Novell Blames Transitions for Disappointing Q3 Financials

by Timothy Prickett Morgan

Commercial operating system, groupware, and systems management software supplier Novell announced its fiscal 2005 third quarter financial results ended July 31, and those results were somewhat disappointing to the company's management. That said, they shrugged it off as the consequences of moving from NetWare and closed source tools to Linux and open source tools as Novell is revamping its sales channels around the world; Novell's top brass also warned that they were only halfway through a two-year transformation process, and that investors should expect more bumps in the road.

Novell's sales for the third fiscal quarter were $290 million, down 5 percent from the prior year's quarter. New software license sales were $45.6 million, down 20 percent, and maintenance and services sales came to $244.6 million, down 1.2 percent. Although Novell trimmed its software sales costs by a bit, the cost of delivering services sales rose even as revenue dipped, and SG&A costs also rose in the quarter compared to last year's third quarter, and that pushed net earnings to just under $2 million, compared to $23.9 million in Q3 2004. Diluted earnings per share in the quarter were basically zip, compared to 6 cents a share in the prior year's quarter. For the nine months ended, and thanks mostly to a $447.6 million settlement with Microsoft on antitrust issues, Novell has booked sales of $542 million, down 3.2 percent, with net income of $381.7 million, up by a factor of 8.7 compared to last year's third fiscal quarter. Earnings per share for the nine month period on fiscal 2005 are 88 cents per share, up from 5 cents per share. That Microsoft settlement has been a boon for Novell, and has definitely bought it some time to patiently and calmly retool its product line for Linux and its sales force and partner channel to sell it. Novell was sitting on $985.8 million in cash at the end of the quarter, and generated $15 million in cash flow in the quarter as well. This is not a position of weakness, financially speaking.

"Novell continues to be a company in transition," explained Jack Messman, chairman and CEO of Novell during a conference call with Wall Street analysts. He went on to say the "complex transformations" that Novell was undertaking in its product lines as well as in its sales force, reseller channel, and ISV partnerships were making things tough for the company. And he did his act of contrition by saying the $290 million in sales booked in the quarter were "below expectations," and then wiggled out of it by adding that although Novell "was not pleased with our results" that it was "not unexpected given the transformations that are under way." So, humorously, unless you are a Novell shareholder, being below expectations is not unexpected. All kidding aside, what Messman and any IT company executive should be saying is merely that the job of having expectations is Wall Street's, and the executive's job is to try to stay in business and make a profit. And that is all the more difficult given the languid state of the IT spending and the uncertainties of the worldwide economies, which are interwoven and interdependent. Messman said that the economies in Germany and France were not showing very much growth, and that in most areas around the world, CIOs were focused on projects the delivered an immediate return on investment, particularly in areas related to compliance and integration of their disparate applications. He added that sales cycles were continuing to lengthen, a frustrating condition that has plagued a lot of IT players.

Messman did point out some bright spots, saying that according to the market research he has seen from IDC, SUSE Linux's share of the server market in China has increased from just under 5 percent in the second calendar quarter of 2004 to 33 percent in this year's second quarter. One metric that Novell is focused on is the number of platforms and ISVs that are SUSE certified or SUSE Ready. At the end of the third fiscal quarter, the platform count for SUSE certified or SUSE ready applications stood at 1,590, up 13 percent from the second quarter and more than four times as large as a year ago. Similarly, the total number of ISV applications certified or ready for SUSE Linux stood at 865, up 7 percent from the second quarter of this year and almost triple from the 300 ISVs counted in the third quarter of fiscal 2004.

Perhaps most interestingly, the sales decline in the NetWare business has decreased in the quarter, thanks to the advent of Open Enterprise Server, the hybrid NetWare-Linux platform that allows customers to run NetWare services on the Linux kernel and Linux services on the NetWare kernel, all as one big package. The third fiscal quarter of 2005 was the first full quarter of sales for OES, and the decline in NetWare licensing was down 8 percent in the quarter, compared to the more traditional 12 to 15 percent decline Novell has been experiencing for the past couple of years. "We believe it is still too early to tell how fast the transition from NetWare to OES will occur," said Messman. But Novell was very much emboldened by a July survey of OES customers who bought the OES software in March, with some 65 percent of them saying that they would deploy NetWare and Linux services on the Linux kernel.

Novell lumps software sales and support together in categories that are difficult to decipher sometimes. In the cross-platform services line of business, there are two groups: Linux and platforms, and collaboration software. Cross-platform services revenues were $80 million in the third fiscal quarter, down 5 percent after a $14 million payment from The Canopy Group (the company that used to control Novell founder Ray Noorda's investments and which now controls The SCO Group) is removed. Sales of SUSE Linux Enterprise Server were $8 million, driven by shipments of 28,0000 licenses; this figure was up significantly from the 19,000 licenses shipped in both the second fiscal quarter of 2005 and last year's third fiscal quarter. About 47 percent of Novell's SUSE Linux sales were in North America, with 37 percent in Europe, the Middle East, and Africa, and 16 percent for the rest of the world.

These SLES revenue and licenses do not include OES customers or academic licenses. Joe Tibbetts, Novell's chief financial officer, said that Novell estimates that some 130,000 to 150,000 OES licenses have been shipped with a SUSE Linux entitlement, which means that customers can activate SUSE Linux any time they want and Novell won't be sure that they did until they come back in a year for their maintenance contract. Novell ended the quarter with $19 million in deferred SUSE Linux revenues. Tibbetts said if you look at all Linux-related sales, it works out to about $44 million in sales (including desktop, server, and other tools). OES sales came to $31 million, with another $5 million for desktop Linux and other products.

Novell's identity management software category accounted for $27 million in sales, up 3 percent, and Tibbetts said invoicing in the quarter (which is different from sales because Novell has to defer some revenues since Linux and related sales are for services, not products) was up in the double digits. In the resource management group, sales were $33 million, up 3 percent and driven predominantly by ZENworks tools. Collaboration tools, of which the GroupWise groupware is Novell's major product, accounted for $27 million in sales, down 10 percent from the same quarter of last year. But Novell was in the middle of the move to GroupWise 7 in the quarter, and that software is now out, and Novell's execs are hoping that the fact that it is the only groupware program that runs on NetWare, Windows, and Linux is bound to help it sell from this point forward.

Tibbetts said Novell had $130 million in sales in the quarter in the North American region, up 2 percent after the Canopy payment is removed from the comparison. Novell restructured its North American operations earlier this year, and is in the process of doing the same restructuring in EMEA. Sales in that region were flat compared to a year ago at $93 million, but when you take out a bunch of acquisitions, Novell saw sales drop by 7 percent in Europe. That's why the company announced 120 layoffs in early August, which will shave $3 million to $4 million out of costs.

Looking ahead, Tibbetts said Novell would announce another restructuring in its fiscal fourth quarter, but would not elaborate on how deep or where the cuts will be made. Novell had about 5,800 employees at the end of the quarter after those 120 positions in Europe were eliminated. Assuming that the cost savings of eliminating an employee worldwide is roughly the savings Novell is getting in Europe, then Novell would have to eliminate about 420 or so employees to get profitability in the quarter just ended to about 5 percent of revenues. That would be about 7.2 percent of its current workforce worldwide, which would be a pretty deep cut. If Novell wanted to get profitability to 10 percent of revenue, it would have to cut twice as deep. That would be difficult, to say the least.