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Novell (NASDAQ:NOVL)

Q2 2006 Earnings Conference Call

May 31, 2006, 4:00 p.m. EST

Executives:

Jack Messman, Chairman & CEO

Ronald Hovsepian, President & COO

Joseph Tibbetts, Senior Vice President, CFO

William Smith, Vice President Investor Relations

Analysts:

Katherine Egbert, Jefferies & Company

Mark Murphy, First Albany Capital

Kirk Materne, Banc of America Securities

Brent Thill, Citigroup Global Markets

Jason Maynard, Credit Suisse First Boston

Operator

I’d like to remind all parties that your lines have been placed on a listen-only mode until the question and answer segment of today’s conference call, and as a reminder this call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to the turn the call over to Novell, Investor Relations. Thank you, you may begin.

William Smith, VP Investor Relations

Good afternoon everyone and thanks for joining us. I’m Bill Smith, Vice President of Investor Relations for Novell, and with me today from our executive offices in Waltham, Massachusetts are Jack Messman, Chairman and CEO, Ron Hovsepian, President and COO and Joe Tibbetts, Senior Vice President and CFO. We are here this afternoon to discuss Novell’s financial results for the second fiscal quarter 2006. I would like to note that there’s a live webcast of this call taking place on the investor relations page of our website at www.novell.com. That call is being recorded and will be accessible on the website through June 7th. A telephone replay of this call will also be available 15 minutes after the conclusion of this call at 1800-642-1687, and will run through June 7th.

During the call, we will be making references to the financial schedules attached to today’s press release, so I encourage you to keep those at hand. We will also change our format this quarter. We’ll start with Joe Tibbetts reviewing all of the financial highlights followed by jack Messman’s business commentary. I should also note that during this call, we will be making statements that are not historical in nature and that maybe characterized as forward-looking statements. You should be aware that Novell’s actual results could differ materially from those contained in the forward-looking statements which are based on current expectations of Novell management and are subject to a number of risks and uncertainties including factors described in Novell’s annual report on Form 10-K filed with the Securities and Exchange Commission on January 10, 2006. Novell disclaims any intention or obligation to update any forward-looking statements as a result of developments occurring after the date of this call. I’ll now turn the call over to Joe.

Joseph Tibbetts, Senior Vice President, CFO

Thanks Bill, good afternoon everyone. Novell’s second fiscal quarter 2006 financial results were released a short time ago. The company reported net revenues of $278 million and GAAP diluted net income available to common stockholders of $3 million for its second fiscal quarter 2006. GAAP net income per diluted common share was $0.01. Non-GAAP diluted net income available to common stockholders for the quarter was $10 million or $0.03 per diluted common share. This excludes the impact of stock-based compensation expense of $8 million in process, research, and development costs related to the acquisition of eSecurity of $2 million and a $2 million gain on the sale of a corporate jet and $1 million related to the gain on a legal settlement. Excluding our Selerant management consulting subsidiary, which was sold subsequent to quarter end, net revenues were $239 million and non-GAAP diluted net income available to common stockholders was $8 million or $0.02 per diluted common share. I refer you to page 10 of our press release schedules for a presentation of our non-GAAP results excluding Selerant.

Our $278 million of total revenue this quarter represents a 6% decrease from the same quarter a year ago. This decrease is primarily due to the planned declines in IT consulting as well as a number of other factors including negative foreign currency exchange effects, anticipated declines in our Legacy NetWare business and an overall decline in our Selerant business. We are pleased to see strong annual growth in our Identity business and despite the overall revenue decrease, we are also pleased to see both net income and operating income increase on a year-over-year basis largely as a result of our cost reduction program instituted several quarters ago.

Turning to page 12 in the press release schedules, our review revenue by solution category. First category, System Security and Identity Management, which generated $61 million in the quarter, up 16% from the prior year. Within that category, we recorded revenue of $34 million in the Resource Management segment which was up 8% from a year ago quarter and suite sales continue to be the main revenue driver in this category in addition to add on sales such as ZEN asset management products and our patch management products. Also, we’d insist on Security and Identity Management, our Identity and Access Management business generated $22 million in revenue which was an increase of 37% from the same period a year ago. The strong growth in this category was driven by a full quarter of success with our new Identity Manager 3 product.

In the open platform solutions category, we generated revenue of $57 million this quarter compared to $20 million in the year ago quarter. The majority of the year-over-year increase came from the continued transition of NetWare to open Enterprise Server OES, which generated revenue of $46 million during the quarter. This is an increase of 6% from last quarter and up considerably from $8 million back in the second quarter 2005 when the product was launched.

The Linux platform products revenue increased 20% over the prior year to $10 million with growth across virtually every product in that category including SUSE Linux Enterprise Server. Invoicing in this category increased nicely on a year-over-year basis in excess of industry growth rates. Other open platform products which includes our SUSE Linux Professional product decreased on a year-over-year basis. Last year, we generated $14 million in revenue for this product. However, during the first six months this year, that number dropped to just $2 million as a result of our decision to open source the professional retail product and allow the users to download it for free at opensuse.org. While our year-over-year revenue in this category was clearly negatively affected by this decision, this was strategic for Novell as we target Linux for the Enterprise and we see adoption of the SUSE Linux.

In the Work Space Solutions category, we generated $42 million in the quarter and revenue from our NetWare and other NetWare related category came in at $12 million reflecting the continued decline in stand alone NetWare product sales as customers transition to the next generation OES product. The combined OES and NetWare related revenue was down 16% on a year-over-year basis and Jack will actually talk more about this and get into more detail in a few minutes.

