Earnings Call Transcript - OTEX Q3 2024

Operator, Operator

Thank you for your patience. This is the conference operator. Welcome to the Open Text Corporation Third Quarter Fiscal 2024 Financial Results Conference Call. Please note that all participants are in listen-only mode, and the conference is being recorded. Following the presentation, there will be a question and answer session for analysts. I will now hand the conference over to Harry Blount, Senior Vice President of Investor Relations. Please proceed.

Harry Blount, Senior Vice President, Investor Relations

Good afternoon, everyone, and welcome to OpenText's third quarter fiscal 2024 earnings call. With me on the call today are OpenText's Chief Executive Officer and Chief Technology Officer, Mark J. Barrenechea, and OpenText's President, Chief Financial Officer and Corporate Development, 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 supplement our prepared remarks and can be accessed on the OpenText investor relations website, investors.opentext.com. I'm pleased to inform you that OpenText management will be participating at the following upcoming conferences. Needham Technology, Media & Consumer Conference on May 14th in New York. Barclays Leveraged Finance Conference on May 21st in Austin, CIBC Technology & Innovation Conference on May 22nd in Toronto. Jefferies Software Conference on May 30th in Newport Coast, and Bank of America Global Tech Conference on June 6 in San Francisco. And now on to our safe harbor statement. During this call, we will make forward-looking statements relating to the future performance of OpenText. These statements are based on current expectations, assumptions, and other material factors that are subject to risks and uncertainties and actual results could differ materially from the forward-looking statements made today. Additional information about the material factors that could cause actual results to differ materially from such forward-looking statements as well as risk factors that may impact future performance results of OpenText are contained in OpenText’s recent Forms 10-K and 10-Q as well as in our press release that was distributed earlier this afternoon, which may be found on our website. We undertake no obligation to update these forward-looking statements unless required to do so by law. In addition, our conference call may include discussions of certain non-GAAP financial measures. Reconciliations of any non-GAAP financial measures to their most direct, comparable GAAP measures may be found within our public filings and other materials which are available on our website. And with that, I'm pleased to hand the call over to Mark.

