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December 5, 2006

Novell sees slow ramp for Microsoft deal

Novell Inc may have scored a guaranteed $240m in Linux revenue from Microsoft Corp, under the recently announced indemnification and resale deal, but the company is being conservative on how quickly the revenue will be recognized.

By CBR Staff Writer

Announcing its fourth-quarter results yesterday, Novell said that it expects to build up a pipeline of 150 potential customers with Microsoft by January, but that it only expects $4m to $7m to come of the deal in the whole of next year.

The company’s shares took a dive in after-market trading, but that was largely due to the mediocre guidance and the fact that Novell is planning yet another extensive and expensive restructuring — which could include signing one or two more deals like the Microsoft partnership.

In January, we are targeting to build a pipeline of 150 customers and ship approximately 20,000 certificates, chief executive Ron Hovsepian said during a conference call announcing the results. He described the targets as ambitious goals given the short time-frame in question.

But chief financial officer Dana Russell said that the way that revenue will be recognized means a slow start for the deal, and that he believes the estimates for 2007 are conservative.

Microsoft is buying $240m of SUSE Linux service coupons this quarter. All this cash will hit Novell’s balance sheet as deferred revenue immediately, but it will move onto the income statement over time in one of two ways.

Each coupon will be worth between one and three years of Linux support from Novell. The firm expects Microsoft to take 35,000 to 75,000 of these per year, depending on the mix of period lengths offered.

If Microsoft puts a coupon into the hands of a customer, Novell will start to recognize its value as revenue ratably over the lifetime of the customer service agreement, between four and twelve quarters.

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But if Microsoft has not given the coupon to a customer within 12 months of receiving it from Novell, the coupon expires and Novell recognizes the revenue as a lump sum in that single quarter.

While the revenue is guaranteed one way or another over the five years of the deal, it’s obviously better for Novell’s top line over the longer term that Microsoft actually converts the coupons into new SUSE Linux customers.

If the $240m was smoothly realized, that would mean $48m a year for Novell’s income statement, but the fact that the company is only estimating $4m to $7m in 2007 is potentially twitch-making.

If we look at ’08, we know that we’re going to have substantially more revenue than that, in the $40m to $50m range, Russell told analysts, several of whom seemed a bit skeptical.

The $4m to $7m revenue figure is lower in earlier periods of this transaction, as the sales effort and ratable recognition of Linux subscriptions takes time to build, he said.

While the Microsoft deal was heavily scrutinized, the dollar amount expected from the deal is pretty much a footnote on the company’s overall financial situation.

Novell yesterday reported a fiscal fourth-quarter net income of $23.7m, or $0.06 a share, compared with a loss of $5.0m, or 1 cent a share, a year ago. Revenue was down 15% to $244.9m, about $6m shy of analysts’ estimates.

The fiscal 2006 revenue was $967m, down from $1.04bn. Net income was $21m, or $0.06 a share. Both quarter and fiscal year ended on October 31. The results were preliminary, as Novell is still conducting an accounting audit.

The best reflection of the company’s overall health is perhaps its fiscal 2007 targets, which include the goal of keeping revenue flat or near flat at $945m to $975m, which was lower than analysts had expected by tens of millions.

The problem is of course Novell’s dwindling older businesses, such as NetWare, which are taking the shine off growing businesses such as SUSE and its identity management software.

Hovsepian announced some restructuring plans for early 2007 that he said will help Novell stave off the overall revenue decline while also helping the bottom line. This will include offshoring and outsourcing, he said, and could end up also including divesting businesses.

It will also include a realignment of sales channels to focus on the indirect, he said. This hopefully will include one or two more significant reseller deals along the lines of the Microsoft one, he indicated. It will also see more focus on web-based and telesales focused on renewals, freeing up the field sales force for customer acquisition, Hovsepian said.

The company has already spent about $150m over the last five years on restructuring, he said, but while these efforts have had short-time positive effects they have not fully realized the promise of materially altering our long term revenue decline, profitability or the overall manner in which we conduct business.

Asked whether the Microsoft relationship could end up with a net negative effect — due to some of the outcry in what is referred to as the ‘Linux community’ — Hovsepian trod carefully, saying that he recognized these community concerns, but that the deal was designed to improve the SUSE Linux customer experience.

We now have several Linux deals that are now accelerating as a result of the new partnership, he said, later noting that he knew of four big deals he was personally involved in that were lost due to buyer fears of Microsoft. Customer reaction to the collaborative agreement has been tremendously positive, he said.

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