Global Services are shifting to that component of IT Software and Solutions. At $79 million this quarter, Global Services accounted for 28% of total revenue and was down 10% on a year-over-year basis. The IT consulting component in this category contributed $38 million in revenue and was down 21% year-over-year, and this decline again was planned given our focus on consulting engagements around Novell products, thereby reducing revenue from general IT projects and the specific reduction of IT consulting expense during the fourth quarter restriction.

Selerant, a word on that; finally, we had a full quarter of Selerant results in our second quarter figures as we did not have the sale agreement for Selerant in place prior to the end of the quarter. I won’t review those results here, but I’ll get into more detail on the impact of the sales to our future results in a few minutes.

Looking at the geography, the more significant region to which we do business, the Americas region reported revenue of $129 million for the quarter which was down 1% on a year-over-year basis, profitability was fairly flat in this region of the quarter and we’re managing costs accordingly. The EMEA region reported $87 million in revenue for the quarter, down 13% on a year-over-year basis. Foreign Exchange had a $3 million unfavorable impact on our EMEA revenue year-over-year and this region was also the most affected by the planned consulting revenue declines which I just talked about. As for EMEA profitability, we saw significant improvement as a result of the cost reductions implemented several quarters ago. Following a period of sluggish growth, the European market is showing signs of recovery, particularly in Germany for business sentiment appears strong. Also, government spending appears to be on the rise in Europe as a whole.

Leaving the revenue sections, I’m going to review gross margin and operating expenses for the core business only, and by core business, I mean Novell’s business excluding Selerant. This analysis should give you a sense of what our business will be like on a go foreign basis excluding Selerant’s results which were consolidated into our overall results. The GAAP results for the entire consolidated business including Selerant are included on page 9 of the release for your reference in any event and then in addition, this quarter, we are showing non-GAAP core business results on page 10 of the press release schedules for your reference. It should be noted that this one-time schedule was prepared on a non-GAAP basis and excludes the impact of stock-based compensation expense, restructuring another unusual or infrequent items in addition to excluding the Selerant results. So, we did this to give you the four past quarters’ perspective on the core business.

Gross margin, overall core gross margin was 66% in the quarter, up 2 percentage points from the year ago quarter. Our fourth quarter restructuring efforts reduced expenses and technical support in IT consulting services and this effort resulted in a higher mix of products versus services sold in the quarter and lowered the overall cost of revenue structure both of which helped to drive the improved gross margin.

Moving to operating expenses, total core operating expenses and again these exclude stock-based compensation expense, were $156 million in the second quarter, down 5% from the year ago period and up 5% from the first quarter. Compared to the first quarter, we had a 3% increase in core sales and marketing expenses, up to $86 million or 36% of revenue and this sequential increase was due primarily to additional spending related to our annual brand share and partner summit event.

Core product development expenses increased approximately 10% from the first quarter totalling $47 million or 20% of revenue in the second quarter. This was attributable to seasonal fluctuations in vacation and benefits and again increased expenses of our engineering group related to our brand share event.

Core G&A expense was up 7% from the first quarter at $24 million or 10% of revenue due primarily to increased compliance and legal expenses offset by savings and corporate aviation. On a year-over-year basis, we actually saw an increase in core G&A expense which was due to favorable one-time adjustments that we had in the year ago quarter. So, we wanted to make sure you understood why that was up. Excluding Selerant, our total core head count at the end of the quarter was approximately 4800.

Switching to income taxes, the consolidated GAAP income tax provision for the quarter including Selerant was $7.5 million compared to the very similar consolidated non-GAAP income tax provision of $7.3 million. The non-GAAP book income numbers exclude the impact of any stock-related compensation. The high effective book GAAP tax rate which is 69% is due mainly to having to treat stock-related compensation as if it were nondeductible because of our full evaluation allowance on our deferred tax assets. On a non-GAAP basis, our effective tax rate was 41%.

I wrote about the share repurchase program during the second quarter. We commenced our share repurchase program. Additionally on April 4th, we announced that our board of directors had amended the program to increase the amount of common stock that could be repurchased under the program from $200 million to $400 million. In the third quarter, we completed the buyback of shares authorized under the program repurchasing 51 million shares at a total cost of $400 million, 35 million of these shares were repurchased during the second quarter at a cost of $267 million.

Shifting to the balance sheet, a few items there; cash and short-term investments of $1.3 billion were down 16% from the prior year due primarily to the stock repurchases I just talked about $267 million in the quarter and the $72 million used for the purchase of new security in the second quarter and all that was offset partially by positive cash flow operations over the past 12 months and cash flow from operations for the second quarter was a negative $24 million, however, this is consistent with the second quarter trend we’ve seen for several years which is the result of a seasonal increase in current accounts receivable and the effect of decreased deferred revenue compared to the prior quarter.

Net receivables increased $10 million from the same period a year ago due in part to decrease the accounts receivable reserve associated with reduced sales of our channel based offerings, DSO, Day Sales Outstanding, was 66 this quarter, up 7 days compared to the year ago. You’ll note that goodwill increased $62 million from the year ago period that’s due larger to the acquisition of eSecurity. Our deferred revenue balance of $346 million was up 8% year-over-year which reflects improved advance invoicing and Novell’s continued shift to more of a subscription and maintenance business. Deferred revenue associated with Linux and other open platform products excluding OES at the end of the quarter was $34 million and that was up $3 million from the prior quarter and up $17 million from the prior year. Stockholders Equity decreased $270 million from the prior year due to $267 million in common stock repurchases offset by the issuance of common stock for stock option exercises, stock-based compensation, and net income.