Mark J. Barrenechea, CEO

Thank you, Harry, and welcome to today's call. Let me kick off the call with a statement. The strategic value of OpenText to our customers has never been higher. We continue to build cloud momentum with our business clouds, business AI, and business technology. And we see proof points of this as evidenced by our continued strength with large multi-year cloud contracts and our upward revisions in future cloud bookings expectations. And with the AMC divestiture now complete, we have increased our capital flexibility to accelerate growth in the $200 billion information management addressable market. Long term, we expect our business to deliver mid-single-digit total revenue growth through a balanced approach of cloud-led organic growth plus M&A comprised of 20% plus enterprise cloud bookings growth, 7% to 9% organic cloud growth, 2% to 4% total organic growth, and 1% to 2% M&A growth, powerful cash flows at 20% plus of revenues, and a new return of capital framework comprised of 50% of trailing 12-month free cash flows returned to shareholders in the form of dividends and share buybacks and 50% for Cloud M&A. And to jumpstart this new return of capital program, we are announcing today a $250 million share buyback over the next 12 months, and our intention to return $450 million to $500 million of capital to shareholders in fiscal '25. Let's get started. You'll see in our investor deck today our four-point strategy to building shareholder value. Point one of the strategy is to continue to lead the OpenText business system with a relentless focus on execution. Simply said, an OpenTexter always puts customers first, innovates, cares about people, and strives for exceptional performance. Our culture sets us apart. Point two, accelerate cloud growth. Our strategy to accelerate cloud growth is working. We've increased our R&D investment to an annualized $900 million, or 16% of fiscal '24 revenue. This helped drive enterprise cloud bookings growth of 63% in Q2 and 53% in Q3. We've increased our fiscal '24 enterprise cloud bookings targets to 33% to 38%. And we're confidently projecting 20% plus cloud bookings growth in both fiscal '25 and beyond, up from prior targets of 15%. We expect our cloud revenue organic growth to reach between 7% and 9% by fiscal '27. And the best part is we're just getting started in our AI and security journey. The OpenText Cloud opportunity continues to expand across our business clouds, business AI, and business technology. We are well aligned to Gartner and customer spending priorities in cyber, information security, data, cloud platforms, and AI. We're focused on winning more workloads for knowledge workers, business networks, customer experience, and digital operations. We're helping customers build and own their own capabilities in the private and public cloud and to do so securely. We're unlocking new developer opportunities in large-scale software companies and let's understand it, we're all software companies today and we're rapidly adding IoT and AI capabilities. We see two huge opportunities in AI. First, to help our large installation base of customers prepare their operations and data through systems consolidations to our Cloud Editions. And second, to grow our Aviator and Trust offerings. We officially introduced Titanium X at OpenText World Europe a couple of weeks ago, our next-generation autonomous cloud. We demonstrated our latest Aviator technology with Cloud Editions 24.2. We made business AI as easy as pressing a button. And we made clear the step function in productivity a knowledge worker can gain with learning models applied to information management. Customer analyst feedback is extremely positive. And while many customers are still researching and piloting, Aviator is helping us win now. We have unique capabilities to move enterprises into actionable business AI use cases to securely exploit both unstructured and structured data and accelerate customer value through partnerships like SAP, Google, and Microsoft. Consider Pick n Pay, leveraging DevOps Aviator for scaling testing and quality. A leading global apparel company accelerating invoice intelligence with Content Aviator. Zurich Airport leveraging our SaaS service management and universal discovery in the cloud. Please watch on opentext.com the recap of our OpenText World Europe where I demonstrated OpenText’s Content Cloud 24.2 with Content and Search Aviator, running the United States National Transportation Security Board data archive. It shows the power of automation plus AI, providing clear and bankable productivity gains for any knowledge worker. You can also hear directly from our customers at Nationwide, Carl Zeiss, Juniper, Framatome, and Criteo at the event. Point three of our four-point strategy, powerful free cash flow generation. We are targeting a fiscal '24 free cash flow of $725 million to $800 million, and our medium-term aspiration by fiscal '27 of $1.2 billion to $1.3 billion, or 20% plus of free cash flow as a percent of revenue. We expect to achieve these higher free cash flow aspirations through a series of actions. Adjusted EBITDA margin expansion from a technology-enabled business through leveraging our data, automation, and AI. We are just getting started in deploying AI internally, completing all micro-focused integration expense, lower special charges over time, lower interest charges, and potentially lower rates over time. It is a combination of margin expansion, more technology enablement, elimination of integration expense, and a reduction in interest burden that is the path to our free cash flow aspirations. Point four, disciplined capital allocation. We expect to pay down our debt on May 6th by $2 billion, and with our net leverage ratio now below 3x, we are increasing our return to capital to shareholders by introducing a $250 million buyback and re-entering the M&A market with a new framework that is future-oriented while leveraging the best parts of our operational disciplines. You will see