Q2 2023

Operator, Conference Operator

Thank you for your patience. Welcome to the OpenText Corporation Second Quarter Fiscal 2023 Financial Results Conference Call. All participants are currently in listen-only mode and this call is being recorded. After the presentation, there will be a chance to ask questions. I would now like to hand it over to Harry Blount, Senior Vice President of Investor Relations. Please proceed, sir.

Harry Blount, Senior Vice President, Investor Relations

Thank you, operator. Good afternoon, everyone, and welcome to OpenText's second quarter fiscal 2023 earnings call. Joining me today are OpenText’s Chief Executive Officer and Chief Technology Officer, Mark J. Barrenechea, and our Executive Vice President and Chief Financial Officer, Madhu Ranganathan. Today's call is being webcast live and recorded, with a replay available shortly thereafter on the OpenText Investor Relations website. Earlier today, we posted our press release and investor presentation online. These materials will provide additional context to our prepared remarks and can be accessed on the OpenText Investor Relations website at investors.opentext.com. I’m pleased to share that OpenText management will be participating in the following upcoming conferences: Bernstein's Technology, Media, Telecom and Consumer one-on-one forum on March 1 in New York and Scotiabank's TMT Conference on March 7 in Toronto. Now, I’d like to touch on our Safe Harbor statement. Please note that during this call, we may make statements regarding OpenText’s future performance that contain forward-looking information. While these statements reflect our current beliefs, actual results may vary significantly from the conclusions, forecasts, or projections mentioned. Various material factors and assumptions were considered in these statements. Further information about the material factors that could lead to significant differences from the forward-looking information, as well as risk factors regarding OpenText's future performance, can be found in our recent Forms 10-K and 10-Q, along with our press release distributed earlier today, available on our website. We are not obligated to update these forward-looking statements unless legally required. Additionally, our call may cover certain non-GAAP financial measures. You can find reconciliations of those non-GAAP measures to the most directly comparable GAAP measures in our public filings and other available materials. With that, I’ll now hand the call over to Mark.