I assume you’re all aware that last week, we sold our ownership in Selerant, our majority owned management consulting subsidiary. We received approximately $77 million from the buyer group for our shares in Selerant and the implied equity value for the entire transaction taking into account the equity portion which we didn’t own was approximately $83 million and this $83 million figure includes $25 million of cash in Selerant at the time of the transaction of which we owned our proportionate share. So, excluding the entire cash balance, the transaction value or enterprise value implied by the share sale was approximately $58 million and after fees and expenses, we expect our cash balance to increase by approximately $51 million as a result of this transaction.

For the third quarter, on a book basis, we expect to record a gain of $12 to $14 million and a loss for tax purposes of $45 to $50 million due to different book and tax basis in Selerant.

Turning now to guidance, there are several factors which should be considered informing estimates for our financial performance in the third quarter. So, we got a lot of moving parts this quarter and I just want to address to make sure that they are well understood. First is the sale of Selerant. So, we had expected Selerant to contribute approximately $40 million in revenue and 0.5% of earnings per share for the full third quarter period. On a non-GAAP basis, both figures will now need to be eliminated from our financial forecast. Please note that even the stub period of Selerant performance up to the date of sale will be eliminated in reporting our non-GAAP results for the third quarter. So, we are looking to the ongoing business when we talk about third quarter.

Second item is eSecurity and we expect to generate about $2 million in revenue and lose about $0.005 per share in the third quarter as a result of our acquisition of eSecurity during the second quarter. The share repurchase is the third item. The share buyback will reduce the third quarter weighted average shares outstanding by approximately 49 million shares and then you have to consider the average cash balance which has changed considerably. We believe the weighted average cash in short-term investments balance will be low in the third quarter than in the second quarter by approximately $300 million as a result of the share buyback and the acquisition of eSecurity and again offset partially by the net proceeds from the divestiture of Selerant and the expected results of operations from the third quarter. Net of all that is that we expect the decrease interest income by approximately $3 million in the third quarter. So, with all of that in mind for the third fiscal quarter ended July 31st, we expect core, that’s again excluding Selerant, revenues to be in the range of $239 to $247 million.

Core non-GAAP earnings per share excluding the impact of stock-based compensation expense is expected to be $0.03 per share and the impact of the stock-based compensation expense is expected to be about $0.03 per share for the third quarter which would result in reported GAAP break even results. The non-GAAP EPS guidance, remember now that we have different share counts depending on the amount of earnings, so the non-GAAP EPS guidance assumes shares outstanding to be $402 million at the $0.03 per share level which includes the diluted effect of the 52 million potential shares related to the conversion of our outstanding debentures. Because the GAAP EPS is less than $0.03, it’s actually break even, but it is less than $0.03 and for that reason, it assumes shares outstanding to be 350 million shares, 52 million less than the 402 million. We are assuming a non-GAAP effective tax rate of between 40 and 42% which excludes the impact of stock-related compensation.

So to wrap up my piece, we were satisfied with the overall results from the quarter and we continue to make progress toward our longer term goals. And with that, I’ll turn the call over to Jack.

Jack Messman, Chairman & CEO

Thank you Joe. Many of the same trends from previous quarters appeared in our results this quarter. Outstanding growth in our Identity business, steady growth in our Linux business, and some recurring challenges in our worker business. With the acquisition of eSecurity in the quarter, we further strengthened our Identity business.

We have no doubt delivered on its financial guidance again this quarter, we know we still have some hard work ahead of us to reach our exit rate of 12% to 15% operating margin goal in fiscal year 2008, which we had previously shared with you.

Let me get a little deeper into the main business drivers for this quarter. First, let’s talk about our Linux business. Including OES, our open platform solutions business generates approximately $218 million a year in revenue on an annualized basis. As you know, we are migrating our Legacy NetWare business to Linux with our open Enterprise Server product called OES, which is a Linux based product. By the combined NetWare and OES products declined 16% year-over-year, currently 80% of our shipments are now on OES. Two internal key measures for us in the future will be first how much of the OES is deployed on Linux as opposed to the NetWare kernel and second what the renewal rates will be on OES. We believe our dual kernel strategy is delivering choice to the market and will prove successful over time as we protect a large portion of our installed base, and we believe this strategy is mitigating revenue declines for Novell.

If we look at our Linux business without OES, the recognized numbers do not tell the whole story. For example, Novell Linux platform revenues were up 20% and invoicing was up from the prior year at a rate in excessive predicted industry growth rates. Further, as we often sell all products including Linux under Enterprise licensing agreement, for extended contract periods of two to three years, revenue is not recognized beyond the typical invoice period which is usually one year, and similarly no deferred revenue is put on our balance sheet beyond the invoice period.

In addition while we are happy with our decision to open source our SUSE Linux professional retail product and allow users to receive this product for free at opensuse.org as Joe previously mentioned, customer acceptance and enthusiasm for opensuse.org and SUSE Linux has been outstanding. Our recently released community addition of Linux, SUSE Linux 10.1 has already had over 500,000 downloads and over 91,000 registered installations since its release on May 11th, less than three weeks ago. Our previous edition, SUSE Linux 10.0 had downloads of 1.5 million from September 2005 through May 2006.

From the topic of Linux in the Enterprise, we continued our steady progress of selling Linux to our large Enterprise customers. Customers are buying because of our superior product, come to market advantage with key technologies such as virtualization and real-time extensions, and our cross platform networking expertise that makes Linux work in our customers’ heterogenous networks. Some of our recent Linux ones were large customers like Target, Genentech, and young brands which is the parent company of Taco Bell and Pizza Hut.