in our investor presentation today our capital allocation strategy comprised of two elements, primary and additional allocation. For the primary, we intend to allocate 50% of our trailing 12-month free cash flow to dividends and buybacks. We have a strong dividend track record, as you know, of returning $1.9 billion over the last decade. I'm now pleased to add a buyback program to that return strategy. As noted, our target is 50% of trailing 12-month free cash flow allocation. And we're going to start higher with a $250 million buyback, and we intend to return again between $450 million to $500 million to shareholders in fiscal '25. For the additional part, we intend to allocate the other 50% of trailing 12 months free cash flows to cloud-based M&A. Further, we are excited about the M&A opportunity for information management in the cloud for higher recurring revenues. We intend to cast a wide net across information management for established technologies with proven customer value propositions. We're looking for small to medium-sized cloud companies that will benefit from our business system, general operations, benefit from our distribution, and benefit from our multi-billion dollar cloud foundation and cloud operations. We'll always seek value in organic growth. You can expect us to complete multiple M&A transactions in the coming years while growing organically. Let me turn to our financials and our medium-term aspirations. For Q3, our results reflect strong execution and strong customer trust. On cloud bookings, $165 million, up 53% year-over-year. We more than doubled our $1 million plus wins year-over-year from 13 to 28. Average cloud deal size is up 30%. Contract terms are longer. Customers are increasing their commitments for long-term durations with ramps to full value. Our investment is also up to fuel that growth, to get customers ramped, and to introduce new capabilities like AI and IoT. We have total revenues of $1.4 billion, up 16% year-over-year. We ended cash of $1.1 billion and free cash flow of $348 million, up 14% and just had fantastic wins at Akamai, Nestle, Shell, Tyson Foods, BAE Systems, and MAN. Recall, we're an annual business, and for full fiscal of '24, our targets include cloud bookings growth between 33% to 38%, 6% to 8% cloud growth, total revenues between $5.745 billion to $5.795 billion, and free cash flows between $725 million to $800 million, up from $655 million last year. Today we're also presenting preliminary fiscal '25 targets and subject to change. These preliminary targets are without the AMC business. We're expecting enterprise bookings of 20% plus, cloud revenues of up to $1.9 billion, total revenues between $5.3 billion and $5.4 billion, free cash flows between $575 million to $650 million, which includes, really important, a one-time $250 million tax payment for the AMC divestiture. Excluding our tax payment from divestiture, our free cash flow would be growing again year-over-year. And we will talk more about this. And again, a return of capital between $450 million to $500 million. We're excited about our cloud business, cloud additions, Titanium X, our next-generational autonomous cloud, security, SAP, and Aviators. Our cloud bookings are strong and growing faster than the market, and it's a leading indicator of our cloud momentum. We're also maintaining our medium-term aspirations but moving them from '26 to '27. Why? Customers are trending more and more to sign larger contracts with longer-term commitments of four-plus years that also include ramps. This is driven by industry trends and our strong multi-year roadmap of capabilities. This is positive news. Customers are increasing their commitments to OpenText for longer durations. You also see this positive trend from other cloud providers such as SAP, Google, Microsoft, and AWS, our most important partners. Our fiscal '27 aspirations include enterprise cloud bookings of 20% plus, total revenues of $5.7 billion to $5.9 billion, cloud organic growth of 7% to 9%, total organic growth 2% to 4%, adjusted EBITDA of 36% to 38%, and free cash flow between $1.2 billion and $1.3 billion, reflecting strong continuous growth. And M&A will contribute to these aspirations. Well, let me wrap up and thank you for joining today. And let me conclude my remarks where I started. The strategic value of OpenText to our customers has never been higher. We're increasingly confident about our business, our ability to grow in the cloud, and produce higher profits from these higher revenues. And that's reflected in our increased visibility today that we are providing. To recap, OpenText has a highly attractive financial model with a predictable, resilient, and growing revenue stream, top quartile adjusted EBITDA margins, and growing free cash flows and a very strong balance sheet. Our four-point strategy is designed to build shareholder value and to create a long-term recurring revenue and highly profitable business model. And we're excited to reduce our debt by $2 billion, execute to a $250 million buyback, and a new return of capital strategy, return to M&A, and deliver a stellar fiscal '24 of 6% to 8% cloud growth. I want to express my deepest appreciation to the entire OpenText executive team and my colleagues for always putting customers first, innovating, caring about people, and for their exceptional performance. I'm delighted to welcome Todd Cione, President of Worldwide Sales, responsible for all new sales. Let me congratulate Paul Duggan, President and Chief Customer Officer, responsible for all renewals, professional services, and support. And to Madhu Ranganathan, President and CFO, responsible for finance, operations, and corporate development. Please visit opentext.com to read about our exceptional leadership team, ready for the next growth chapter in our business clouds, business AI, and business technology. May the one that brings peace bring peace for all. Let me turn the call over to Madhu, but before I do, I want to wish Madhu a very happy birthday today.