Mark Barrenechea, CEO

Thank you, everyone, for joining our fiscal 2023 Q2 call. Madhu and I are pleased to host today’s call from Ottawa. Tomorrow, we will be ringing the opening bells for NASDAQ live from the nation’s capital, marking NASDAQ's first opening from Canada. This moment serves as a recognition and celebration of Canada's and OpenText’s significant contributions to global technology innovation. We are an innovative young company, and we are just at the beginning of our journey. I want to highlight OpenText's outstanding Q2, reporting a constant currency revenue growth of 7.8%, driven by a remarkable 16% growth in cloud revenue, strong performance in renewals, and an adjusted EBITDA margin of 37.7%, all while our teams worked diligently on the integration of Micro Focus. The factors that fueled our growth also underpin our confidence in the potential of the Micro Focus acquisition. In today's data-driven world, our customers require actionable insights, robust security, and ongoing innovation to navigate their complex business environments efficiently. We are committed to fulfilling every promise made during the Micro Focus acquisition announcement. I will provide further details later, but our confidence in delivering value to our shareholders, customers, and employees has never been higher as we leverage the OpenText business system alongside highly skilled integrators. Our track record of successfully integrating large acquisitions over the past decade supports this. Additionally, we are positioned to achieve $6 billion in annual revenues, grow our cloud business to $2 billion, and exceed $2 billion in adjusted EBITDA with strong free cash flow driven by customer trust. Today, I will address five specific topics: our vision and differentiation, our expanded information management mission and growth programs, our financial milestones and aspirations, and our capital allocation strategy. Let’s start with our vision and how we plan to excel in our markets. Markets are ever-evolving. We have broadened our information management focus to encompass various content experiences and business networks. With the Micro Focus acquisition, OpenText is expanding its mission to assist enterprise professionals in securing operations, deriving insights from their information, and managing complex digital landscapes using advanced tools in cybersecurity, digital operations, automation, AI, and analytics. The era of digital life is upon us, which we term Business 2030. Companies can only realize their strategic goals by becoming digital leaders, and top performers are heavily investing in digital capabilities. We are on the brink of a new era, characterized by digital transformation, productivity enhancement, and the seamless exchange of goods, capital, ideas, and innovation. Achieving Business 2030 will involve four key digital transformations: comprehensive enterprise reinvention, a workforce led by Generation Y and Z with a digital mindset, a focus on sustainability and social justice, and new digital requirements coupled with extended reality and AI. Businesses will continue to benefit from the advantages provided by ERP and CRM systems, but these advantages rely on data and actionable insights, which customers receive from OpenText’s digital solutions. I engage frequently with customers, and they face increasing complexity as they operate across various regulatory environments, platforms, and clouds, all while managing heightened security and compliance requirements. The rising demand for business information and automation spans multiple domains such as commerce, supply chain, service management, and communications. As connectivity increases, so does operational complexity. At OpenText, we offer a comprehensive software and cloud solution, positioning ourselves as the go-to platform for information management. Customers require a unified, real-time view of information across complex infrastructures that is intelligent, connected, secure, and responsible—this is the OpenText Information Advantage. We see six essential markets enabling the Information Advantage required for effective transformation into Business 2030. These markets are content services, business networks, cybersecurity, application automation, digital operations management, and analytics and AI. We are organizing ourselves around this strategic market, which exceeds $200 billion, and we will keep you informed of our advancements in each area. Moving on, I want to address how we are advancing our information management vision and growth initiatives. This week has been energizing as we’ve engaged with Micro Focus employees and customers, completing our leadership and structural integration swiftly. Notably, the financial highlights from the acquisition include an enterprise value of $5.8 billion, financed through cash and debt, resulting in an attractive revenue multiple. The business immediately contributes to our adjusted EBITDA dollars. We are excited about the exceptional talent and products we've acquired, including key technologies across various spaces. Our approach includes fixing operational inefficiencies, accelerating cloud services, enhancing customer engagement, and implementing best practices to streamline our organization for agility and growth. OpenText achieved a 95% renewal rate in Q2, and we aim to elevate Micro Focus's renewal rates to match our standards by fiscal 2025 or sooner, through rapid innovation that correlates closely with high renewal rates. We are accelerating customer migration to the OpenText private cloud and implementing faster release cycles for Micro Focus products. Our growth strategy focuses on excelling in these six markets while pursuing strategic integrations in cloud, AI, and security. In terms of our cost-saving measures, we are targeting a reduction of $400 million in combined company expenses over the next 18 months by eliminating redundancies and improving efficiencies. We've recently announced plans to adjust our workforce from 25,000 to 23,000, representing an 8% reduction driven by the acquisition, while still actively hiring for critical roles to fuel growth and innovation. Reflecting on our financial journey, we’ve marked a successful Q2 as we integrate Micro Focus from a position of strength. We achieved $945 million in total revenue (7.8% growth), $423 million in cloud revenue (16% growth), and substantial cloud bookings growth at 12%. Our adjusted EBITDA was 37.7%, with $163 million in free cash flow and adjusted EPS figures illustrating our strong performance this quarter. We have welcomed some notable customers accelerating their digital transformations. Despite ongoing challenges in the economy, our customers continue to exhibit high engagement and demand for our solutions, demonstrating the importance of digitalization for improved insights and efficiencies. As we look ahead, our fiscal 2023 targets indicate revenue growth of 28% to 30%, with Micro Focus expected to contribute significantly. We are forecasting robust cloud growth, with continued increases in bookings and EBITDA. The preliminary targets for fiscal 2024 signal ambitions of $5.7 billion to $5.9 billion in revenue and further growth in adjusted EBITDA. Our baseline for Micro Focus is set to ensure clear expectations moving forward. In terms of capital allocation, we have a well-defined three-year plan aimed at building a $2 billion cloud revenue business while maintaining a commitment to our dividend program. We will manage our share count and ensure a high conversion rate from revenue to free cash flow, reflecting strong operational efficiency. In conclusion, I have great confidence in our business strategy and team. OpenText is uniquely positioned to help our customers manage complexity effectively, thereby earning their trust and delivering exceptional market value through our Information Advantage. I reaffirm our commitment to returning Micro Focus offerings to organic growth and enhancing engagement, renewal rates, and overall customer value. Thank you to our customers for their trust and to our colleagues for their hard work that has led to our impressive results and momentum as we welcome our new team members from Micro Focus and continue to innovate and grow together. Now, I’ll hand over to Madhu Ranganathan, our CFO.

