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Novell, Inc. (NASDAQ:NOVL)

F4Q06 Earnings Call

December 5, 2006 5:00 pm ET

Executives

Bill Smith - VP of IR

Ron Hovsepian - President and CEO

Dana Russell - Interim CFO

Analysts

Kirk Materne - Banc of America Securities

Katherine Egbert - Jefferies

Mark Murphy - First Albany

Aaron Schwartz - JP Morgan

Jason Maynard - Credit Suisse

Brent Thill - Citigroup

Brendan Barnicle - Pacific Crest

Presentation

Operator

Good evening. My name is Tanisha and I will be your conference operator. At this time I would like to welcome everyone to the Novell Fourth Quarter 2006 Financial Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there would be a question-and-answer session. [Operator Instructions]. Thank you. Mr. Smith, you may begin.

Bill Smith

Thank you, operator. 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 Ron Hovsepian, President and Chief and Executive Officer and Dana Russell, Interim Chief Financial Officer.

We are here this afternoon to discuss Novell’s preliminary financial results for the fourth fiscal quarter and full fiscal year 2006. There is 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 December 12th. A telephone replay of this call will also be available two hours after the conclusion of this call at phone number 800-642-1687, and will run through December 12th.

You should note that the results we are announcing today are preliminary financial results for the fourth fiscal quarter and full fiscal year ended October 31, 2006. These financial results are preliminary because Novell during the third fiscal quarter 2006 began a self-initiated voluntary review of the company’s historical stock-based compensation practices and related potential accounting impact.

The financial results reported today do not take into account any adjustments that may be required in connection with the completion of the stock-based compensation review and should be considered preliminary until Novell files its Form 10-Q for the third fiscal quarter ended July 31, 2006 and Form 10-K report for the full fiscal year ended October 31, 2006, following the conclusion of the review. This review may result in the need to record non-cash stock compensation charges and related tax effects. Novell does not know whether any such compensation charges would affect the preliminary financial results for its third quarter fiscal quarter 2006, fourth fiscal quarter 2006, or full fiscal year ended October 31, 2006 or would be deemed to be material and require the company to restate previously issued financial statements.

Novell did not file its quarterly report on Form 10-Q for the quarter ended July 31, 2006 on a timely basis and it is possible that as a result of the ongoing options review, Novell may not file its Form 10-K report for the full fiscal year ended October 31, 2006 on a timely basis.

I should also note that during this call we will be making statements that are not historical in nature and they may be 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 Dana.

Dana Russell

Thanks, Bill. Good afternoon everyone. Novell's preliminary fourth quarter 2006 financial results were released a short time ago. For the quarter, the company reported net revenues of $245 million. The GAAP income available to common stockholders from continuing operations was $25 million resulting in a diluted earnings per share of $0.06. Non-GAAP diluted income available to common stockholders from continuing operations for the quarter was $20 million or $0.05 per diluted common share. Those amounts excluded stock-based compensation, restructuring expenses, gains on the sale of investments, asset impairments, stock-based compensation review expense, and the related adjustments for income taxes and the allocation of earnings to preferred stock holders.

Our $245 million of total revenue this quarter represents a 15% decrease from the same quarter a year ago. The significant impact of the deal from the UK National Health Service in last year's quarter was a primary contributing factor to the year-over-year revenue decline. This large deal which contributed over 20 million through recognized revenue and 29 million in invoicing significantly impacts the year-over-year comparability of our resource management figures and to a lesser extent, our identity and access management numbers.

Also contributing to the decline were planned declines in IT consulting as well as anticipated declines in our legacy NetWare business. There was no meaningful year-over-year impact from foreign currency on either revenue or net income.

Turning to page 12 in the press release schedules, I'll briefly highlight some of the quarterly revenue items unaffected by the NHS deal impact in the year ago period.

Within open platform solutions our Linux platform products category revenue increased 32% over the prior year's quarter to $13 million including 31% growth in SUSE Linux Enterprise Server. Invoicing was up 18% over the prior year's period. We have built up a stronger base of deferred revenue in this category that is contributing to higher recognized revenues. Deferred revenue associated with Linux and other platform products -- other open platform products at the end of the quarter was $46 million, up 16% from the prior quarter and up 57% year-over-year.