Madhu Ranganathan, President and CFO

Great, Thank you, Mark. And we appreciate all of you joining us today. So let me start with a few key points. In Q3, we successfully achieved our operating goals while focusing on initiatives for growing our cloud business. This was our 13th quarter of organic cloud growth. We announced yesterday, May 1st, that we have successfully completed divesting the AMC assets. This transaction returns us to capital flexibility. Last quarter, I mentioned that Micro Focus will be on our operating model, both adjusted EBITDA and free cash flows, as well as returning to organic growth by the end of fiscal 2024, we are on track to achieving that. Our outlook, targets, and aspirations fully reflect the opportunity in front of OpenText with enterprise cloud bookings leading the way as our customers prepare for AI. Mark spoke to our Q3 results and let me share some additional comments. During the call, I will refer to the investor presentation posted on our IR website. All references are in millions of USD and compared to the same period in the prior fiscal year and are on a reported basis unless stated otherwise. On a year-over-year basis, Q3 cloud revenue was $455 million, up 4.4% as well as 4.4% in constant currency. Our enterprise cloud business is doing extremely well with 53% year-over-year bookings growth in the quarter, increasing our visibility towards cloud revenue growth. Q3 ARR, annual recurring revenue, of $1.146 billion, up 13.3% and 13.1% in constant currency, that represents approximately 79.2% of total revenue. And now moving to other financial metrics. GAAP net income was $98.3 million, reflecting increased interest expense amortization and special charges that relate to the broader acquisition of Micro Focus, driving GAAP EPS of $0.36. GAAP gross margin of 73%, up from 70.3%, also reflecting a healthy revenue contribution from our customer support and licensed businesses. Non-GAAP gross margin of 76.7%, up from 75.8%, also reflecting increased relative contribution from a revenue standpoint from customer support and license. Adjusted EBITDA was $463.7 million, an increase of 27% and 26.4% in constant currency. Our adjusted EBITDA margin was 32% as we continued to make solid progress bringing Micro Focus to our operating model. Adjusted EPS was $0.94, was up 28.8%, and the same in constant currency. Our overall working capital performance remains strong with our DSOs at 45 days that was consistent with Q3 of the prior year. We generated $384.7 million in operating cash flows and $348.2 million free cash flows in the quarter. Turning to the balance sheet, we finished Q3 with $1.125 billion in cash. Our net leverage ratio on March 31st was 3.8 times. With the successful completion of AMC divestiture, we have provided notice of our intent to prepay $1.060 billion of the acquisition term loan as well as to prepay in full the $940 million outstanding principal balance of the Term Loan B. That is a total of $2 billion debt repayments that we expect to make on May 6, which will bring our net leverage ratio to less than three times. The repayment will reduce our debt from $8.5 billion to $6.5 billion, and our annual interest expense from $537 million to $383 million, a reduction of $150 million. We're extremely satisfied with the outcome and well positioned to execute on our capital allocation program given this flexibility. Now regarding M&A, our capital allocation model leaves ample room to invest in strategic M&A to drive future cloud growth. In my expanded role as President, I'm excited to lead our corporate development function. As Mark noted, we expect to do multiple deals, targeting small to medium sized cloud businesses. We have fully outlined our cloud M&A strategy on Page 26 of our investor deck. Turning to the dividend program. On April 30th, our Board of Directors also approved a quarterly cash dividend of $0.25 per common share. The record date for the next quarterly dividend is May 31st, 2024, and the payment date is June 18th, 2024. OpenText ex AMC. Yesterday, after we announced the divestiture completion of the AMC business, we also filed pro forma statements to provide a historic view of how our business looked from July to December 2023 without AMC. I'll walk through a few points to ensure your financial models and year-over-year comparisons are accurate. Please also refer to slide 32. For fiscal 2023 actuals, AMC revenue is approximately $225 million and primarily representing the five months of AMC business since the original close of the acquisition. For fiscal 2024, AMC business annualized is approximately $528 million of revenue. Given completion of divestiture on May 1st, earlier than our previous target of June 30th, 2024, we're reducing our fiscal 2024 target model by approximately $100 million, the expected AMC revenue contribution for the months of May and June 2024. There will be no AMC revenues in fiscal 2025 and beyond. And now let me turn to our outlook starting on Page 36. Starting with our Q4 fiscal '24 quarterly factors in our investor presentation, revenue on a year-over-year basis, we expect $1.39 billion to $1.44 billion. ARR of $1.08 billion to $1.12 billion, a slight FX headwind. Adjusted EBITDA margin between 32.5% and 33.5%. Our assumptions today include the following. AMC divestiture closed as of May 1st and removing two months of AMC business from Q4, including a reduction in Q4 and fiscal '24 revenue of approximately $100 million, as I mentioned earlier. AMC divestiture related expenses now included in Q4. And regarding our cloud business, we now have a second consecutive data point with strong cloud bookings of 53% growth in the third quarter and greater than 60% growth in our second quarter. The longer-term customer commitments and ramps we are seeing are now factored into the Q4 revenue projections. We have also now further increased our cloud investments in SaaS, IoT, and security. Last is our AI and customer investment, which are further increased in Q4 as we see continued benefit to cloud bookings. Our fiscal '24 target model in constant currency is provided on Page 38. So building on my prior comments, the target model ranges for fiscal '24 reflect only 10 months of contribution from AMC. Total revenues between $5.745 billion to $5.795 billion. Total revenue growth of 27% with organic growth in the range of 1% to 2%. Cloud revenue growth, 6% to 8%. Enterprise cloud bookings growing 33% to 38%. Annual recurring revenue up 23.5% to 25.5%. Adjusted EBITDA margin in the range of 33.5% to 34.5%, again, reflecting higher investments in AI and cloud sales and marketing, expenses related to the AMC divestiture, and Micro Focus integration expenses. We expect full fiscal '24 free cash flows of $725 million to $800 million, again reflecting AMC divestiture closure two months earlier than expected. This excludes two months cash flow we would have seen from AMC of approximately $50 million and divestiture-related expenses of $40 million with a slight positive offset of lower interest. On Page 39, we have laid out our preliminary fiscal 2025 targets and fiscal 2027 aspirations. As Mark mentioned, we're maintaining our medium-term aspirations but moving from fiscal '26 to '27 driven by the cloud acceleration of our business. We now have increased our expected growth in cloud bookings to 20% plus annually. We continue to watch the markets closely on interest rates and currency, noting that our long-term models today do not assume any interest rate benefit or improvements in the euro or the yen. Both will positively benefit our model should they materialize. We expect total revenue in fiscal '25 to be $5.3 to $5.4 billion in constant currency with cloud growing to $1.85 to $1.9 billion. Our adjusted EBITDA will be lower, in the 32% to 33% in fiscal '25, and that reflects spending on our cloud and AI growth programs, as well as some trailing expenses from the Micro Focus acquisition. Free cash flows in fiscal '25 will be in the $575 million to $650 million range and include a one-time tax payment of $250 million relating to the gain of the AMC divestiture. Without the tax payment, free cash flow in fiscal '25 will grow year-over-year. The tax payment is expected to be made in Q1 of fiscal '25 and will be reflected in our Q1 and fiscal '25 free cash flows. The path to our fiscal 27 free cash flow aspirations of $1.2 billion to $1.3 billion is highlighted on Page 24 of our materials. Our goal to improve free cash flows to 20% of revenue is supported by greater scale and efficiencies including automation and AI. An example is Project Athena, utilizing our own AI technology to automate development. The following key improvements in fiscal '27 create a clear path in our planning towards reaching these 2027 aspirations. Adjusted EBITDA margin expansion of 36% to 38%. Interest expense post-deleveraging coming down approximately $150 million. Special charges reduction down approximately $30 million. And a one-time $250 million AMC tax charge that will be completed in fiscal '25. With all of this, we expect continuous future year-over-year growth in free cash flows. So in summary, when we talk about the OpenText financial profile, investors should think about a mid-single-digit growing software company led by cloud revenue growth plus small-to-mid cloud M&A. Shareholders can expect us to complete M&A transactions in a few years. We have established our return on capital framework to complement our dividends previously at 20% of trailing 12-month cash flows to 50% overall return on capital by leveraging a new share buyback program. We raised enterprise cloud bookings from 15% to 20% and have a clear path to growing free cash flows to 20% plus of revenues in fiscal '27. On behalf of OpenText, I would like to thank our shareholders, our loyal customers, and partners and to all the OpenText team members. I will now request the operator to open the call for your questions.