Madhu Ranganathan, CFO

Thank you, Mark, and thank you all for joining us today. All references are in millions of USD compared to the same period in the prior fiscal year and are on a reported basis unless stated otherwise. During Q2, at OpenText, we redefined what consistent and solid execution means. We delivered impressive results, exceeding the expectations of our growth strategy discussed in the last earnings call, and moved forward with closing the Micro Focus acquisition on the 31st as planned. OpenText is entering an exciting new phase, acquiring Micro Focus from a strong position with momentum and confidence in our growth and integration plan. We are pleased with our Q2 revenue performance. Enterprise cloud bookings were $145 million, up 12% year-over-year. Forex in Q2 was a revenue headwind of $48 million, with approximately 45% in customer support and 31% in cloud. Cloud revenue reached $409 million, up 12% as reported and 15% in constant currency. Renewals were strong at 94% for Enterprise Cloud and 95% for off-cloud. Annual recurring revenue stood at $725 million, up 3.6% as reported and 8.7% in constant currency, representing 81% of total revenue. Total revenue was $897 million, up 2.4% as reported and 7.8% in constant currency. Q2 marks the eighth consecutive quarter of organic growth in constant currency for both Cloud and ARR. In other financial metrics, GAAP net income was $259 million, up from $88 million due to a non-cash mark-to-market benefit from Micro Focus-related derivatives and lower debt extinguishment costs. The mark-to-market benefit in Q2 represents a reversal of a Q1 loss, partly reflecting significant currency movements. GAAP gross margin improved to 71% from 70%, driven by better cloud margins. Adjusted EBITDA was $341 million, or 38% of revenue, down from $344 million, or 39.2%, reflecting a 0.8% decrease as reported but a 3.7% increase in constant currency. Cost of sales and operating expenses increased by $24 million on a non-GAAP basis, all associated with revenue growth, Zix integration, and investments in R&D and sales and marketing. Our organic growth rate trends underline the benefits of ongoing investments in products and market strategy. For operating cash flow, we generated $195 million in Q2. Free cash flow for the quarter was $163 million, or 18% of revenue. Days Sales Outstanding were 47 days, compared to 44 days the previous year, reflecting December quarter seasonality with high annual billings from renewals. Our working capital performance remained strong. Year-over-year, free cash flow was impacted by pre-loaded CapEx investments. Our trailing 12-month cloud bookings reached a strong $511 million, up 25%, the highest in our history. We continue to experience steady demand for large cloud deals, with average minimum cloud contract value increases. In content, we saw strength in insurance, engineering, construction, and telecommunications. Business networks saw growth in wholesale, retail, and banking sectors, particularly telecommunications. Regionally, our international markets such as Bill [ph] and APAC showed significant cloud wins. Our full quarter cloud pipeline growth is trending upwards, with solid growth in key industries like government, healthcare, and banking. Moving to our balance sheet and liquidity, we ended the December quarter with $2.8 billion in cash, which includes $990 million in net proceeds from the senior notes offering completed on December 1, 2022. Our net leverage ratio was two times for Q2. For our outlook, we plan our business and present on a constant currency basis for quarterly factors, total growth strategy, and medium-term aspirations. The financial visibility provided earlier reflects our integration and business planning. The Micro Focus financial consolidation starts on February 1 and will be included for five months during our fiscal year ending June 30, 2022. This means Micro Focus revenue will contribute for two months in our March quarter and three full months in the June quarter. Our outlook aligns IFRS to GAAP and reporting periods. Given the partial year inclusion, we are providing insights for five months related to Micro Focus. For fiscal 2024 and beyond, we view OpenText in total and will discuss the entire company, including our products and the six markets outlined earlier. With respect to Micro Focus' adjusted EBITDA profile, it is a high EBITDA margin business. Transitioning from IFRS to US GAAP will burden Micro Focus adjusted EBITDA due to factors like revenue timing from license renewals, R&D capitalization, and lease accounting. Our baseline for Micro Focus starting February 1 will reflect the IFRS to US GAAP conversion. During integration and beyond, we expect operational efficiencies in the combined company. The margin target for the combined company is set at 36% to 38% for fiscal 2024, aiming for over $2 billion in adjusted EBITDA dollars. I will now detail significant items in our outlook regarding overall expense structure, cost reduction, interest and integration expenses, and special charges. We remain confident in our $400 million cost reduction plan. This week, we announced a restructuring plan affecting our global workforce following the Micro Focus acquisition to streamline operations. This plan is expected to reduce the combined workforce by approximately 8% or 2,000 employees, with an estimated cost of $70 million to $80 million, to be completed by the end of fiscal 2023. We also expect to consolidate redundant global facilities with the Micro Focus acquisition and will provide further details as they become available. We have programs to optimize duplicative efforts, including automation and vendor consolidation as part of our operational integration. These savings span several quarters and are accounted for in our outlook. Interest expense is based on our debt service arrangements and is included in our free cash flow projection. Our capital structure was intentionally designed with an initial mix of fixed and floating debt to allow for repayments, deleveraging, and reduced interest expenses over time. Integration expenses are estimated at $80 million and are included in the outlook for our adjusted results for fiscal 2023 and 2024. Special charges for aligning global entities require significant investments, estimated between $380 million and $420 million, and are also included in our outlook for fiscal 2023 and 2024. These estimates will be refined as integration efforts commence. Our free cash flow targets are between $500 million to $600 million for fiscal 2023 and $800 million to $900 million for fiscal 2024, with a growth trajectory to $1.5 billion by fiscal 2026. The outlined expenses and investments will significantly impact fiscal 2023 and 2024, while our cost reduction programs and working capital improvements will encourage a highly efficient organization with upper quartile adjusted EBITDA and free cash flows. Regarding debt levels and our deleveraging plan, with the Micro Focus acquisition closing on January 31, we expect to finish the March quarter with approximately $9.3 billion in debt, excluding cash. This pro forma debt structure reflects the senior secured note financing, the acquisition terminal amendment finalized on December 1, 2022, and the subsequent $450 million withdrawal from our revolver in January. Our pro forma debt structure has a 5.9-year weighted average maturity, a 6.3% weighted average interest rate, and a net leverage ratio of 2.8 times, with about half of our debt fixed. We plan to repay at least $175 million per quarter, starting in Q4 fiscal 2023, to lower our leverage to below three times within eight quarters, as previously committed. We have a solid deleveraging plan, and you can refer to our investor presentation for details on our debt objectives and plan. Regarding outlook targets, I will reiterate Mark's comments, focusing on Q3 fiscal 2023 targets. In Q3, we expect revenue of $1.18 billion to $1.22 billion, which includes $310 million to $325 million from Micro Focus; ARR is expected to be between $0.96 billion and $1 billion, inclusive of $245 million to $260 million from Micro Focus. Our forecast indicates a foreign exchange headwind of $30 million to $35 million, with adjusted EBITDA margin percentage down 600 to 700 basis points due to Micro Focus integration costs. However, excluding Micro Focus, adjusted EBITDA dollars and margin would remain constant. Micro Focus is expected to be immediately accretive from an EBITDA dollar perspective, with FX as a headwind of less than $5 million. For the Q3 fiscal 2023 target model, we expect cloud revenue to be 35% to 37% of total revenue, ARR to be between 82% to 84%, with license revenue at 9% to 11%, and non-GAAP gross margin of 74% to 76%. R&D is projected at 17% to 19%, sales and marketing at 21% to 23%, G&A at 9% to 11%, and total operating expenses at 52% to 54%, with interest expense between $115 million and $125 million. For preliminary fiscal 2024 financial targets, refer to our earlier comments and investor presentation. Our medium-term aspirations for fiscal 2026 reflect strong targets and the ability of the combined company to generate upper quartile cash flows. Our aspirations of 38% to 40% adjusted EBITDA and free cash flow exceeding $1.5 billion fully consider ongoing OpenText growth, particularly in the cloud, alongside Micro Focus’s return to organic growth, as well as the cost reduction and integration efforts. In conclusion, consistent and solid execution remains fundamental to the OpenText business model and operational DNA. Our successful Q2 demonstrates our readiness for the transformative acquisition of Micro Focus. In the last 48 hours since announcing the close, our teams have started a successful onboarding process for 11,000 new professionals from Micro Focus to OpenText, exemplifying our commitment to continue moving forward. I would like to thank our shareholders, loyal customers, partners, and team members as we embark on this exciting journey ahead. I will now open the call for your questions.