Within our workspace solutions category, the combined OES and NetWare related revenue was down 25% on a year-over-year basis. Year-over-year invoicing declined 18% for our combined OES and network related products. We expect year-over-year declines of 15% to 20% in this category over the next year.

Stepping back from the quarters -- quarterly comparisons for a moment, an examination of the fiscal year revenue trends for our solution categories show some encouraging signs. Where we have chosen to invest is in our Linux and Identity and Access Management products, we have seen very good growth.

For the full fiscal year 2006 as compared to fiscal year 2005, we generated Linux platform product revenue and the invoicing growth of 26% and 31% respectively and Identity and Access Management revenue and invoicing growth of 30% and 25% respectively. Resource management revenue and invoicing declined 7% and 12% respectively. Now excluding the impact of the NHS deal, Identity and Access Management revenue and invoicing growth would have been 35% and 30% respectively and resource management revenue and invoicing growth would have been 1% and a negative 2% respectively.

The results for both Linux platform products and Identity and Access Management are in access of reported market growth rate and give us confidences that we are well positioned in these markets. Our cost of sales and operating expenses will reduce significantly from 2005 levels before considering the impact of stock-based compensation. The reduction of these expenses offset the revenue decline between the two periods.

Now shifting to the balance sheet, we have few items to note. Cash and short-term investments of $1.5 billion, up 13% from the prior quarter due primarily to the sale of our venture capital limited partnership interests and positive cash flow from operations, which was a positive $62 million, up 4 million over the prior year.

Net receivables decreased $60 million from the same period a year ago due primarily to the sale of Celerant and the NHS deal. DSO, day sales outstanding was 86, up 5 days compared to a year ago. And our accounts receivable aging remains consistent with prior periods.

Deferred revenue at $427 million was up 5% year-over-year, which reflects increased advanced invoicing and a continued shift to a more subscription based and a ratably recognized revenue stream. Our total headcount at the end of the quarter was approximately 4,700.

I'll now cover some of the details between two recent successful transactions we had, the Microsoft partnership and the consent solicitation process. Regarding the Microsoft partnership announced on November 2, 2006 there are two significant aspects of this arrangement, which will have an impact on our P&L. First, Microsoft has purchased 240 million worth of coupons with entirely activator of the coupon to one or three years of maintenance and support to the Novel, SUSE Linux OS distribution. We expect to deliver the coupons to Microsoft in equal quarterly installments which is expected to result in an estimated 35,000 to 70,000 coupons per annum, depending on the mix of one or three year coupon used.

Novell will recognize revenue in this arrangement upon the earlier of, one the activation of the coupon by a customer via our website, which will result in ratable revenue recognition of the value of that subscription over 12 or 36 months or two, the expiration of the coupon in 12 months from the date of the delivery of that coupon to Microsoft, which will result in the recognition of the entire value of the coupon at that point. This revenue will be reported as Linux platform products revenue. The entire $240 million will be recorded in cash and deferred revenue in Q1 2007, and deferred revenue will be reduced as revenue is recognized for the previously mentioned factors.

Additionally, Novell will recognize $58 million to $68 million in net balancing payments from Microsoft in exchange for providing Microsoft a release from potential liability for patent infringement and a covenant not to sue Microsoft’s customers. This amount will be recorded as product revenue and recognized over the 5-year life of the partnership.

Now regarding the consent solicitation. On November 9, 2006, we completed the previously announced consent solicitation with respect to our convertible senior debentures. Under the terms of the consent, Novell will pay additional interest expense totaling $44 million with payments on January 15, 2007; July 15, 2007; and January 15, 2008. These payments will be accounted for as interest expense on a ratable basis through July 2009. The first -- the date of the first put call arrangement on the debt.

Now let me turn the call over to Ron for a brief review of the strategic initiatives in the quarter, plus an overview of what to expect in fiscal year 2007. Ron?