Operator, Operator

We will now begin the analyst question-and-answer session. The first question comes from Daniel Chan of TD Cowen. Please go ahead.

Daniel Chan, Analyst

Hi, guys. Just want to get some clarification on the pushout of the midterm aspirations from fiscal '26 to fiscal '27. Sounds like there's a lot of demand, a lot of strength, a lot of traction here. Just trying to understand why that pushes the aspirations out of year rather than pulling it forward.

Mark J. Barrenechea, CEO

Yeah, Dan, Mark here, thanks for the question. I'll just start obviously with the headline, which is we're divesting $528 million of revenue via the divestiture. And as I noted in my remarks, we're signing larger, longer-term cloud contracts that have ramps in them, ramps to full value, supported by strong multi-year roadmaps. We're also seeing and hearing from others in the industry, like SAP, Microsoft, Google, who are seeing various trends. Now, we have various accelerants that are not factored into those aspirations yet. Like faster cloud adoption, aka, can we grow faster than 20%, and can we get faster ramps. We haven't factored in yet AI taking off, we haven't factored in M&A, we haven't factored in the euro rebounding and helping customers spend more in Europe, if you will. So those are the reasons for maintaining the aspirations, but seeing them as part of fiscal '27, not part of fiscal '26.

Daniel Chan, Analyst

Okay, thanks for that, Mark. And then on the margin guide for next year, if I back out AMC from fiscal '24, it looks like EBITDA margin this year is expected to be about 32.5% as well based on your fiscal '24 targets. So you called out additional AI investments, AMC divestment, having an impact on some of those margins. Can you help break down what is driving, how much is coming from each of those? How much more are you accelerating R&D for AI investments that's causing that flattish EBITDA margin trajectory versus how much of it is going to come from additional expenses from AMC divestment? Thank you.

Madhu Ranganathan, President and CFO

Yeah, thank you again. The AMC divestiture expenses are predominantly in Q4. And if your question is about fiscal '25, the categories would be, as I mentioned earlier, it is certainly investing towards the cloud bookings growth and you'll see those investments predominantly in cost of sales and some below the line as well. When it comes to below the line, yes, we are absolutely investing in R&D line as well as sales and marketing. But also keep in mind, fiscal '25 adjusted EBITDA is growing from a year-over-year perspective.

Operator, Operator

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

Unidentified Analyst, Analyst

Thanks for taking the question. This is George on for Steve, and congrats on a great quarter. A lot going on, not least of which, happy birthday, Madhu.

Madhu Ranganathan, President and CFO

Thank you.

Unidentified Analyst, Analyst

Maybe just to start, the cloud bookings number, second really impressive growth number, obviously impacted by duration and maybe bumped up your long-term target to 20%. Maybe if you can just help us kind of tease apart, bumping that up, how much of that is kind of the underlying strength versus what you're seeing on the duration side?

Mark J. Barrenechea, CEO

Yeah, George, thank you for the question. No, it's definitely the strength of the portfolio, long-term roadmap. I encourage everyone to watch our demonstration of the United States National Transportation Security Board data archive and just the power of having Aviator or Business AI integrated into information management and it's helping us win now. So it's the strength of the underlying business. These are large numbers, 63% growth in Q2, 53% in Q3. We continue to see a strong pipeline on the cloud bookings. And like I noted, the duration is longer. Average deal size was up in Q3, 30%, contract terms are longer. We more than doubled our $1 million wins year-over-year from 13 to 28. So it's reflective of the strength of the product. That's the underlying reason.

Unidentified Analyst, Analyst

Got it. That makes sense. And I wanted to ask about what you're seeing from customers on AI budgeting. I think you kind of framed it in the past as kind of early spend really being about preparing data estates, so they can ultimately make the best use out of their data assets. Maybe if you could just talk about where customers are at on their journey of making those preparations and if you think about kind of the leading edge versus more the median customer?

Mark J. Barrenechea, CEO

Yes, as I mentioned earlier, it's a topic that's central to all our discussions and it’s very real. Some customers are exploring vision, while others are in the pilot phase. The strength of our larger, longer cloud contracts is that we understand the need for this. We're looking forward to seeing cloud bookings increase, but we recognize it will take time to ramp up. There's no question that customers are consolidating and gearing up for AI because investing in fragmented systems and data is not efficient. We have some internal preparations to undertake in our systems before we can fully leverage the productivity benefits of a language model. This topic comes up in every conversation. Our Aviator tool is contributing to our current success, and you can see that reflected in our bookings. For instance, Pick n Pay has gone live with DevOps Aviator, indicating we are moving forward into production.

Unidentified Analyst, Analyst

Great. Thanks for taking the questions.

Mark J. Barrenechea, CEO

Yeah, thank you, George.

Operator, Operator

The next question comes from Paul Treiber of RBC Capital Markets. Please go ahead.

Paul Treiber, Analyst

Thanks so much and good afternoon. First question, just on the M&A strategy, you mentioned to be more cloud oriented, but then also you remain a value buyer. Can you just elaborate on what you mean and how you bridge those two? I mean, how should we think about valuations that you would consider deploying capital at versus what you typically in the past deployed it at?

Mark J. Barrenechea, CEO

We believe the two are complementary as we continue to focus on value and organic growth. It's all about the future. We have insights from the past, but the framework being announced, which Madhu has played a significant role in, emphasizes a future-oriented approach with Corporate Development as part of Madhu's team. We're pursuing cloud revenues and high recurring revenues rather than licensed businesses. Our past experiences are interesting, but it's about moving forward. We're leveraging our maintenance and the scale from the 80 license acquisitions we made, and we now have nearly a $2 billion cloud platform, which will provide leverage going forward. While we expect to gain general operating synergies from acquiring companies, we are particularly excited about acquiring cloud companies that can take advantage of our operational scale in the cloud and achieve growth synergies. We will remain focused on value. I'm not here to discuss specific multiples, but we will target small to medium-sized companies that align with our value-driven approach and can benefit from our operational discipline, distribution, and extensive cloud operational scale. Madhu, is there anything you would like to add?

Madhu Ranganathan, President and CFO

Thank you, Mark. I'm completely aligned. And as I said, looking forward to putting these assets in motion.

Mark J. Barrenechea, CEO

And expect us to close multiple transactions over the next 12 months.

Paul Treiber, Analyst

Thanks for that. The second question is on longer-term free cash flow conversion. You mentioned a couple of drivers that will help improve it. But what do you see? How do you rank them in terms of the most material ones that you see executing on in the near term to drive it up?