Operator, Conference Operator

Thank you. We will now begin the question-and-answer session. The first question comes from Paul Treiber of RBC. Please go ahead.

Paul Treiber, Analyst

Hello. Thank you and good afternoon. I have a couple of open-ended questions. First, regarding the product roadmap, you seem very enthusiastic about the combined product roadmap. How would you assess the product fit and the potential revenue synergy opportunity from products alone between the two companies, considering all the acquisitions OpenText has made?

Mark Barrenechea, CEO

Yes. Paul, thanks for the question. Great to hear your voice. This is the largest expansion of information management that we've done. Documentum effectively bought market share and some capabilities in a couple of industries. GXS certainly put us in business networks, and we've added to that over time, like Liaison. And our acquisition of Carbonite and Zix put us, gave us a footprint, a solid footprint in cybersecurity. So this is the largest expansion of our mission, a large expansion of information management. As I noted in my remarks, this has created a cybersecurity business of scale that will rival our content business in terms of scale and resources. We're entering a whole new application automation space, which we think is essential for the needs of digitalization, digital operations management. And we're bringing on Global 10,000 critical technologies. We're the market leader in EDI. We're going to be the market leader in Mainframe technologies and bringing those workloads distributed. So Paul, and then, of course, Vertica and some other tools. So it's the large expansion that brings our TAM up to over $200 billion. And at this scale, I'll bridge back to what I said on our fiscal 2024 plan. We'll, on this growth rate, we're looking to generate $2.1 billion to $2.24 billion in adjusted EBITDA. So it's also the largest expansion of being able to generate profit and EBITDA. So it's the largest step forward we've made.

Paul Treiber, Analyst

That's good to hear. There's a lot of work involved with the integration that you'll need to manage over the next few quarters or possibly years. In your opinion, what are the key factors that must be in place for this acquisition to be successful for shareholders?

Mark Barrenechea, CEO

Yes. Thank you, Paul. We're off to a great start. The energy and excitement internally in week one have been incredible. We wanted to share our preliminary plan for fiscal 2024. I have confidence in our approach, and I believe the results will speak for themselves. In our fiscal 2024 plan, we aim to deliver total revenues between $5.75 billion and $5.8 billion, adjusted EBITDA of $2.1 billion to $2.24 billion, and up to $900 million in free cash flow. This plan includes transforming how we engage with customers and improve renewal rates, along with an accelerated product roadmap every 90 days, which will create long-term value by shifting customers to private cloud services and then expanding into public cloud offerings. As we discussed before the close, our strategy remains consistent post-close. Our focus is on increasing renewal rates, which closely ties to product innovation. We believe OpenText can significantly enhance value through our private cloud and by accelerating innovation and expanding public cloud services. We know how to execute this plan, and we are confident in presenting our fiscal 2024 goals of $2.2 billion to $2.24 billion in adjusted EBITDA, 15% growth in Enterprise Cloud bookings, and revenues reaching up to $5.8 billion.

Paul Treiber, Analyst

Thank you. I’ll pass it on.

Operator, Conference Operator

The next question comes from Steven Enders of Citi. Please go ahead.

Unidentified Analyst, Analyst

Hi. This is George on for Steve. Congrats on closing the deal. It's very exciting. I wanted to talk about the FY '23 guide. I'm understanding correctly, the organic revenue growth guide came down a couple of points despite a really strong quarter. So I guess I'm wondering how much macro is potentially baked in there? How much conservatism, if you could just talk through that change. Thank you.