Ron Hovsepian

Thanks, Dana. Let me now comment on three general areas: first, an update on our growth businesses of Linux and Identity; second, a view into our latest progress around data center management; and third, specifics around our progress and focus on our most critical strategic initiatives. In our Linux business, clearly the big story here is our partnership with Microsoft. For many quarters now, we have worked hard to expand our indirect channel sales to improve our Linux performance. In our partnership with Microsoft, we have taken a giant step forward to that end. Frankly, Microsoft is more than just a channel for us. They are a partner in technical innovation and development and a go-to-market partner in marketing and sales. In short, a true global strategic partner for Novell. This new relationship has the potential to reshape the future of our entire Linux business. We now have the endorsement of the largest software company in the world, who is now recommending SUSE Linux Enterprise Server as their preferred solution in the Microsoft environment. This is very exciting for thousands of clients who are looking to deploy both Linux and Windows in their mixed environment. It's equally exciting for our direct and indirect sales teams as they now have a new offer of interoperability to promote to our customers.

Customer reception of the collaboration agreement has been tremendously positive. I have already heard from customers and they are looking forward to the benefits of our new relationship with Microsoft. In fact, we now have several Linux deals that are accelerating as a result of our new partnership.

As always, execution will be the key to success here and I feel that we are off to a strong start in this regard. For example, the Novell and Microsoft senior alliance executives have already met on numerous occasions and have outlined goals for a quick start to the relationship. We've already started joint marketing of the solution and an integrated marketing plan is being developed with Microsoft this month. In January, we are targeting to build a pipeline of 150 customers and ship approximately 20,000 certificates. These are ambitious goals given the short timeframe in question, but our joint teams are highly confident they can be achieved.

Looking at our FY 2006 Linux performance for a moment. Overall, it was a very good year. Our strong financial performance in both recognized and invoiced revenues reflect our leading technology within the newly released SUSE Linux 10 distribution. Our strategy of focusing on enterprise adoption of Linux in a mixed source environment is bearing fruit and is shaping up to be the future of -- to be the future of Linux.

For the full year, Novell's Identity and security management products experienced another year of significant growth and progress. Fiscal year 2006 saw a strong product growth in bold preparations for the fiscal year 2007, through key development initiatives and product releases, including Novell Identity Manager 3, Novell SecureLogin 6 and Novell Access Manager 3. Our e-Security Sentinel product acquisition has opened the door to provide a comprehensive compliance solution to integrate people, systems, and processes. We have market leading products and a sales force that is executed well over the last 12 months.

For the year, within the Identity and Access Management category, revenue grew 30% and invoicing was up 25%. For the quarter, the business exceeded market growth rates but did not perform up to our high expectations. Our products within the Identity and Access Management category are receiving high marks. An area of good progress in the quarter is with the industry analyst community. In addition to our previously announced recognition for our Identity Manager 3 product, our recently announced Novell Access Manager 3 has been ranked by Gartner as a market leader in Web Access Management in their October 2006 Magic Quadrant. We anticipate benefiting from these changes and perception in 2007.

Finally, just last week, we announced the first offerings around data center automation branded under the ZENworks family. Following the interoperability agreement with Microsoft, these offerings are important next steps in Novell's plan to deliver on its vision of interoperability -- interoperable cross-platform management solutions. Given the fragmentation in the market, coupled with our unique positioning, we are excited about the potential this market holds for us.

Now, turning to the state of our business and our plans for next year. I've been CEO -- I've been in the CEO job here for over 5 months. And I am even more excited about Novell's potential today than I was when I first took the leadership job here. We have strong businesses built around our leading Linux, open source, Identity, and systems management technologies. Since I began, our leadership team has been focused on the following areas, to put us on a path towards long-term sustained profitability. We have sharpened our strategy. As a software company, we will focus on selling software products and offer services that support these products. We will be a leader in the enterprise-wide Linux and security and systems management services required for mixed IT environments. We will use Linux and it's ubiquity as an insertion point to sell cross-platform enterprise management services, such as, Identity, security and systems management. These services will be of a mixed source nature, reflecting our customers' mixed source IT environments.

We are changing management focus of the company by shifting from a geographic focus to a product focus. Therefore beginning in Q1 2007, we will externally report some of our results by business unit. This new reporting structure is simply a reflection of how we will manage the business in the future. We will also bring increased levels of market focus and alignment in our efforts to drive our business along product lines.