Madhu Ranganathan, President and CFO

I'll take that one, Paul. Mark, feel free to add your thoughts. First off, by fiscal '27, we expect the growth in cloud revenue at scale to boost adjusted EBITDA margin. Additionally, we believe the investments we're currently making in the cloud, primarily in '24 and '25, will yield significant returns by '27. We also anticipate improvements in cloud gross margin leading up to that point, which will help enhance the EBITDA margin. From a free cash flow standpoint, the savings we're realizing from de-leveraging will continue. As mentioned, we are not seeing any improvements in interest rates just yet. Special charges are projected to be slightly lower, and the AMC tax will also contribute positively. Importantly, as we scale in '27, we expect to gain efficiencies through automation and AI within OpenText, with Project Athena being one example. We're still in the early stages of developing this plan across the company as we approach the end of fiscal '24. Mark, do you have anything to add?

Mark J. Barrenechea, CEO

I'm really excited about our three President structure, with Todd leading our sales force, Paul overseeing aftersales for renewals, professional services, and support, and Madhu managing more operations. This allows me to focus on building a more efficient and scalable company, particularly through technology. We recently welcomed Shannon Bell as our new Chief Digital Officer and Chief Information Officer. It's like re-launching the company with AI tools and seeking the next level of efficiency. We see opportunities in support, pre-sales, and generated code, as highlighted with Athena. We're planning a new approach to digital renewals. This marks a new era of leveraging AI internally. To achieve our goal of $1.2 billion to $1.3 billion for fiscal '27, we must lead with technology-driven initiatives, utilizing automation, data, and AI.

Paul Treiber, Analyst

Thanks for taking the questions.

Mark J. Barrenechea, CEO

Thank you.

Operator, Operator

The next question comes from Samad Samana of Jefferies. Please go ahead.

Billy Fitzsimmons, Analyst

Hey everyone. This is Billy Fitzsimmons on for Samad from Jefferies. Last quarter you both talked about strengths in large enterprise, but maybe some potential weakness in SMB, which informed the guide. It sounds like the enterprise strength continued, but any change there quarter-over-quarter in terms of the SMB market? And then what did the fiscal Q4 guide assume in terms of macro? And obviously, it's still very early, but what did you assume around macro when putting together that initial fiscal 2025 guide?

Mark J. Barrenechea, CEO

Yeah, let me take the first part. Thanks for the question on SMB. Look, we're expecting an SMB uptick in fiscal '25. We have Microsoft, who's obviously our largest ecosystem partner here, pushing very hard in the market with Azure, Dynamics, and Copilot. We're also upgrading our own partner platform, really important. We've codenamed it El Dorado. And we'll be upgraded to this new platform that we've built later this year that's going to allow us to bring more product to market, more quickly, and go across more countries now, because we're primarily a US based SMB platform. We're also seeing higher partner engagement right now, especially with Cloud Editions 24.2 and what's coming in El Dorado. We're also seeing some churn in SMB resellers. I don't want to necessarily call them out, but some of the larger ones, we're seeing some churn. So we're actually excited about SMB. I know we've shouted out the last few quarters. We've had some modest headwinds. But we see it now back on an uptick starting in Q1 with the things I just outlined. And Madhu, anything you want to shout out on Q4 macro?

Madhu Ranganathan, President and CFO

Yep, so on the macro side from an externality perspective, we've certainly considered the geopolitical aspects and as you know, we have a very global business. And look, the lower GDP growth is everywhere and how that affects some of the customer decisions we've really factored that in. And inflation is high and we expect that to continue, right? And two other pieces if you consider the interest rate environment and the FX impact as I outlined in my commentaries, we're not assuming any benefit from the interest rate environment at this point and also we have a strong European business and an Asia business. So with respect to the euro and the yen, which are the key drivers for some of that revenue, we're also not assuming improvement in those currencies. And of course, if there's improvement there, our customers in those regions would also feel better about buying, but we're not assuming those benefits in our model.

Billy Fitzsimmons, Analyst

Super helpful. And then if I can sneak in a second question here, Mark, maybe building on some of the prior questions and answers around your Aviators investments and opportunity, given that you highlighted that Aviators helping OpenText win now and given what you've seen with the Get Your Wings program, maybe you could share some anecdotes or just general feedback from early customers who have adopted or tried these solutions.

Mark J. Barrenechea, CEO

Yeah, I'm very happy to. And I, look, seeing is believing. And I encourage everyone, we've posted some short clips on opentext.com of applying our content cloud, plus Content Aviator, and Search Aviator to the US National Transportation Security Board data archive. And that was the centerpiece of our demonstrations in Europe two weeks ago. I encourage everyone to watch it, because seeing is believing. And we had thousands of people across London, Munich, Paris. It was literally standing room only to watch that demonstration of applying a language model to a very rich data archive. And you can just see, as a knowledge worker, your life on just automation and your life with automation and AI. And what would take three weeks of a knowledge worker, we got down to three hours. And so I think seeing is believing, go check out the video. And the demonstration was live. It's our shipping product. It's the published NTSB data. It was literally us pressing a button. So look, everyone saw that. And you can see our every 90 day progress. So, Pick n Pay, using a different Aviator for testing in QA. A large apparel company inspecting invoices. A large manufacturer doing contract compliance. But we think that the heart of what we're going to do and win is that knowledge worker. And just like we went from no automation to content management, to digital folders, to search, to metadata, now this is the next progression in the evolution of knowledge management to bring in a language model. So obviously, you can hear the excitement in my voice, but seeing is believing. Go watch the demo and draw your own conclusions.