Madhu Ranganathan, CFO

Thank you for your comments. This is Madhu. When we consider fiscal 2023, the growth trajectory for OpenText remains unchanged. With the integration of Micro Focus over five months, we anticipate a baseline of $2.3 billion for fiscal 2024, which we have communicated, alongside the five-month figures. However, I must emphasize that it’s not appropriate to annualize these five-month results due to their seasonality and specific operational aspects, which we understand well. Therefore, I can confirm that OpenText's organic growth rate is robust, and our cloud revenue growth rate also remains strong. The incorporation of Micro Focus into our five-month analysis is notable.

Unidentified Analyst, Analyst

Got it. That makes sense. Thank you. And then one quick follow-up. You announced this headcount reduction cost savings plan. I'm just wondering, is that fully just according to your acquisition preplanned cost out, or is there any element of kind of responding to some of the same pressures that some of your peers are facing that are going through similar programs? Thank you.

Madhu Ranganathan, CFO

Yes, Mark, do you want to take that and I can add as needed.

Mark Barrenechea, CEO

Yes, sure, George. Thanks for the question. We announced conjunction with our announcement of our intent to acquire Micro Focus. We said we'd take out $400 million. And after closing here, we're confirming we're going to take out $400 million of expense. And our 8% reduction, rebalancing of the workforce is completely due to the acquisition. Our cloud bookings growth is growing 15% plus, as you can see. We had a stealth superb Q2. And it's interesting when you look at the economy and the factors out there, my best way to describe it is it's uneven. There are very specific issues to companies, and they need to all talk about their own companies. In relation to OpenText, our demand is strong. Digitalization is the only answer. And you're seeing that in our 16% cloud revenue growth, near 8% total revenue growth and our increased confidence in growing enterprise cloud bookings at 15% plus. The factors exist out there, for sure. But it's uneven and disproportional. And digitalization is the only answer, and we're doing well in this volatile time.

Madhu Ranganathan, CFO

Yes. And thank you, Mark. I was just going to add that before COVID or during COVID, the OpenText operating model has always been very thoughtful and measured adding the resources that are very conjunctive with growth and innovation. So the factors you hear outside are absolutely not applicable to us. Even now the rebalancing of the workforce, as Mark shared in his comments, will continue to hire in the sales and the product innovation areas.

Unidentified Analyst, Analyst

Great. Thanks for taking the questions.

Mark Barrenechea, CEO

Yeah. Thank you, George.

Operator, Conference Operator

The next question comes from Kevin Krishnaratne from Scotiabank. Please go ahead.

Kevin Krishnaratne, Analyst

Good evening and congratulations on the deal. It’s an exciting time. I have a question regarding your outlook from 2024 to 2026; it seems like there is an improving organic growth profile. I'm curious about the various factors involved, specifically how you see the contributions from actual cross-selling compared to enhancing Micro Focus's capabilities on your cloud platform and the improvements in renewal rates. Could you elaborate on these different components and indicate which might be the key drivers for the projected organic growth in the coming years?

Mark Barrenechea, CEO

Yeah. Thank you, Kevin. The first is, as I outlined in my remarks, we want to win each of the markets. And so I don't think of that as cross-selling per se, but winning that stack. We want to win the cybersecurity full stack. It's suite selling. Win the cybersecurity suite, win the content suite, win the business network suite. And that is a straightforward growth on-ramp for us to win the stack in each of those six markets. Second is select strategic integrations across the six markets, like Vertica and Magellan across the six, security across the six, private cloud, and our cloud APIs across the six. So it's a very straightforward play for us, and we've actually organized the company around that. Ted in enterprise, sales apprentices or we're giving cybersecurity a lot of focus, apprentice leading cybersecurity. We have James McGourlay leading Enterprise Sales, Paul Duggan running all worldwide renewals through Customer Success and Kristina leading our Corporate Sales. So we structure follows strategy, and we put that structure underneath that growth play of winning each. Now there are some very select things that we think are going to stand out, Idle and Content Services. Our ability to compete against FileNet, Fox, Highland, and others by incorporating facial recognition and voice imitative, we're going to take a big step up with this capability. It's a gem. And they would like to integrate security, voltage into content and having the most secure content platform. So play number one is, win the stack. Number two, select integrations; and then three, fixing the things that need fixing Micro Focus acceleration in private cloud, get the renewal rate up as we outlined. And Kevin, it's a pretty straightforward run of plate, easy to articulate, and we're putting it all in motion.

Kevin Krishnaratne, Analyst

Thanks for the information, Mark. I have a follow-up question. The Microsoft integrations seem really unique and interesting. How should we view the opportunities once they are integrated, operational, and available to customers? Are they primarily opening up new market opportunities or enhancing existing use cases? Or do they represent better competitive products that might displace others? How do you perceive where and how the successes are materializing as we look ahead?

