Linux Growth Doesn't Offset NetWare Decline in Q1

Published: March 7, 2006

by Timothy Prickett Morgan

While Novell may be relatively new to the Linux game, it is no stranger to the difficulties of operating system transitions. Back when Linus Torvalds was just an unsatisfied young man who wanted a cheap Unix-oid operating system, Novell came out of nowhere to create a business based on cheap network operating systems. However, making the transition from NetWare to Linux is proving as troublesome as Novell's top brass has always said it would be.

When Novell last week announced its financial results for the fiscal first quarter ended January 31, it said that growth in its SUSE Linux and related products was decent, but that sales of its NetWare and Open Enterprise Server--a variant of NetWare that uses Linux as the operating system kernel that was announced last year--declined by 11 percent. Wall Street, which is not particularly patient with product transitions and which can still recall the boom when Red Hat went public nearly seven years ago, took the news about as well as you would expect. Novell's shares have enjoyed a bump up since last summer when it reorganized, started some share buybacks, laid off some workers, and made a few key management changes. And a number of stock touters that cover Novell immediately cut their ratings on the company and Novell's stock lost 17 percent of its value on Friday, giving back about half of its growth since last summer. It also leaves Novell with a market capitalization of just under $3.1 billion, making it a ripe takeover target for someone who wants to buy their way into the Linux operating system business, much as Novell did in the fall of 2003. Until Novell essentially replaces NetWare revenues with Linux or OES sales and is making decent profits, people will talk about a Novell takeover--as some are doing this week. The pressure is on Novell to sell its Celerant consulting business, but with sales off in that unit, too, the idea that it will generate much money now seems remote.

During the first fiscal quarter of 2006, Novell booked $274.4 million in sales, down 5.5 percent from the $290.1 million it brought in this time last year. As has been the case for all computer companies based in the United States, the improving strength of the U.S. dollar has hurt comparisons. Novell reckons that $7 million of its declines can be attributed to unfavorable currency exchange rates, but the company added that currency rates brought $1 million in extra dough to the bottom line, too. (That's a neat trick, when you think about it.) Sales of what Novell calls open platform solutions--meaning SUSE Linux, Open Enterprise Server, and a few other smaller items--accounted for $56 million in sales during the fiscal first quarter. Open Enterprise Server made up the bulk of this, with $43 million in sales (compared to nothing because OES wasn't shipping this time last year). SUSE Linux for servers, related desktop products, and the other minor open source products accounted for $13 million during Q1. Of this, $10.4 million was for strictly Linux products, up a healthy 22 percent. When you add NetWare and OES together, those two businesses actually declined by 11 percent. But the NetWare/OES slice of the business is much, much larger. As First Albany analyst Mark Murphy so aptly put it in his research report, Red Hat is growing its Linux licenses at twice this rate and has five times as much revenue coming in. That is a very tough compare for Novell.

Having said that, Novell has little choice but to offer a transitional product like OES and patiently wait as NetWare customers move at their own pace first to OES and then to SUSE Linux. As is the case with any venerable and well-loved platform, that reliability and familiarity of the legacy environment acts as a drag on sales of new and different products. Novell has first crack at these customers, provided they stay happy and do not jump ship to Microsoft's Windows--as many customers have done in the past decade before Novell caught Linux religion.

It is all just a matter of time, and the question is will Novell's top executives be given the time by Wall Street and investors to ride this out? While it seems incredibly unlikely that Novell will outgrow Red Hat, it is perfectly reasonable to assume that Novell can become a respectably profitable, $1 billion Linux and open source company over the course of many years. Comparisons to Red Hat are harsh, but the fact still remains that the IT marketplace needs at least two strong Linux suppliers. The SUSE distribution is, in many ways, more widely supported than the Red Hat distribution--I know from personal experience that I can get SUSE to run on machines that will not run Fedora. And Novell does have a large support organization behind it with which to support customers, and has made its pricing much less onerous in recent months, thereby making SUSE support a more affordable option.

All of these things make SUSE Linux a potentially higher volume product than it currently is. And it must be frustrating for Novell employees to see it taking longer for the ramp up to take off. It may be time for Novell to do something dramatic and crazy to get people to pick SUSE Linux over Red Hat--a free annual license to Unix, Windows, Red Hat, Mandriva, Turbolinux, and other Linux distributions plus very affordable tech support services for those who come over. The cost of spinning a CD is not very high, and you have a shot at the renewal revenue stream after that for licenses and services. This is the approach that Sun Microsystems has taken with Solaris 10, which is freely distributed and which has seen 4 million downloads in a little more than a year. Sun is just now seeing "tens of thousands" of customers who got the freebie software to sign up for support services for Solaris 10. Such an approach clearly will take patience. But getting SUSE Linux into as many hands as possible is an obvious tactic. Just making ISOs available on the Web is not enough. Make patching and installation support free or at least less expensive might be necessary to get better growth rates with SUSE Linux over the long haul if the NetWare base is not moving to OES and then Linux in a timely fashion.

For the quarter, software license revenues were $42.1 million, down 5 percent. Maintenance and services revenues were $232.3 million, down 5.5 percent. (Yes, I know that the solutions revenues cited above appear to have some services elements in them, and yes I think companies that sell open source software should have to do a better job explaining what is what.) Gross profits for the software licenses was 10 percent, which means there is not a lot of room for price cutting here; gross profits on the maintenance and services offerings at Novell, which make up the vast majority of its revenues, were just under 42 percent.

For all of the hullabaloo last week, Novell actually beat the consensus as calculated by Thomson First Call, which polled analysts and averaged $269.3 million in sales. But, during the fiscal first quarter, Wall Street was (on average) expecting 3 cents a share in net earnings, and net income only came in at $1.87 million, which worked out to basically just above zero cents a share. In the prior year's quarter, Novell had settled an antitrust lawsuit with Microsoft and received a $448 million payout, which allowed it to bring $395 million to the bottom line, or $1.04 a share. This is what you call a tough compare, indeed.

Looking ahead, Novell said it expects sales of between $272 million and $282 million in the fiscal second quarter, and non-GAAP earnings of 2 cents to 3 cents a share. However, Novell also said it would have to book about 2 cents a share in stock-based compensation expenses, which means it told Wall Street that it wasn't expecting to make much or any money in the coming quarter. This is another reason why Novell's stock took a beating on Friday. It is also the main reason I do not think Novell will start giving away boxed licenses to SUSE Linux or reducing support costs to customers replacing competitive Linux boxes or Windows on their X86 and X64 servers. That said, Novell has nearly $1.7 billion in cash and short-term investments and it could use some of that money to buy Linux market share and take a piece of the Unix and Windows market. This would be a much better long-term investment than spending $200 million on share buybacks, which Novell promised to do last summer to appease Wall Street and which it has not started to do yet.