Customers have been very satisfied with Novell as their Linux provider as evidenced by our high renewal rates against our target set of Enterprise customers. In fact, all of our top 10 accounts that were up for renewal this quarter, renewed their contracts. As Linux moves from the edge server to encompass more of the Enterprise, we believe that Novell has the best solution with our Code 10 that ships this summer. Among the leadership capabilities we have are first to market with the ZEN virtualization technology, a differentiated security solution with App Armor Application Security Containers, CIM based monitoring which is critical for the data center, and support for high availability and scale especially with heartbreak functions in Oracle’s clustered filed system.

Aside from the Code 10 features I just mentioned, we have significant competitive differentiation as well such as an experience direct sale force, an enterprise class, an experience worldwide support organization with broader and more robust product line including Identity Systems and Resource Management, 20 years of Enterprise operating system experience, a common code base from the desktop to the server to the data center that allows customers to reduce their operating cost and share a common skill base, and we have the best Linux IP indemnification in the industry.

This quarter, we continued our progress in increasing the value of the SUSE Linux Platform through increased partner involvement. We announced ISV certifications on SUSE Linux from writers in Oracle and we co-branded our ZENworks for Linux management product with Dell to be sold through Dell channels. Gross total SUSE Linux ISV certifications also showed a nice increase this quarter. Total software app certify on SUSE Linux increased to 1006, an increase of almost 25% from the year ago totals. So, clearly ISVs are responding to demand from their customers that they want the ISVs to support their application from SUSE Linux. We also have over 270 ISVs who have already converted to the 2.6 kernel and more importantly over half of the top tier software vendors have done so.

From the technology alliance perspective, we announced in the first half several programs with IBM, HP, Dell, Oracle, Intel, and AMD, all focussed around Linux. And we believe these initiatives will have a positive benefit in our Linux business going forward. Yet we still have some critical issues we need to address on our Linux business. While our renewals for our top accounts are outstanding, we still have room to improve overall renewals in our Linux business. The release of SUSE Linux Enterprise Server 10 / 10 which we’ll ship this summer will address most of the renewal issues on a going forward basis. Specifically, / 10 will contain code that requires customers to register before using. For all subscriptions prior to / 10, we have taken several steps to capture every renewal possible; the capturing renewals of customers when they ask for support and we have manual processes to capture renewals where we have customer names. Also, we need to engage better with our hardware and other distribution partners to attack more respectively the volume distribution channels.

While our strategy centers around the Enterprise market, a market that one would expect to experience an overall smaller percentage of indirect channel business, we must strive and drive with better Linux volumes through the channel. Last year, our indirect channel accounted for 40% to 55% of invoiced Linux revenue as a percent of total Linux invoiced revenue depending on the quarter. Our goal in 2006 is to stay above 50% and we’ve been above 50% for the first two quarters of this year. To further enhance our Linux revenues through our distribution channels, we are highlighting a distribution cash back and enablement program that rewards participating resellers with higher distribution margins for the Linux Solutions. With progress on the above initiatives and as the market moves toward our focus of Linux in the Enterprise, I believe we can grow revenues in excess of the industry growth rates of 20% to 25% and take revenue market share.

Let’s turn to our Identity business. We’re pleased that this business continues to be an outstanding revenue performer. As the market continues to expand, our current product set is being well received by customers and we are providing the market with a unique vision of a roadmap combining Identity Management and Security Information Management to further expand our footprint in customer and prospect accounts. However, given the competitive dynamics in this market, we must continue to advance and enhance our overall solution to maintain our position. To improve our position in this market, Novell aggressively entered the Security Management market as a way to expand our overall compliance management portfolio by acquiring eSecurity for its leading compliance monitoring and reporting capabilities. eSecurities Sentinel 5 product is an Enterprise class security information and event management product and has received many industry awards in recognition for its rich feature set and vision, broad device system and application support, and ease of use. Security Management market demand for Novell appears strong for the rest of the year. One area for improvement and a key component of our strategy for Identity and Security Management business is to establish strategic relationships with consulting systems integrators and business process outsourcers. Novell cannot reach all the potential customers with its direct sale force, we need to leverage the CSIs and the BPOs and use our own consulting force to support them. Novell has committed to a significant expansion in this key area globally and we’ve established a dedicated Identity and Security team responsible for the program.

With several new relationships ready to be launched and other relationships obtained through the acquisition of eSecurity, Novell is now very active in this community. We will continue to aggressively expand and develop new formal relationships and alliances to more effectively take Identity technology to all segments of the industry that we serve, and we will update you periodically on the status of our efforts here.

The near-term outlook for our Identity category remains encouraging, invoicing a strong and a most recent period and a steady flow of new products and aggressive sales and marketing campaigns should sustain over the near term with already strong performance.

Let’s switch to our Workgroup solutions category. OES continues to make inroads within our customer base. We’ve shipped over 8 million OES licenses to nearly 10,000 new and existing customers. Yet, we were disappointed by the revenue performance of the combined category of NetWare and OES as I stated earlier. While we believe many of customers have upgraded OES, we don’t yet know the exact percentages deployed on Linux, and to increase these conversion rates, we’re giving our field organization objectives and incentives to step up the rate of conversion.

We have implemented marketing and other retention programs to improve revenue trends in the Workgroup solutions category while offering increased value to our customers. One such program is our OES-based open Workgroup suite, which we announced in our second quarter and began shipping on May 9th. This suite contains OES, GroupWise, ZENworks, a Linux desktop, and OpenOffice for Windows. This suite sells at a 70% discount to Microsoft’s collaboration suite. We believe it is ideally sold by our channel partners to the SMB market. We believe also that the upcoming release of SUSE Linux Desktop 10, SLED 10, also helped the decline rates in the combined NetWare-OES category over the next year.