Billy Fitzsimmons, Analyst

Super helpful. Thank you both very much.

Mark J. Barrenechea, CEO

Thank you.

Madhu Ranganathan, President and CFO

Thank you.

Operator, Operator

The next question comes from Adhir Kadve of Eight Capital. Please go ahead.

Adhir Kadve, Analyst

Great, Thanks for taking my questions, guys. Mark, you mentioned that a lot of your customers continue to test different use cases. Obviously, you've given some anecdotes on what customers are using right now. But in your conversation with those customers, you also mentioned that a lot of them are doing the pre-work to kind of really kind of full-scale deploy AI. How long do you see that pre-work taking and kind of browsing that journey, and what and how long do you see until those full-scale deployments kind of take place?

Mark J. Barrenechea, CEO

Yeah, a great question. One of the strengths of having a market-leading professional services organization, I mean we have close to 2,000 billable consultants at OpenText covering every major theater in the global 10,000 is putting in place our Earn Your Wings program across that breadth. And since our first Aviator, I think we've collected over 100 use cases, right, across all our customer interactions. So there's probably three categories. There are those who are going to just continue to lightly experiment and understand. There are those that are going to take a very long view. Let me consolidate, get down to one, purify my data. And then there's probably the third case, which is they're going to go now because they can see the productivity gains in very specific use cases. So we're seeing success reflected in bookings. There's a ramp time, as we've noted. And look, I'm going to keep you updated every quarter on that progress. But I certainly would hope to see that next step up in revenue contribution in fiscal '25, even though in our preliminary numbers, we're not factoring that in yet.

Adhir Kadve, Analyst

Okay, great. And of course, all the talk about cloud is great to hear. My second question will be around Micro Focus and how that plays and that product feed plays into all of your cloud growth aspirations.

Mark J. Barrenechea, CEO

Absolutely. There are three main areas of focus. The first is IT operations management and digital operations along with service management. We are very enthusiastic about a new range of big data opportunities. At OpenText, we have always been engaged with big data, whether it involves contracts, employees, or invoices. IT operations management and digital operations provide us with access to additional significant datasets, particularly IT data and service data. We are pleased to integrate hybrid digital operations and service management into our offerings. The second area pertains to developers. I believe we cannot fully achieve our potential without empowering developers. Companies like Oracle, Microsoft, and SAP became what they are today by fostering strong developer communities. In addition to our application development management product line, we plan to enhance opportunities for developers. This forms a key part of our approach to thrust services, Athena, and comprehensive developer management. Currently, we are securing substantial business with large software companies, particularly in sectors like automotive, financial services, banking, biotech, and healthcare. We are genuinely excited about the progress in these areas.

Adhir Kadve, Analyst

Great, thanks a lot guys, I'll pass the line.

Operator, Operator

The next question comes from Thanos Moschopoulos of BMO capital markets. Please go ahead.

Thanos Moschopoulos, Analyst

Hi, good afternoon. A couple for Madhu and happy birthday by the way.

Madhu Ranganathan, President and CFO

Thank you.

Thanos Moschopoulos, Analyst

Madhu, can you remind us what your thoughts are on target leverage? So after you pay down the $2 billion, how high or not might you take leverage up again for future M&A?

Madhu Ranganathan, President and CFO

Yeah, absolutely. Perhaps I'll answer the question with respect to what we said on where we're targeting for M&A, right? Cloud's ARR small to medium sizes, right, so being under three pretty imminently, I do think we will come back to around the three-ish. Our M&A, the capital allocation program, as you saw, if primary, we refer to dividend and buybacks, but the second bucket is really the remainder of the 50% is M&A. So at the moment, I think with the $6.5 billion of debt, our own cash flows, the strategy around the acquisitions being small to mid, I think we expect to remain around the 3 times. And the last thing I'd say is the strategy around the small to mid cloud M&A is about those assets contributing to growth in the future, right? That also is going to again contribute to our free cash flow target, the $1.2 billion to $1.3 billion for fiscal '27. So again, that's how we're seeing it at this point in terms of M&A and annual leverage.

Thanos Moschopoulos, Analyst

Great. And just a point of clarification, the transition services agreement related to AMC, is that neutral to margins?

Madhu Ranganathan, President and CFO

Yes, that is neutral to margins at this point.

Thanos Moschopoulos, Analyst

Okay. Great. And then finally, maybe one for Mark. Just in terms of Micro Focus, outside of the AMC business, it seems like it's stabilizing based on the 10-Q disclosure, but just commentary there in terms of how close you are to that returning to organic growth? How much work may need to be done in that regard?

Mark J. Barrenechea, CEO

Thank you, Thanos, for your question. We anticipate that Micro Focus will achieve organic growth this year. Additionally, our renewal rates are performing exceptionally well. In Q3, we recorded renewal rates in the high 80s, marking our best performance since the acquisition, and we expect to maintain that level again this quarter. Following the divestiture of the mainframe, we are now concentrating on our three key areas: ITOM, which includes digital operations and service management, as well as our developer and security segments.

Thanos Moschopoulos, Analyst

Great, I'll pass the line, thanks.

Mark J. Barrenechea, CEO

Thank you.

Madhu Ranganathan, President and CFO

Thank you.

Operator, Operator

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

Kevin Krishnaratne, Analyst

Hey, good evening. Just a couple of small ones for me. I noticed in the deck that the cloud renewal rates inched down 92% from 93%. Just wondering what happened there and does that ramp back up in Q4?

