Description

Investment Summary

A chronic underperformer with a cash-rich balance sheet ($2.79 per diluted share) and a steady annuity-like software maintenance revenue stream, Novell is ripe for a shakeup to increase shareholder value. On the surface Novell looks like it deserves its low multiple, but the company has two sources of hidden value. The first is an open source software unit that would get a high revenue multiple as a standalone business. The second is the steady, recurring, high-margin software maintenance cash flow that is being frittered away by current management. On a sum-of-the-parts basis, I believe that NOVL is 50 to 150% undervalued. With a recent 13D filing by a prominent activist investor, it appears that the catalyst to realize this value is on the way.

Company Overview (lifted from NOVL's 10-K)

Novell develops, sells and install enterprise-quality software that is positioned in the operating systems and infrastructure software layers of the information technology industry. Novell's business units are:

Open Platform Solutions (OPS):

Novell delivers Linux and related solutions for the enterprise. The SUSE Linux Enterprise platform underpins all of the company's products. SUSE Linux Enterprise is a leading distribution system that focuses considerable effort on interoperability, support for mission-critical computing requirements, and virtualization and provides ease in usability and management. The most important product is SUSE Linux Enterprise Server ("SLES"), an enterprise-class, open source server operating system for professional deployment in heterogeneous (open source and proprietary) IT environments of all sizes and sectors.

Identity and Security Management (ISM):

Novell's identity, security, and compliance management solutions are designed to help customers integrate, secure, and manage IT assets while reducing complexity and ensuring compliance with government and industry mandates. Adding this intelligence to every part of a customer's IT environment makes their systems more agile and secure. Novell's solutions leverage automated, centrally-managed policies to provide insight into events happening throughout the enterprise. Primary products are Identity Manager, Access Manager, SecureLogin, Sentinel and Compliance Management Platform.

Systems and Resource Management (SRM):

With Novell's systems and resource management solutions, customers can define business and IT policies to automate the management of multiple IT resources, including the emerging challenge of managing virtual environments. As a result, customers are able to reduce IT effort, control IT costs, and reduce IT skill requirements to manage and leverage their IT investment. Primary products are ZENworks and PlateSpin.

Workgroup/Collaboration:

Novell provides comprehensive and adaptable workgroup solutions that provide the infrastructure, services, and tools customers require to effectively and securely collaborate across a myriad of devices. Primary products are OES, Netware and Groupwise.

History of Underperformance

As you can probably tell from the business description, the Novell product portfolio is diverse and wide ranging. Novell was a software high-flier back in the early 1990's based on its leadership in the network access control and collaboration markets. However, Novell lost this lead to other players and has generally been an underperformer for the better part of two decades. The company has gone through multiple executive changes, restructurings and strategy shifts over the years, and a good portion of its current product portfolio was acquired through M&A. While the company has sold a lot of software over the years and has a large installed base of customers that depend on its products, organic growth has been elusive and profitability has been sub-par.

I think of Novell as having two primary lines of businesses- an Open Source business which primarily involves selling maintenance and services contracts for companies running Linux application servers, and a traditional enterprise software business encompassing the ISM, SRM and Workgroup units. The Linux business is in an interesting segment with some good organic growth, which is why closest public comp Red Hat trades at a 6x revenue multiple. The traditional enterprise software business is no longer a leader in any of the markets it competes in, but does generate some new license sales. More importantly, it has a large installed base that pays for annual maintenance upgrades and support. This revenue stream is nearly $500M annually, and held steady last year despite a tough economic environment for software sales that caused Novell's new license revenue to decline significantly. Companies renew their annual software maintenance contracts almost automatically, because Novell's customers depend on the software and paying maintenance is much cheaper than buying new. Small and mid-cap enterprise software companies (I compared NOVL to BMC, CA, EPIC, LWSN, TIBX, OTEX) trade at an average of 3.5x their annual maintenance revenue (i.e. EV/annual maintenance revenue), NOVL trades at 1.1x (including Linux maintenance).