These are the types of efforts we’re making to lower the year-over-year decline rates in this product. We’ve made a concerted effort to protect our legacy products for several good reasons. The products have combined revenues of nearly $400 million, are very profitable, and provide cash flow to finance our expansion into Linux and Identity. And lastly, protecting our install base, we love these products. It is important in maintaining our commitment to our customers and to be able to sell our new products in the future.

Let me close my comments with some color on the actions that we’ve taken in the quarter to increase shareholder value. After the culmination of a thorough process to explore all strategic alternatives available to us with respect to Selerant, which is our operations management consulting subsidiary, we decided to sell our entire equity stake to a group including Selerant’s management. We think it is a very good outcome for all constituencies. Our shareholders received a good price for the assets, there should be little-to-no disruption for Selerant’s customers, and Selerant’s management and employees are now owner operators and should be excited about their ownership positions. Selerant is not a significant distraction to our Novell management team, the divestiture will make it easier for shareholders and analysts to better understand our core operations.

With the closing of the transaction, Novell will have no operational or shareholding relationship with Selerant. There are no Novell customer relationships that are impacted by this transaction, nor are there any other material operational impacts to Novell’s business.

As you heard from Joe, we have completed our entire $400 million share repurchase program and several factors led us to complete promptly our repurchases; first we saw good value on our shares, and secondly the management board concluded that the $400 million in cash was excess to the business and should be returned to shareholders in the most efficient manner. The completion of this share repurchase completes our entire board authorized program for share repurchases. Our cash balances are now in line with our current and potential short-term needs, so I do not foresee additional share repurchase authorizations in the very near term. However, as we have said in the past, we review market conditions and our financial situation periodically to determine whether additional share repurchases are warranted.

Lastly, I’d like to spend a moment or two on some initiatives we have implemented to improve our operational and financial efficiency that should lead to higher operating margins in the future. We have previously shared with our objectives of achieving an exit runrate of 12% to 15% operating margins in FY’08. We have many initiatives underway that will yield results by FY’08 but also will have an impact on fiscal year 2007. Such initiatives include general expense control, business process reengineering, selective activity outsourcing, simplified pricing and licensing programs, and a consistent route to market model for our sales organization.

With that, I’ll stop there and we’ll open it up for questions. Operator, we’re now ready to take questions and so would you please open up the queue.

Question-and-Answer Session

Operator

At this time, I would like to remind everyone, if you would like to ask a question, please press “*” then the number “1” on our telephone keypad. If you would like to withdraw your question, press “*” then the number “2” on your telephone keypad. Again, “*” and “1” to ask a question. We’ll pause for just a moment to compile the Q&A roster.

Your first question comes from Katherine Egbert with Jefferies & Company.

Katherine Egbert, Jefferies & Company

Hi, thank you very much. My question is with regard to the Linux platform business. It looks like it was down sequentially, except that business should be pretty fast growing, I’m wondering how it did relative to plan. Also, Jack, can you elaborate on how you expect to grow that business that you mentioned you could get to 20% to 25% growth and take share, can you just elaborate on how you plan to do that?

Jack Messman, Chairman & CEO

Yeah, I didn’t hear the first part of your question, the telephone blanked out for a second. Did you hear it Joe.

Joseph Tibbetts, Senior Vice President, CFO

Yeah, it was just that the revenue in the Linux platform products category were slightly down than last quarter.

Jack Messman, Chairman & CEO

Well, I think that we have tried to explain it with some of the facts that I mentioned in my talk, which is basically we’re signing a lot of longer term contracts where the revenue recognition gets pushed out. We can’t time the mix of that at any given period of time, and I think we believe that the Linux market is moving towards our sweet spot, which is in the Enterprise. I mentioned some of the strengths that we had there, and I believe that as the Linux market moves to our sweet spot we will get more revenue.

Katherine Egbert, Jefferies & Company

Can you say how that product did relative to plan, or give us some sense of maybe a book to bill?

Joseph Tibbetts, Senior Vice President, CFO

Yeah, Katherine, we really wouldn’t give out that information. We haven’t ever talked about our results versus our plan, nor have we given out the invoicing or book to bill data at this point. What we have said is that our invoicing is very strong in this category and that it exceeds industry growth rates, so it’s considerably in excess of the recognized revenue percentage growth, as you can gather from that comment.

Katherine Egbert, Jefferies & Company

Okay, can you give us any sense or are you able to calculate apples to apples, how much NetWare standalone was down year-on-year for the quarter?

Joseph Tibbetts, Senior Vice President, CFO

You’re breaking up a little bit, but I think you asked whether we could calculate how much NetWare apples to apples was down in the quarter?

Katherine Egbert, Jefferies & Company

Right.

Joseph Tibbetts, Senior Vice President, CFO

Well, I don’t know what you mean by apples to apples, because the NetWare number we defined there is considerable obviously because the OES conversions result in the reduced NetWare revenue and increased OES revenue, and then the combined number is down 16%. I’m sure you heard that, so I’m not sure what your question is.

Katherine Egbert, Jefferies & Company

Well, I was just trying to get at, if the line number if 16% down year-over-year, what was NetWare standalone year-on-year?

Jack Messman, Chairman & CEO

Well, I think on page 12 of the press release we break out the NetWare year-over-year, second quarter 2005 went from $60 million to $11.5 million in second quarter 2006. And on the bottom of that schedule pattern you’ll see…page 11 of 13 has the comparison of NetWare and OES combined together.

Joseph Tibbetts, Senior Vice President, CFO

It’s actually a yearly win on an earlier version; it’s on page 12 and 14, on the bottom you can see the combination.

Katherine Egbert, Jefferies & Company

Okay, thanks, and then one last question, just on the Identity and assets management side, is it seasonality that took that down quarter-on-quarter, and if so should we expect an uptake later as we go through the back half of the year?