Mark J. Barrenechea, CEO

Thank you for the question, Kevin. I'll address that. I want to clarify that the cloud renewal rate we present is a gross measure of cancellations only and does not account for the net effects of upsells or downsells. In comparison, our peers in the industry, particularly the larger multibillion-dollar cloud companies, report their figures differently, incorporating the impacts of both upsells and downsells. If we were to present our cloud renewal rate similarly, we would be in the high 90s for Q3. As we enter fiscal '25, we aim to align with industry standards. Currently, our reporting solely reflects gross cancellations, which is not the complete picture. Therefore, we’ll start using these new metrics in '25 and will keep you updated on our progress.

Kevin Krishnaratne, Analyst

Okay. That's very helpful. My other question is regarding the updated guidance for 2024. I've noticed that the growth in licenses and customer support has decreased, which I believe is partly due to the AMC divestiture. Could you remind us of the ratio of licenses to customer support for AMC? Additionally, excluding AMC, have your expectations changed regarding your ability to achieve a higher volume of license revenue bookings that usually occurs in the fourth quarter? I'm curious if the current outlook for the business remains consistent with what you observed in the second quarter compared to today's situation, particularly regarding the health of the business without AMC.

Madhu Ranganathan, President and CFO

Yes. So I'll take the first one on the AMC components of revenue. We've shared this before, cloud is still very small or zero from an AMC perspective, and PS is small. It's predominantly license and customer support.

Kevin Krishnaratne, Analyst

Got it. What is the mix between the license and customer support?

Madhu Ranganathan, President and CFO

License and customer support. I’m not sure we’ve shared that, but it is in our 305 filing, so you can certainly take a look at that.

Mark J. Barrenechea, CEO

We can follow up offline.

Madhu Ranganathan, President and CFO

Yeah, and we can actually follow up offline. So it's predominantly license and customer support given zero cloud and very small PS.

Mark J. Barrenechea, CEO

I presume that supports larger than license.

Madhu Ranganathan, President and CFO

The support would be larger than the license, yeah. And I think on your second piece in terms of Q4, what are we assuming as far as the license business goes. Is that your second question?

Kevin Krishnaratne, Analyst

Correct. Yeah, that's it. Yeah.

Madhu Ranganathan, President and CFO

In Q4, from a licensing perspective, both Micro Focus and OpenText are performing quite similarly. Looking back 18 months to when they had different fiscal year ends, we have integrated their compensation plans and regional focuses. I believe we have reached a stable point. Therefore, we should anticipate consistent business strength and focus from OpenText and, now excluding AMC, from Micro Focus as well.

Mark J. Barrenechea, CEO

Yeah. I mean the ITOM security and developer business units are on the mother ship cadence at OpenText, right? So they're well aligned to the end of our fiscal year and will be well aligned to our kick off July 1.

Kevin Krishnaratne, Analyst

Great. Thanks a lot. I’ll pass the line. Thank you.

Madhu Ranganathan, President and CFO

Yeah. Thank you, Kevin.

Operator, Operator

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

Stephanie Price, Analyst

Hi, good evening and happy birthday, Madhu.

Madhu Ranganathan, President and CFO

Thank you, Stephanie.

Stephanie Price, Analyst

I was hoping you could talk a little bit about the Micro Focus cost savings realization. Have there been any surprises in the process? And how should we think about the quantify the micro integration on the fiscal '25 adjusted EBITDA margin outlook?

Madhu Ranganathan, President and CFO

It's actually gone very well, and from a supply perspective, it has proceeded as we anticipated during our due diligence and planning stages. Micro Focus is on track with the OpenText operating model regarding adjusted EBITDA. The EBITDA has been affected by our efforts to reduce churn and return Micro Focus to organic growth. We will continue to optimize expenses, incorporating AI in our operations, particularly within OpenText’s environment. Overall, our design plan and our focus on operational excellence have remained aligned with our targets.

Stephanie Price, Analyst

Okay. Thanks. And then maybe another one for you, Madhu. Just on the cost of cloud services line. It seems to be ticking up here. Wondering how we should think about the puts and takes?

Madhu Ranganathan, President and CFO

Yes, absolutely. I'll address the cost aspect and see if Mark can add more from an environmental perspective. Our notable point is the 53% growth in cloud bookings during the third quarter, following over 60% in the second quarter. Looking back at the previous four to six quarters, we saw healthy growth, but this recent figure stands out. To maintain this momentum, we've adjusted our future projections upwards, which necessitates investment. These investments mainly focus on internal cloud infrastructure and partnerships with hyperscalers. While there is a gradual ramp-up, significant costs are involved. Mark has previously discussed the increasing compliance and certification requirements, including security measures for our cloud operations, which we are more than willing to undertake but do require upfront investments. Additionally, regarding margins for fiscal '27, these larger-scale investments are expected to optimize over time, resulting in greater benefits as we approach that year. Therefore, these investments are not linear but represent a significant step change.

Stephanie Price, Analyst

Great. Thank you.

Madhu Ranganathan, President and CFO

Thank you.

Operator, Operator

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

Mark J. Barrenechea, CEO

Very good. Well, let me thank everyone for joining us today. As you can see, we're extremely excited about our cloud and AI path in front of us. And Madhu, happy birthday, and thank you all for joining us today. That ends today's call.

Operator, Operator

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