Novell Sees Sales Slip in Q3, Undertakes Stock Option Review

Published: September 5, 2006

by Timothy Prickett Morgan

Commercial operating system and identity management software maker Novell announced preliminary financial results for the third quarter of fiscal 2006 after the markets closed last Tuesday after we were on press, which was something of a surprise. And so was Novell's announcement that it had begun a voluntary review of past stock option grants and the related accounting issues surrounding them and that it might not file its 10-Q quarterly report with the Securities and Exchange Commission on time, pending the completion of that review.

Novell's new president and chief executive officer, Ron Hovsepian, and its chief financial officer, Dana Russell, are both only 60 days into their new jobs at the company, and they hosted a conference call with Wall Street analysts to explain Novell's numbers and the situation as it relates to stock-based compensation. They said more about the former than the latter.

For the quarter ended July 31, Novell posted sales of $241.4 million, a decrease of 4.4 percent, which was just a hair lower than Wall Street consensus as gauged by Thomson/First Call. Novell sold off its Celerant consulting business during the quarter, and the results of this unit were excluded from its figures for continuing operations. Novell's sales of new software licenses were $45.4 million in fiscal Q3, down a fraction of a percent, while maintenance and services revenues declined by 5 percent to $195.9 million.

For the past three years, Novell has been trying to manage a smooth transition from its legacy and proprietary NetWare operating system to its open source SUSE Linux variant, and this has not been as smooth as Novell or its investors would have liked. The decline in NetWare sales and related maintenance streams has been faster than many had expected, and sales of Linux and identity management products, while growing decently, have not been enough to offset the NetWare declines. Russell said that the decline in NetWare-related sales has been exacerbated by pricing pressure from competitors, that have been attacking the NetWare base with alternatives. Once customers leave, not only does Novell lose out on software licenses, but ongoing maintenance revenues in following years. This same thing has happened in other legacy server lines, and in this regard, Novell is not exceptional.

The trick, of course, is to get customers to upgrade themselves, gradually, and Open Enterprise Server, which was launched with much fanfare last year and which bolstered Novell for a few quarters, was supposed to do that. With OES, customers can mix and match NetWare and SUSE Linux components and gradually move off NetWare and onto Linux at their own pace. Customers can keep their NetWare print and file services, for instance, and run them on the Linux kernel, and then deploy Linux applications beside their existing NetWare applications.

During the quarter, Novell said its Linux platform revenues--which is mostly income attributed to support contracts for SUSE Linux server and desktop variants--increased by 30 percent to $12 million. The company's identity- and access-management product lines saw sales increase by 46 percent to $26 million. But the combined NetWare-OES sales declined by 19 percent. Novell did not provide a revenue figure for that category, but it stands to reason that NetWare sales are dropping like a stone and that OES is helping prop up the legacy side of the Novell house. "We are getting hit very hard by competitors, who are giving incentives for customers to migrate from NetWare or OES," Hovsepian said.

Novell did not answer a direct question about which of its products were profitable during the call.

Hovsepian did say that while the Linux server market seemed to cool in the second calendar quarter according to IDC's and Gartner's reckoning of server hardware sales by platform, Novell did not see a slow down as far as SUSE Linux is concerned.

"The SLES business was strong, both on an invoice and a recognized revenue basis," he explained. He said that channel rebates and proactive team selling with Novell's channel partners are enabling Novell to do a better job of focused marketing and sales. "I haven't seen any slow down. If there is any pause, it is potentially when customers are going from edge servers to enterprise servers. This is also where we are seeing a lot of interest and activity."

Novell booked an $11.96 million gain on the sale of the Celerant unit, and because of that, it was able to report a net income of $11.65 million in the quarter. It also booked a $3.8 million gain on the sale of property. On a continuing operations basis, Novell had a loss of $2.5 million after taxes. In the prior year's fiscal third quarter, Novell booked a gain of $560,000 on continuing operations and a net income of $2.1 million.

The company exited the quarter with $1.3 billion in cash and marketable securities, and Hovsepian did not lay out any plans for that cash--aside from what he said when he took the helm two months ago. "We will look to make the right acquisitions," Hovsepian said. "I have indicated in the past that we are going to be acquisitive, and that is still in our future."

Novell did not say much about the review of past stock-based compensation and the related accounting and tax issues involved, other than to say that all of the news coverage of backdated stock grants motivated its audit committee, which is a subset of its board of directors, to do a preliminary review of Novell's past actions. Based on that review, Novell has hired lawyers to conduct a more formal review in conjunction with the audit committee. Novell said in a statement that it would file its 10-Q quarterly report as fast as possible after the review is conducted and that it could not predict when that might be. The company conceded that it might not be able to file its report on time, which triggers actions by the SEC and the NASDAQ exchange on which Novell's shares are traded.

When asked to talk a little more specifically about the issue, Hovsepian put his foot down. "We have said all we can say at this point," he offered. "Except to say that this is in no way a reflection of our business or our future growth prospects."