Joseph Tibbetts, Senior Vice President, CFO

Some amount of seasonality, some amount of specific transactions that were involved in first quarter. It’s very much transaction oriented in terms of revenue recognition.

Katherine Egbert, Jefferies & Company

It’s a perpetual license module, right?

Joseph Tibbetts, Senior Vice President, CFO

Yes, sorry, perpetual, not subscription. So, it’s recognized when we fulfill the obligations we have to recognize revenues. So, it’s going to have some lumpiness to it.

Jack Messman, Chairman & CEO

Some of those Identity projects have consulting mixed with it, so you can’t recognize the product upfront; you have to recognize it over the life of the project. Significantly over a year ago, as you know, and the other phenomenon is that that causes some of the licensing to be considered as services revenue as a result.

Operator

Your next question comes from Mark Murphy.

Mark Murphy, First Albany Capital

Thank you very much, Jack. I’m interested in getting your thoughts on RedHat’s acquisition of JBoss and how that might affect the competitive dynamic in the Linux market place, and does it all impact Novell’s plans as far as Linux acquisitions, possibly encounter the JBoss acquisition?

Jack Messman, Chairman & CEO

Well, I’m going to let my esteemed associate sitting right here with me, Mr. Ronald Hovsepian, who has been intimately involved with that question answer that one for you.

Ronald Hovsepian, President & COO

From my point of view and the distribution point of view, we have been supporting both the JBoss as well as the Geronimo pieces of the AppServer layer in the market, so specifically this is AppServer oriented. And the way I would look at it right now is in that young market you have two OpenSource picks. There were three, RedHat was supporting Jonas and has abandoned that, so we are not sure where RedHat may shift to in the future; you have to ask them. But most importantly, what you’ll see from us is continued support of the multiple AppServers in the market place. We think that’s what the customer wants from a choice perspective and we will continue that from an overall distribution perspective. In terms of other opportunities that it may create or what it had in the market, right now what we’ve seen is positive reaction from a number of the partners that we have that may have competing products in the market place, and we see that as a positive opportunity for us to take advantage of.

Mark Murphy, First Albany Capital

Okay, thank you Ron, and then just as a followup for Joe, within the Linux business I’m trying to understand the comment around how the long-term contractor causing the revenue recognition to get pushed out; it seems that in my experience with other subscription businesses, a move to longer-term contracts would cause the deferred revenue on the balance sheet to increase a little, but would not necessarily impact the current period revenue. Can you just walk us through how that dynamic is working?

Jack Messman, Chairman & CEO

Yeah, I think we’re seeing it from two perspectives, one is if a customer is willing to sign up for multi-year contracts, they are probably getting a better price. They are buying volume and they are getting at better price. So the amount that we would currently recognize in a given period is going to be impacted for that reason, and then we’re not necessarily saying that the other thing decreases the current revenue recognition. It’s just that we’re showing you and commenting on the fact that when we’re selling some of these contracts we’re getting more business that is reflected in our revenue being recognized currently or even in the deferred revenue, because the longer term pieces that are not yet invoicible under the contract don’t end up in the financial statements until such time as their invoice, at which time they would go into both receivables and deferred revenue. So, in the example of the three-year contract and you had invoicing occurring annually, we would recognize the current amount of revenue, we would defer the rest of the first year’s revenue as we build it, and years two and three would not enter into our accounts until years two and three when their invoicing is done.

Ronald Hovsepian, President & COO

This is Ron. In Joe’s example, in a $900,000 contract, just for simple math, year one would get recognized by dividing by 12, and as Joe said until will go invoice, those other two years, years two and three, they do not show up in the deferred revenue bucket. They sit more in an off balance sheet.

Mark Murphy, First Albany Capital

Okay, and then Joe just to clarify the part of, the equation pertains not to the accounting effect but rather to the effect of the different ASPs by moving from one year to a multi-year contract, did you view that as a decision that’s being made on your part as tradeoff for better visibility into future revenue streams, or is there to any extent part of the demand environment that’s having an impact on ASPs?

Joseph Tibbetts, Senior Vice President, CFO

I think it’s a customer by customer decision that we make. Ron, you may want to address this from a sales perspective how you view it.

Ronald Hovsepian, President & COO

I agree with the customer dimension to it, it’s a little workload sensitive. So, if somebody happens to have a grid computing environment that puts up a single image across 2000 servers, and that is the same image that gets replicated, we’re more sensitive to the customer’s needs that the overall amount of use of that particular code and of our support is different than when they’re in a traditional OLPP type environment. We will have multiple workloads existing there. So, when we talk to the customer it’s that full enterprise look putting those three different things together, in that example, we will take into account of that, and that’s what Joe means by “it’s customer by customer.” We do take a hard look at that.

Jack Messman, Chairman & CEO

And one other factor is that we have a broader product line than our competitor and we’re using it to our advantage by trying to bundle other products into a larger sale, and that creates some of these accounting issues.

Mark Murphy, First Albany Capital

Okay, thank you very much.

Operator

Your next question comes from Kirk Materne with Banc of America Securities.

Kirk Materne, Banc of America Securities

Yeah, thanks very much. Joe, I guess my question is really about the cost level heading in the third quarter, as you alluded to in your comments, obviously some of the cost going up were somewhat seasonal due to brain share or some of the reasons how you accrue for expenses. I guess my question is, if you guys can put up a 6% operating margin the first quarter, I don’t know why you’re headed back in that direction pretty quickly at some of the seasonality effects switch back in your favor? I’m just wondering how you guys are I guess adjusting your cost structure given that we’ve obviously seen a decline in NetWare and I guess how would you maintain a little better balance in terms of balancing the cost associated with a declining product line as well as with the revenue going down?

