Novell Boosts Profits in Fiscal Q4 Despite Revenue Declines

Published: December 12, 2006

by Timothy Prickett Morgan

Commercial Linux distributor Novell announced its financial results for its fiscal fourth quarter and year ended October 31 last week, and the numbers were mixed, as they tend to be with Novell. For both the quarter and the full year, Novell's sales were off as its NetWare platform continues to plummet, but profits were up in the fourth quarter after a particularly bad quarter a year ago. About two-thirds of the profits Novell booked for the full year came in the final fiscal quarter, however.

In the fourth quarter, Novell had software license sales of $46.1 million, down 41 percent from the year ago period. The bulk of this drop is attributed to a rapid decline in NetWare and its related Open Enterprise Server license sales, but Novell had issues in other areas. Linux is not growing fast enough to fill the NetWare hole, and neither are the company's identity management or server management product lines.

In Q4, Novell sold and booked revenue for $13 million in Linux-related product sales, up 32 percent. To be fair to Novell, the company had inked a $20 million deal with the United Kingdom's National Health Service in the fourth quarter of last year, which it did not book this year. Deferred revenue for Linux and related open platform products increased by 16 percent in the quarter, to $46 million. This deferred revenue figure is up 57 percent from last year's fiscal fourth quarter, which is a very high growth rate by any other standards. However, NetWare and OES sales were down 25 percent in the quarter (Novell did not say how big or small this number was) while sales of identity and access management products increased only 3 percent to $24 million. Dana Russell, Novell's chief financial officer, said in a conference call with Wall Street analysts that the company was anticipating NetWare-related sales declines in the range of 15 percent to 20 percent each quarter in fiscal 2007. You can see now why Novell was interested in doing a $240 million, five-year SUSE Linux distribution deal with Microsoft. You can also see why Novell bought SUSE three years ago. If it had not, Novell would be dead right now.

On the services side of the books, Novell had sales of $198.8 million in revenue relating to software maintenance and other services rendered by its 4,700 employees. Just because customers are not buying new NetWare or even OES licenses doesn't mean that they take their machines off support, which is why services sales in Q4 were only down 5 percent.

In the quarter, Novell's gross profits plummeted, since software is inherently very profitable regardless of what code it is, but the company trimmed its costs to keep things in line. Novell's gross profits fell by 14 percent to $167.9 million, and operating expenses fell faster, by 22 percent, to $165.5 million. Novell actually booked a $2.5 million profit on operations, compared to a $12.5 million operating loss a year ago. Adding in other income and taking into account taxes, Novell had a net income of $22.3 million, compared to a loss of just under $5 million a year ago.

For the full fiscal 2006 year, Novell's sales dropped by 7 percent to $967.3 million. Software license sales declined by 19 percent to $173.7 million, and maintenance and services sales fell by 4 percent to $793.6 million. Profits were way down this year, of course, since Novell had booked $447 million from a legal settlement with Microsoft a year ago. For the fiscal 2006 year, Novell brought just under $33 million to the bottom line, compared to $376.6 million for fiscal 2005.

Novell exited the quarter with $1.5 billion in cash, up 13 percent, and $427 million in deferred license and services revenue, up 5 percent on that latter item. This is not a terrible position to be in. It would be far worse to have declining sales and no deferred revenue and no cash. But Wall Street is not patient with such attitudes, and when they see cash, they want to get their hands on it or encourage a vendor to use it in such a way as to boost the stock price so they can dump the stock and run. They tend to like restructurings to cut costs, too.

But Novell's president and chief executive officer, Ron Hovsepian, was pretty clear that he was not interested in any of that. He said that Novell would invest $20 million to $25 million in initiatives to build out its Web-based and telephone-based infrastructure for sales, therefore allowing Novell's direct sales force to better attack new accounts and bring in new customers. The company is looking for more strategic deals like the Microsoft one, which will get SUSE Linux in the hands of a lot more people--and do so quickly. And the company would continue to get its own back office in order and invest in research and development--for both SUSE and NetWare products--to grow the installed base of the former and maintain the support revenue stream from the latter. A classic Novell restructuring was not part of the plan Hovsepian outlined in the call.

"These initiatives will require investment in 2007," he explained, and then told Wall Street why he was not going to do layoffs and other cost-cutting maneuvers. "Novell has undergone many restructurings in the past five years, incurring restructure expenses of almost $150 million. And while these efforts have had short-term positive effects, they have not fully realized the promise of materially altering our long-term revenue declines, or the overall manner in which we conduct business. While we strongly considered another restructuring at the start of this coming fiscal year, we believe that a more sustained and impactful approach is required for long-term profitability. Simply taking another cost reduction without a strategy, business model, and operational alignment would put our business model at significant risk and prevent us from capitalizing on our market opportunities."

To that end, Hovsepian warned Wall Street that operating expenses would increase in fiscal 2007. He said that the company expected flat sales in fiscal 2007 compared to fiscal 2006, with increases in Linux and identity management products. Novell is working with Microsoft to get 20,000 of those Linux licenses Big Bill acquired activated in January--which is pretty ambitious. Hovsepian said that he believed that Novell could show organic revenue growth in fiscal 2008 and was on track to deliver 12 percent to 15 percent operating margins by the fourth quarter of 2008. Both he and Russell warned everyone that the effect of the $240 million Microsoft deal would take time, but that it would kick in big time in 2008.

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