In support of our strategy and execution -- focus on execution, we have underway three important initiatives to redesign our business. Initiative one: sales, we are investing in and aligning our sales model to address our unique markets and opportunities. Specifically, we are undertaking a major shift from direct to indirect coverage and capabilities. To accomplish this transition, we are building out a world-class infrastructure for web and telesales. These new capabilities will be focused on our renewal activities, freeing up our direct field force for new customer acquisition. Additionally, we are investing in new dedicated specialization rules and training that will allow for a clearer, more differentiated conversation about our product benefits.

Finally, we are increasing our overall development of and investment in a targeted set of global strategic partners with whom we can go to market within our strategic categories. The net impact of these routes to market initiatives will be a more cost effective channel that increases the breadth, the depth and the impact of our coverage.

Initiative two: research and development. With our increased emphasis on our business unit structure, we have already begun the process for improving the cost and productivity balance between on and offshore R&D locations. To manage a thoughtful transition to this balance state, we are investing and overlapping offshore teams to eventually assume functions once handled by more expensive environments. Additionally, our investments in improved product life cycle management process will help facilitate this activity, while assuring our products are addressing the market needs.

Initiative three, back office. Our study of back office functions and costs led by an external specialist consulting firm is complete and we are reviewing the results. We believe moving to a service center model with standard processes will yield positive results. We expect to implement a series of actions in the very near term to capitalize on the recommendations. These three initiatives will require investment in 2007. Novell has undergone multiple restructurings over the last five years, incurring restructuring expense of almost $150 million. And while these efforts have had short-term positive affects, they have not fully realized their full promise in materially altering our long-term revenue declines, our profitability, via the overall manner in which we conduct business.

While we strongly considered another restructuring at the start of this financial year, we believe a more sustained, thoughtful, and impactful approach is required for long-term profitability. Simply undertaking another significant cost reduction without strategy, business model, and operational alignment would put our business at significant risk and restrict us from capitalizing on the timeliness of our market opportunities.

As I've said in the past, we are absolutely focused on achieving sustainable profitability. While recent actions and results are encouraging, I realize there is much to do to place Novell on a consistent path to profitability. All of the previously mentioned set of actions will require investments in 2007.

Operating expenses in fiscal year 2007 will temporarily increase as we build out these initiatives. Operate some functions and parallel and transition to new business models. We must incur these costs to redesign our business to ensure long-term revenue growth and return to industry standards of profitability.

To track this management team's progress on our initiatives, we will provide you with a set of specific milestones. As we exit Q4 fiscal year 2007, we expect to have: One, revenue that is at or near flat on a year-over-year basis stemming years of top-line organic revenue decline. Two, increased both the revenue and invoiced Linux product platform revenue growth rates from our fiscal year 2006 levels. Three, sustain our strong growth rates in identity, revenue and invoicing. Four, adding another one to two strategic partners to fortify our indirect channel, Microsoft was the first. Five, improved from fiscal year 2006 levels our sales expense to revenue ratio by 50 to 100 basis points while making a significant sales model change, product development expense ratio -- expense to revenue ratio by 100 to 200 basis points while implementing consistent processes, and G&A expense to revenue ratio by 50 to 100 basis points while implementing more of a shared services model with common processes. And six, achieve an exit rate operating margin of 5% to 7%, a significant improvement over recent historical trends. For example, the comparable exit rate for full year 2006 is 1%.

These plans are being executed to create a more focused software company that provides greater differentiated value for our customers. In doing so, we will drive a set of achievable, financial goals including and most importantly a 12% to 15% exit operating margin at the end of Q4 2008 and longer term sustainable revenue and profitability. All structural options available to us are under consideration. We will examine acquisitions, divestitures, and other capital structure alternatives only and so far, as they speed up progress toward our financial and business goals.

While these plans are ambitious, our opportunity is now and we cannot afford to wait. I am confident our strategic clarity supported by a thoughtful model design and a focus on operational execution will lead to a combination of short- and long-term benefits.

Let me turn it back over to Dana for specific financial and other guidance for FY 2007 and beyond. Dana?

Dana Russell

Thanks, Ron. Fiscal year 2007 will be a year of significant change for Novell. We will make investments to facilitate changes in our business model while sustaining our revenue momentum in our growth businesses, such as Linux and Identity and managing the revenue declines in our legacy work group businesses, such as NetWare, OES, and group-wise.