Joseph Tibbetts, Senior Vice President, CFO

I can only answer you generally and can’t give any further specific guidance on the items of our cost, but generally we’re being very sensitive about cost looking in all the aspects of business. Jack actually wired up a pretty good list of things that we’re trying to do to allow us to run the business more efficiently, to take advantage of higher margin opportunities, and to reduce unnecessary cost or at least discretionary cost that perhaps is not contributing to the business the way we want them to do. So, the sensitivity is absolutely here and I can tell you it’s a day-to-day thing here where we’re looking at our cost structure and identifying ways to do things better in the all the ways that I think Jack summarized quite well.

Kirk Materne, Banc of America Securities

I guess maybe this question is for Ron. It seems that you guys haven’t really been able to gain any steam with some of the OEMs on the distribution site. What has to happen there and how are we anywhere closer to a turning corner in terms of getting better leverage from distribution partners, because it seems that in the broader Linux market you guys still seem to be lagging behind I guess.

Ronald Hovsepian, President & COO

Yeah, I think in the commentary there were two pieces made; one, A little more focus on that enterprise, so we expect to be more in that 50-50 range, and two, from the distribution partners inside the customers, and to get that broader reach, the leverage there that’s still something we’re working through is while we’re making it now into all of the distributors, catalogs, etc., there is the dimension of building in the marketing programs which we are doing with them, but there’s also the dimension of building up their solution sales that they’re doing, meaning that we should be bundled into a whole stack of things that they go sell and that’s what the teams have been very focused on recently, to now cross that next chiasm with them. So, we do expect that to kick in. As I said here, a lot of those are multi-tiered models, meaning IBM may distribute through Avnet, so we’ve got to hit both sides of that equation to actually make it function properly, and hopefully I’ll be able to give you a little bit of more color into that next quarter with some statistics as we go forward as we look at these things, some of the more sharing that we’d like to do going forward.

Jack Messman, Chairman & CEO

Yeah, I eluded Kirk in my comments to fact that we’re piloting a distribution cash back ennoblement program to reward participating resellers with higher distribution margins. So, we’re not prepared to state too many of those details for competitive reasons right now, but those programs are being evaluated to do what you just suggested, which is get more revenue out of the OEMs.

Kirk Materne, Banc of America Securities

A followup question, just on your OA guidance, I guess targets rates from margins, how much of that is going to be based on revenue picking up and how much qualitatively is based on getting better efficient, because it seems like you guys are in a little bit of a flat revenue state right now?

Joseph Tibbetts, Senior Vice President, CFO

Yeah, I think it’s both, I think it’s probably weighted towards…I don’t want to give you too much insight into our revenue growth plans, but I think we still got a deal with the revenue offsets, NetWare going down and new core businesses coming up, which is obviously favorable to the business but doesn’t give us expanded revenue overall until the ups or downs changes there. So, it’s going to be very much oriented towards taking advantage of revenue growth without increasing cost structure disproportionately and then doing all of the other things that we talked about. So, it is really both and we’re really shooting to exit or wait with that kind of an increase in our operating margins.

Operator

Your next question comes from Brent Thill with Citigroup.

Brent Thill, Citigroup Global Markets

Thanks. If you measure a business right now, perpetual versus subscription, how do you measure what percent of the business is on subscription today?

Joseph Tibbetts, Senior Vice President, CFO

Well, if you look at our maintenance business, that’s all subscription of a sort. So, anything on the maintenance line is of a subscription nature, and then when you look at the open source business on the Linux side that is all listed as maintenance and services, because that’s subscription. So, on page 13 or 14, you can get a good sense of the licenses versus maintenance and services, and that’s summarized down the bottom there and those are really the two elements. We’re largely oriented towards maintenance and services and subscriptions as you know.

Brent Thill, Citigroup Global Markets

Have there been thoughts for the entire business, going back to Ron’s presentation at the user conference, the focus on simplification, has there been thought of just making a change to make this a little more consistent across all product lines. Is that something that you’ve given thought to, or what will be the limitations of going to that model?

Ronald Hovsepian, President & COO

To answer your question directly, yes we’ve given thoughts to it, yes there’s a team working on it, that’s one of the simplification things that Jack had highlighted. As you know, if you were to roll out anything like that it takes a lot of work both to prepare the customer and to prepare the financial impact of that, and we’re looking at that. That is an area I think that’s target rich for simplification. That’s as far as I’m willing to go right now.

Jack Messman, Chairman & CEO

The only other thing I’d say on that is there are definitely customers out there who want that and there are definitely customers out there who say “no, I do not want to pay the bigger amount every year. I want to pay upfront and get it through my budget cycle and then move on.”

Ronald Hovsepian, President & COO

So, again highlighting my answer, it’s an area for simplification. I’m not saying which way the model will land, but I think it’s an area for us to simplify the variety of pricing models that we have.

Jack Messman, Chairman & CEO

I have an example of that on our Workgroups suite that we recently announced. We gave them a purchase option and a subscription option; that simplified those options very well.

Operator

Your next question comes from Jason Maynard with Credit Suisse.

Jason Maynard, Credit Suisse First Boston

Good afternoon guys. I wanted to follow up on the expense items and just some of the areas that you highlighted for operating efficiencies that gets around, expense control, business process reengineering, outsourcing, and how are you guys thinking about the timing of implementing those things; I mean is this 90 plus days into Ron’s tenure as President and now that he has had a chance to may be do an evaluation start putting that in motion, or what are the sort of the gating factors to determine when this step actually becomes a reality?