Mark Barrenechea, CEO

These markets are leading us to a total addressable market of $200 billion. We don't need to expand this market size, as we have a significant opportunity ahead of us. There are new use cases we can pursue, such as smart cities and smart transportation. As technology evolves, with more reliance on voice commands, we are well-positioned to take advantage of that. In addition, we are expanding into new markets like cybersecurity, where we will stand out among established names like RSA due to our comprehensive offerings. Our competitive edge is improving against existing competitors, including FileNet, Box, Sterling Commerce, and some security providers. We have exciting new use cases, and we are confident in our current market size. We're focused on strengthening our full stack and enhancing our competitive stance. We plan to share more details about this at our Investor Day and in future presentations. Thank you for your question; it’s a valuable topic for discussion.

Kevin Krishnaratne, Analyst

Great. Look forward to the progress and congrats again and pass the line.

Madhu Ranganathan, CFO

Thank you.

Operator, Conference Operator

The next question comes from Stephanie Price of CIBC. Please go ahead.

Stephanie Price, Analyst

Good evening and thanks for taking my question.

Mark Barrenechea, CEO

Hi Stephanie.

Stephanie Price, Analyst

Hi. I wanted to just focus in on that fiscal 2023 and fiscal 2024 target markets, oh, sorry, target model. And maybe talk a little bit about where you potentially baked in some conservatism and what you think kind of get you to exceed potentially the targets that you've set out, especially on the margin side?

Mark Barrenechea, CEO

Yes. If there's any model questions of Target, I hand that to Madhu first, and then I can take maybe the second part. Any questions on the model you want to go through, Steph?

Stephanie Price, Analyst

Just more generally on where you might have baked in some conservatism in that fiscal 2023 and fiscal 2024 target model. Just thinking about upside from here.

Madhu Ranganathan, CFO

Yes, I'll address that, Stephanie. Firstly, we have a well-informed baseline for Micro Focus. We've provided detailed insights over the past five months, which show that there is significant seasonality to support both us and you. Regarding fiscal 2023, we've indicated where we anticipate Micro Focus's numbers will land. Compared to the historical adjusted EBITDA, these numbers are currently impacted by the three factors I previously mentioned: some license impacts, lease accounting, and R&D capitalization. The transition from IFRS to US GAAP for Micro Focus has been clearly aligned. In fiscal 2023, as we examine our annual model ranges, we expect our enterprise cloud bookings to continue at over 15%. Our cloud revenue, which includes Micro Focus, is projected to be between 11% and 13%, an increase from the previous 8% to 10% for OpenText alone. In summary, the strong demand for cloud bookings and revenue is accurately reflected in our target model as integration efforts commence. I've also discussed some integration costs we will encounter, all of which have been taken into account.

Mark Barrenechea, CEO

And Stephanie, I would add two points to Madhu's comments. To achieve the targets we’ve set, we need to determine whether they are conservative or can be exceeded. I am very confident in our ability to meet these great targets based on our track record of large acquisitions over the past decade. If we can accelerate our pace, the results will follow suit. I would be pleased to achieve an adjusted EBITDA between $2.1 billion and $2.24 billion for 2024, but it would be even better if we could do it a bit faster, which should lead to improved results. Additionally, I appreciate our exposure to the euro. With OpenText and now the Micro Focus customers included in OpenText, a rising euro benefits us. I also value our diverse geographic business mix, so if the euro increases, we are well-positioned.

Stephanie Price, Analyst

Thank you for that. I have one last question. I'm curious about your approach to R&D and how you plan to combine it within the business. What areas do you plan to prioritize after the Micro Focus acquisition?

Mark Barrenechea, CEO

Yes. As we have integrated the two organizations, you'll see that in fiscal 2023, our engineering investment is projected to be between 14% to 16%.

Madhu Ranganathan, CFO

The partial year.

Mark Barrenechea, CEO

On the partial year. And you can expect it on a combined basis to pick up from the previous OpenText model, right? So, it's not just up on a combined basis, it's up because we're going to be investing to accelerate cloud. Continue to accelerate cloud 15% plus bookings growth. And you can see our fiscal 2026 aspirations of obviously to the organic growth. Madhu?

Madhu Ranganathan, CFO

Give the 7% to 9%.

Mark Barrenechea, CEO

7% to 9% organic cloud revenue growth in fiscal 2026. That's a big number, very important number, a strategic set of initiatives for us. So you can see that R&D percent up 15% plus cloud bookings growth, and 7% to 9% organic cloud revenue growth as we approach at 26%. So where is that investment going to go? It's going to go right to where I highlight in my script today. I won't repeat it, but we'll go back to the transcript I outlined quite precisely where the priority is going to be.

Madhu Ranganathan, CFO

And Mark, I was just going to add and certainly amplify definitely the global footprint of R&D; new professionals we are acquiring to add to the OpenText team is quite incredible. Then it's going to be somewhere to 8,000 people. We have a huge concentration in India now including Canada, Germany, et cetera. So, I mean I was just going to add the quality and caliber of the skill sets of the R&D professionals. I mean, it's really going to be very strong.

Stephanie Price, Analyst

Great. Thank you very much.

Madhu Ranganathan, CFO

Thank you.