Unfortunately, Novell has brought in a series of CEOs that think they can make the company grow again and recapture its former glory. While in the past few years Novell has experienced some sporadic growth and margin improvement, the net effect on the stock has been minimal. The steady maintenance cash flow is mostly being wasted on unproductive opex and overpriced M&A. To give you a sense for how poorly Novell invests its software maintenance cash flow consider the ratio of operating expenses (mostly sales and R&D) to new license sales. For a well-run company like Oracle, the ratio is something like 1.1/1- each dollar of opex generates almost $1 of virtually 100% GM license revenue with further profits from future maintenance renewals. For Novell's traditional software business (i.e. backing out the opex for the Linux business) it has been closer to 3.5/1- meaning that in aggregate the money Novell puts into creating and selling its new products is generating a negative ROI for shareholders. Of course, some level of opex is necessary to update products and secure maintenance renewals, but you get the idea. JP Morgan analyst John DiFucci spent a lot of time taking them to task for their completely out-of-line operating expenses on their 2/25 earnings call, so I am not the only one noticing this.

From my perspective the recent earnings were a non-event. The company claimed invoicing was strong but both revenue and deferred revenue was down. Most importantly, Novell's reorganization of its business segments afforded a glimpse of just how profitable a legacy software business with high maintenance renewals can be. In the past they had broken out the operating performance of their four business units, but most corporate SG&A and R&D costs were left unallocated so it was hard to get a true view of operating unit performance. With their Q1 FY 2010 report, they are now reporting in only two operating units (which I will discuss later), combining OPS, ISM and SRM while leaving Collaboration separate. However, Novell is now allocating almost all corporate costs to one unit or another. Novell's Collaboration unit is the most "legacy" of its businesses, as Novell is primarily in maintenance harvest mode for OES and Netware. This unit generates a 47% EBIT margin while the rest of the business (despite a lot of legacy maintenance revenue) is being run at breakeven! If the entire non-Linux business was being run at a 47% EBIT margin the company would generate over $400M in EBIT per year.

As you would expect, both management and the board owns little stock outright, but takes huge cash comp out of the business. Amazingly, according to Novell's 2009 proxy, the entire management team received FY 2008 bonuses of 1.2 to 2.0x the targeted amount based on achieving in excess of their supposed "performance goals". The CEO (who only owns only 777K shares, I believe acquired through grants of restricted stock and options) got nearly $3M in cash comp alone, for running a business that generated a measly $18M of free cash flow on revenue of nearly $1B! In FY 2009, as Novell experienced declining revenue, this amount was reduced to "only" $2.2M. Despite the decline in the business, the executives supposedly hit 123% of their "performance goals" again. One of the other amazing facts in the proxy is that, of the software peer group that Novell compares itself to, Novell has the lowest TTM EV/Revenue multiple indeed is the only company below 1. No one gets less from a dollar of software revenue than Novell under current management. Of course, that doesn't stop them from paying their executives total comp between the 50^th and 75^th percentiles.

Recent Developments: Hope for Shareholders

I had looked at Novell in the past, but given the lack of catalysts and the fact that management could expect to make more in present value of cash comp than from increasing the value of the stock, I could never get comfortable. However, the recent 13D filing by Elliott Associates makes me believe that change will be coming whether management likes it or not. Elliott is a well-respected activist investor, and although no specific proposals were laid out in the filing I have to believe they see many of the same things I do.

There are a number of things that Novell could do to improve shareholder value, which I believe Elliott will push management towards. The business clearly has too much cash, so they at the very least can push for a large buyback and/or a dividend. A sexy open source business is hidden inside an underperforming enterprise software perpetual license business, so I think it makes sense to either spin off or sell the Open Platforms Solutions division to someone who will pay a high multiple. Most importantly, Novell has a huge, recurring, high margin software maintenance revenue stream, and it is not being converted to cash flow like it should be due to what I think is mal-investment by a management vainly striving for growth. This cash flow stream could be much better managed by a software consolidator or private equity firm. I think the end game is to sell the company- likely in two pieces split between Linux and traditional software- and I have to believe that consolidators like Oracle, IBM and Computer Associates as well as private equity firms would be interested in the latter part.

Other things to note: Novell's entire 9 member board is elected annually. In the past Elliott has been involved in sales of other chronically underperforming tech companies like Borland Software, Packeteer, MSC Software and 3Com. Novell is Elliott's largest reported publicly traded equity position according to Bloomberg, and it appears nearly all shares were purchased recently at prices similar to today's. Obviously I don't know for sure, but I suspect Elliott is waiting to make their proposals until after the FY 2009 proxy comes out- and it just showed up. Elliott purchased the shares detailed in their latest SC 13D before the stockholder voting date of record, February 18^th.