Ronald Hovsepian, President & COO

In terms of timing, we’re not waiting for a big bang theory. We will take advantage of the opportunities as they present them and move aggressively, obviously after taking into account customers and employees and how we go about that. But, those are the things that are absolutely on the target list. I think Jack put them into proper summary categories. Underneath that we’ve identified in those major buckets of jacket highlighted, we identified some 18 projects that we’re focused on as a leadership team and ploughing through those at different stages right now, from proposals, to opportunity, to execute on, some we’ve actually closed the loop on now that we’ve brought up our new Oracle system, we’ve been able to reduce some SKUs; I mean this is a lot of movement pieces that we are focused on in detail, and at the right point in time we’ll walk you through sharing those pieces as to what they are driving.

Jack Messman, Chairman & CEO

You always have to have more opportunities than you expect to net, because you got to play the odds games, so you’ve have got lots of opportunities. Some of them will occur in a short period of time and some of them will take longer, and we think we have enough opportunities if we can execute on them to get to the 12% to 15% operating exit rate in FY’08.

Jason Maynard, Credit Suisse First Boston

Okay, and then maybe shift gears on OES and NetWare, what do you think the problem is in terms of getting your install based to buy into the OES value proposition, because I think minus 16 is probably not the ballpark you guys were hoping for when you originally launched the product?

Ronald Hovsepian, President & COO

Yeah, I think there are several things that we all need to make sure we understand. So, one of them is when you look underneath the numbers, my assessment is it’s mostly occurring in the license area. If you actually look at the deferred line item on deferred revenue, which is primarily one of the key drivers underneath it, the drop there was a fairly small number when you look a that 16% decline. The bulk of it really came out of what I would define as more license orientation. So that’s how we’re going into it, which is to be constructive to a certain degree in that market given where it is. Item two, what we’ve done is we’ve systematically put in place, one, getting our customers to move at a contractual level from NetWare to OES, and as Jack had indicated we have made good progress against that in terms of the contract level at 80%, I believe, is what we shared with the group. The next step is when you migrate down into your pilots and then from your pilots to the full role out. And in the sample that we’ve done the analysis on, which is multiple hundreds of customers where we have physically gone out and touched those customers through our service account managers, we are now tracking towards an objective that we set for this fiscal year, we’ve got another one for next fiscal year to make those migrations happen. And you have to remember these things are embedded in peoples’ networks and core businesses. They just don’t throw them out and whip them out and move along very quickly on these things. So, what’s most important is we’re tracking internally, and as Jack had indicated, what we’d like to share with you overtime is the pilot rate that we’re seeing right now and then the conversion over to the full roll outs, and this is something that we’re doing right now on a statistical basis on obviously the largest accounts that we see into. So that’s the gameplan to get those customers converted over as part of that process.

Jason Maynard, Credit Suisse First Boston

Did I read it right then when you said instead of the new software licenses that the overall product bookings would be only down a few percentage points annually, is that the implication?

Ronald Hovsepian, President & COO

I don’t want to misspeak because I’m not quite sure which data you are referring to. What I was highlighting was when I look at the numbers for that this past quarter specifically under the invoicing and what we referred to as the 16% decline, the bulk of it came in the invoicing area, which tells me that it’s mostly the license revenue that’s getting hit, because we’re not seeing it realtime within the quarter. And when I look at the deferred revenue bucket, that particular line item for that one category or product of the core piece of it is something that was a fairly small number on the deferred. So we absolutely are feeling it on the license side of it; we did not feel it on the deferred revenue piece of it, which is primarily maintenance. Did that answer your question? I’m sorry I just want to make sure I get you right on it.

Jason Maynard, Credit Suisse First Boston

I get that but I’m trying to figure out if I take new software license related to OES and NetWare and add in what you we call maybe an overall booking around or maintenance contract of that. If you jam that two together, do you end up with a number that’s up or down or sideways, relative to your minus 16 report?

Ronald Hovsepian, President & COO

I think the way I would like to answer that question, as Jack had indicated, we’d like to give you some more leading indicators in the business in the near term, and one of the things that would help you solve that equation would be a view into our invoicing and these are some of the things that we’re trying to make sure we pull together so that we can give you that. Right now, I do not want to comment on it beyond that in this sphere.

Joseph Tibbetts, Senior Vice President, CFO

Yeah this is the modeling exercise, Jason, as you know, and I think there are three factors that you have to take into account to predict the long term here; that is how much of NetWare goes to OES, and it is felt that that’s been happening at about 80%. The next thing from Ron’s point of view is how many of the people who take OES are going to actually use Linux; that’s the conversion factor that is going to push ourselves to make that happens, and that’s determined by many customers who have not yet made the Linux decision and they wait for their next hardware upgrade or next software upgrade to do something with this new set of functionality they got with our product. And thirdly is, what’s the renewal rate on OES; when these contracts or purchases that were made a year ago, what happens when they start renewing? And obviously we’re hoping that the renewals will be a fairly high percentage. So, our aspiration is that the combined OES and NetWare decline rate will asymptotically approach some level number and if we do the right things with things like Workgroup Server or Open Workgroup Server and other products that we’re thinking about, we can actually add products to the category that will make the total.

Operator

Ladies and gentleman we have run out of time for our question and answer segment of today’s program. I’ll now turn the call back over to management for closing remarks.

Jack Messman, Chairman & CEO

Thank you all for being with us and we look forward to sharing our progress with you in the coming months.

Operator

Ladies and gentleman, this does conclude our conference call for this afternoon. We appreciate your joining, you may now disconnect.

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Source: Novell, Inc. Q2 2006 Earnings Conference Call Transcript (NOVL)

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