Operator, Conference Operator

The next question comes from Thanos Moschopoulos of BMO Capital Markets. Please go ahead.

Thanos Moschopoulos, Analyst

Hi. Good afternoon. Madhu, can you clarify the difference between IFRS US GAAP that you referenced on the licenses? Is it that they were booking upfront license on multiyear terms and you're going to recognize it ratably or what's the dynamic there as you go from Micro Focus?

Madhu Ranganathan, CFO

Yes, of course, happy to. I specifically mentioned the license renewals, which means the IFRS allows you to take it upon signing of a renewal contract, whether it's in the U.S. GAAP, you start to take revenue obviously on a ratable basis upon the official date of the renewal when you start delivering the services, so that's the big difference. And the other two pieces, as I mentioned, IFRS allows a higher rate of R&D capitalization than US GAAP does and lease accounting in US GAAP is treated as rent, so it goes into the operating expense model, as a full appreciation.

Thanos Moschopoulos, Analyst

Great. And then just to clarify since it's hard for us to do an apples-to-apples comparison, if we look at your fiscal 2023 revenue contribution from Micro Focus, apples-to-apples, does that sort of imply a single-digit type of organic decline or might it be larger than that initially because of some of the near-term integration?

Madhu Ranganathan, CFO

Yes. Is that question, Thanos to Micro Focus? Because if you look at our target model, OpenText, the organic growth is still making 1% to 2%, was your question specific to Micro Focus.

Thanos Moschopoulos, Analyst

Specific to the Micro Focus contribution implied in the fiscal 2023 guidance, is that assume sort of apples-to-apples, yes?

Madhu Ranganathan, CFO

I would say the best reference for the Micro Focus contribution is the range of $870 million to $920 million, with a baseline of $2.3 billion for fiscal 2024. This approach removes the uncertainty regarding whether the actual figure will be over or under, and this is our well-informed estimate for the partial year, along with the baseline revenue for fiscal 2024.

Mark Barrenechea, CEO

Yes. Thanos just to add to that, look, I'm expecting solid performance from Micro Focus on these five months. It's really tough. And I don't actually think it's meaningful to look at those five months a year ago because they didn't run the business that way. And they don't have an end of March, right? They didn't have an end of March had an end of April, we have an end of March. They didn't have an end of June, right? They had an end of October. So we're going to get them on board to our periods, and we're going to drive performance hard. The team is quite motivated, right? So I'm expecting solid performance, as Madhu highlighted $870 million to $920 million do not annualize that number, because they didn't run as an IFS reporter every six months to our period. So we get all that period stuff out of the way, immediately, we can get all that noise out of the system. We've aligned to our calendar. And we wanted to make it easy for you and say, it's $870 to $920 million. And next year, the baseline is $2.33. But we expect strong performance, strong customer wins. I can't wait to shout some out when we close the quarter.

Thanos Moschopoulos, Analyst

Perfect. I appreciate all that and appreciate all the guidance and stuff you provided. Thanks.

Madhu Ranganathan, CFO

Thank you.

Mark Barrenechea, CEO

Thank you.

Operator, Conference Operator

The next question comes from Richard Tse of National Bank Financial. Please go ahead.

Richard Tse, Analyst

Yes. Thanks for providing all the color. That's super helpful in terms of kind of helping us forecast the outlook. I just have one question. It looks like a great transaction from a valuation standpoint, everything. If there were any potential blind spots, where would they be sort of based on your past experience with previous acquisitions?

Mark Barrenechea, CEO

Yeah, it, fair enough. Look, I always thought to the house is our talent, which we're off to a great start on understanding customer needs, and that's going to be a big outreach for us. On the system side, in this case, we're integrating to our systems. And I appreciate all the work that they've done historically, but we're taking their product line, and we're integrating into SAP, or integrating into our sales force. We'll integrate into our M365 teams environment. We'll integrate into our information system. So typically, there could be surprises on the system side, but we'll be integrating into our world-class tech stack that run and scales OpenText. So I think it's the usual markers that we're going to continue to pay, obviously, very close attention to people, customers, and systems.

Richard Tse, Analyst

Okay. Great. Thank you.

Operator, Conference Operator

The next question comes from Daniel Chan of TD Securities. Please go ahead.

Daniel Chan, Analyst

Hey, Mark. Now that the deal is closed, I'm hoping you can give us more color on how some of those early conversations are going with Micro Focus' customers on being able to cross-sell cost services into the installations?

Mark Barrenechea, CEO

I've had a busy week speaking to nearly a dozen customers, and the main takeaway is that they are very pleased with the current state of our products and the talent behind them. Customers appreciate where Micro Focus products are positioned and see many joint opportunities for integration. There are exciting use cases and potential emerging, reinforcing our belief that faster integration is a key value driver. It’s important to note that they haven’t traditionally had a culture of innovation. We have a CEO, CTO, and an excellent Head of Engineering, and we’re structured to focus on innovation with our rapid 90-day cycles. They have a highly skilled engineering team that is now equipped with more tools, which will enhance their capabilities. Overall, it’s a strong validation of our strategy, emphasizing the importance of talented people, quality products, quicker operations, and expanding cloud options, particularly with private cloud setups and more API development.