The Upside Growth Case

I don't put a lot of stock into this, but it is worth noting that Novell recently re-organized its business in an attempt to be an "arms merchant" to the cloud computing market. The company has been trying to categorize its disparate businesses into being considered the "Intelligent Workload Management" segment and recently combined its ISM, SRM and OPS business units into a new Security, Management and Operating Platforms business unit (leaving Workgroup as a separate business unit). Novell claims enterprises need a combination of their products to build, deploy, operate and maintain cloud computing applications. I am skeptical, but if this reorganization resonates with customers and Wall St. the stock might get a multiple again. Elliott Associates may be waiting to see whether this initiative bears fruit before putting forth their proposals.

Valuation and Return Potential

On paper, Novell's valuation does not look all that compelling on a forward P/E (14x) or EV multiple of F 2009 free cash flow (15x). However, NOVL's profitability and FCF metrics are depressed by management's wasteful spending and investment initiatives. I think it makes sense to look at Novell on a sum-of-the-parts basis, separating out: (1) the balance sheet cash; (2) the Open Platforms Solutions Linux business; (3) Non-Linux maintenance; (4) other license sales; and (5) services. I believe that Novell is currently 50-150% undervalued, below is a table detailing my sum-of-the-parts calculation:

			Multiple		Value		Per Share
Item	Amount	Type	Low	High	Low	High	Low	High
Cash & CE	$ 993.4	Bal Sht	1.0	1.0	$ 993.4	$ 993.4	$ 2.79	$ 2.79
Open Platforms (Linux)	$ 174.0	Revenue	3.0	5.0	$ 522.0	$ 870.0	$ 1.47	$ 2.45
Other Maintenance	$ 483.0	Revenue	2.0	4.0	$ 966.0	$ 1,932.0	$ 2.72	$ 5.43
Other License	$ 116.8	Revenue	1.0	2.0	$ 116.8	$ 233.6	$ 0.33	$ 0.66
Services	$ 87.0	Revenue	0.5	1.0	$ 43.5	$ 87.0	$ 0.12	$ 0.24
Total	$ 1,854.2				$ 2,641.7	$ 4,116.0	$ 7.42	$ 11.57
Upside							58.0%	146.1%

Cash and CE:

No explanation needed.

Open Platforms:

This line might get the most push-back from the VIC community, but Linux application servers are a hot area in IT and the industry leader Red Hat currently trades at over a 6x revenue multiple. RHT grew at 17.5% Y on Y in their last reported quarter. Novell's Linux business results are a bit hard to decipher because of their one-time prepaid distribution deal with Microsoft, but on their last call the company claimed non-Microsoft invoicing grew 10% Y on Y. Therefore, I took a revenue multiple range from half of Red Hat's to just below its current trading multiple.

Other Maintenance:

This is where most of the hidden value lies. Due its long history as a software supplier, Novell has thousands of customers that depend on its platforms to run their businesses and secure their networks. For these customers paying the annual maintenance and support contract is much cheaper than buying new software, so it is done almost automatically. This business is very high margin, high visibility recurring revenue- practically an annuity. Generating this revenue takes relatively little opex investment. Maintenance revenue was flat in FY 2009 despite a very tough environment for software sales. The general rule of thumb is that software consolidators and private equity firms are willing to pay 3-4x annual maintenance for high renewal rate streams. As a point of reference, Oracle paid 7-8x EV/annual maintenance revenue for PeopleSoft, Siebel, Hyperion and BEA. $12.00, the high end of my range, would be 7x EV/maintenance revenue and give no consideration to the Linux, other license and service revenues.

Other License:

Worth something, but not growing. 1 to 2x revenue is low for license revenue in software M&A.

Services:

Not a particularly high value business, but worth something, hence my 0.5x to 1.0x range.

Investment Risks

• I view the primary risk as the opportunity cost of being stuck in a value trap. Cash on the balance and cash generation should limit downside.
• Similarly, Elliott's activist initiatives may take a long time to play out.
• Novell is comprised of several tangentially-related business lines and products, so Novell's complexity may make it difficult to restructure the business profitably and put off acquirers.
• Some have speculated that large corporations will increasingly scrutinize software maintenance renewals, a significant reduction in software maintenance renewals would harm NOVL.

Disclosure: Needless to say, long NOVL.

Catalyst

The primary catalyst is future activist proposals by Elliott Associates. Specifically, they could push for any combination of a major share buyback, dividend, spin-off or sale of the Open Platform Solutions business, sale of the traditional software businesses or a major cost-cutting restructuring to enhance cash flow.