Daniel Chan, Analyst

Sounds good. Thanks for that. And then maybe switching gears to the renewals business. Based on our prior conversations, it sounds like you had some pretty big structural shifts in changing micro focuses renewals business. So what's the timeline on completely revamping that business? And how long do you think it will take before we start seeing those renewal rates start to improve?

Mark Barrenechea, CEO

Their renewal rates are in the low 80s, while ours were in the mid-90s for Q2. Our business approach has elevated our renewal rates over time towards expansion business, and I intend to eventually discuss expansion rates in comparison to renewal rates. This is significant as we aim to grow our $2 billion cloud business and beyond; our focus will shift from renewal rates to expansion rates. However, for now, we are seeing strong mid-90s performance, while they are at low 80s. We are actively implementing the OpenText model, which emphasizes land, operate, value, and expand, with a focus on renewal centralization, new procedures, and direct authority, rather than through partners. We anticipate that by the end of FY 2025 we will elevate their rates to match ours, making gradual improvements along the way. Renewals occur in one-year cycles, and as we integrate more effectively and accelerate our offerings, we will see consistent progress. While the current renewal rate serves as a lagging indicator, we expect to reach our target rate by the end of FY 2025 and will keep you informed throughout the process.

Daniel Chan, Analyst

Thank you.

Operator, Conference Operator

The next question comes from Steven Li of Raymond James. Please, go ahead.

Steven Li, Analyst

Hey, guys. Hi, Mark. Hi, Madhu. So I understand IFRS to GAAP has an impact on it. But the free cash flow also looks a bit off. So what I'm looking at is OpenText on its own TTM generated $800 million. The free cash flow with Micro Focus for 2023 is below that, and for 2024 is $800 million to $900 million. And I already had OpenText in that range. So my question is why is Micro Focus not additive to free cash flow for the first six quarters?

Madhu Ranganathan, CFO

Thank you for the question, Steve. Referring back to the expenses I mentioned, the $400 million cost reduction is certainly relevant as we consider fiscal years 2023 and 2024. Additionally, we have special charges and integration costs that need to be addressed. I want to clarify that all these costs, whether they fall under non-GAAP or otherwise, do affect free cash flow. We anticipate around $80 million in integration expenses and about $380 million in total, including $220 million related to special charges and cash outflows as we streamline our global operations. The merged company will be quite large and complex, and rationalizing these operations requires investments and expenses. We also have considerable interest expenses to factor in. Throughout fiscal 2023 and 2024, while setting aside interest expenses, we expect charges to impact cash flows, but we should start recovering quickly, aiming for $1.5 billion or more as early as fiscal 2025. It's important to mention that during this process, we expect to steadily improve Micro Focus working capital from the outset and maintain strong performance with OpenText working capital as well.

Steven Li, Analyst

Madhu, to clarify, when Micro Focus acquired the HP assets, they implemented a reverse moving structure. Is that reflected in your numbers, and when does it expire? Is it already gone?

Mark Barrenechea, CEO

It's gone; does not exist. It's their history; does not exist at OpenText.

Madhu Ranganathan, CFO

Right. I was just going to add that our efforts on this are going to be grounds-up brand new; taking what they have today and looking at the opportunities for optimization ahead. But I agree with Mark on the divers’ more tough question.

Mark Barrenechea, CEO

Yeah, absolutely gone; doesn't exist. Stephen, if I can. I just want to note something, right? So we're being crystal clear on what our free cash flow targets are, right? $500 million to $600 million in fiscal '23, $800 million to $900 million in fiscal '24, and $1.5 billion plus in fiscal '26. So I know you can see that place will be crystal clear, right, that we're providing that visibility today. As Madhu noted, I do want to make kind of three pieces of emphasis that in fiscal '24, we're not reaching our free cash flow potential yet. We're reaching our EBITDA potential of $2.1 billion to $2.24 billion in adjusted EBITDA, but we have three things going on that are really important. One is the integration expenses, as Madhu spoke about. We're going for a rapid integration, and we're going for simplification, right? We are going to simplify this business and we're going to do it upfront. Legal entity structures, all the things Madhu talked about, the word simplification; and three, we're investing in our cloud. 15% plus cloud bookings growth, 7% to 9% organic cloud revenue growth in fiscal '26, and that takes investment. Those are the three things that we've decided on to make, as you say, over the next six months, six quarters.

Steven Li, Analyst

Thank you. Very helpful, Mark and Madhu.

Madhu Ranganathan, CFO

Thank you.

Operator, Conference Operator

Thank you. I will now hand the call back over to Mr. Barrenechea for closing remarks.

Mark Barrenechea, CEO

All right. Thank you, everyone. I know today's call ran a little longer than usual, and our script is a bit more fulsome than most. But Madhu and I felt it was very important to provide this level of visibility and simplification to how we're looking at the Micro Focus business and their products combined into OpenText. And I hope you'll join us live tomorrow as we open the NASDAQ from the National Arts Center here in Ottawa. Have a good evening.

Operator, Conference Operator

Thank you. This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.