As we exit fiscal year 2007, the company will be leaner, more efficient, and positioned for increased operating profit. More specifically, in 2007, we plan on generating revenue of $945 million to $975 million and generate a breakeven to $10 million operating income before consideration of extraordinary items and stock-based compensation expenses. These figures include the effect of the Microsoft partnership, such as the net balance in payments of approximately $16 million and the prepaid subscription rights revenue of between $4 million and $7 million in fiscal year 2007. The $4 million to $7 million revenue figure is lower in earlier periods of this transaction as the sales effort and ratable recognition of the Linux subscription takes time to build.

This fiscal 2007 revenue target represents flat or close to flat revenue performance from fiscal year 2006. We are encouraged by the growth rates in our key strategic products and we see the real possibility of total company organic revenue growth in fiscal year 2008.

By way of other guidance, we estimate stock-based compensation expenses to be approximately $35 million in 2007 and also our effective tax rate for fiscal year 2007 is estimated to be 100%. Shares outstanding for the year are estimated to be between $350 million and $355 million.

To better manage our long-term outlook on the business and the work we need to perform on the business this year, we're providing annual guidance and anticipate updating our annual guidance only if events during the year causes to materially change our fiscal year 2007 outlook. We are targeting to remove certain expenses throughout 2007, while investing for improved profitability in 2008. We will not get into the ins and outs of quarterly expense estimates, but we plan to invest $20 million to $25 million in operating expense to execute our model changes in the fiscal year.

Just to be sure I make the point, the overlapping expenses will be eliminated by the end of fiscal year 2007. After the elimination of these expenses and the realization of the run rate savings from these investments, we are targeting a Q4 2007 exit rate operating margin of 5% to 7%, which excludes stock-based compensation. As Ron mentioned, the 5% to 7% exit rate would be comparable to 1% exit rate in fiscal year 2006. This exit rate in fiscal year 2006 is primarily due to including a full year of expenses from e-Security and other recurring cost of living increases. By exit rate, we mean at the end of Q4 2007, we will have an annualized expense run rate that when compared to the fiscal year 2007 revenue would result in an operating margin of 5% to 7%. This exit rate operating margin will not be able to be calculated from our reported financials in the Q4 2007 period as any cost actions taken in the fourth quarter will not be fully reflected in the fourth quarter figures. We will provide the exit run rate calculation to you in Q4 2007.

This exit rate analysis is a good approximation for the run rate costs as we enter fiscal year 2008 and will give us a good indicator of our progress toward the ultimate longer term goal of a 12% to 15% exit rate operating margin in Q4 2008, which we have provided previously and we are now reaffirming.

I'll stop there for now and open it up for questions. Operator, will you please open up the queue for our listeners.

Question-and-Answer Session

Operator

[Operator Instructions]. Your first question comes from Kirk Materne with BoA, Banc of America Securities.

Kirk Materne - Banc of America Securities

Thanks very much. I guess, Ron, just on the increased investments you're making, I guess where I get a little confused is with NetWare in decline, with a number of your businesses in decline, I would think that there would be some savings around those businesses as they are in decline as you adjust the cost structure around those businesses to offset some of the investments you need to make. It seems to me that you guys are almost saying you're stretched right now in terms of op expenses whereas your op margins would tell a different story relative to your gross margins. So, I guess, just could you give us some more color on why you can't find some cost savings in other places and repurpose that to some of the initiatives you've outlined?

Dana Russell

Hey, Kirk, this is Dana and I will take a crack out and then Ron can fill in if I leave some blanks. But, I think a couple of things that we haven’t talked about, one is, that we're going to be providing segment reporting, it’s a little different where we are going to actually have business unit reporting in 2007, where we really reported from a geographical basis in 2006. And what we're going to be able to show then is the revenue streams associated with some of the direct investments that we’re making in each of these groups it will give you a better indication in terms of what we're spending our money on. With respect to the overlapping expenses, what we are saying from this model is we do believe that we can reduce expenses, but we believe a more systematic approach to it where we actually transition to lower cost environment is going to be the most beneficial and the best for us long term. So, I think that’s probably where I'd leave that.

Ron Hovsepian

Yeah. The only part that I would add to that would be, Kirk, as you are appropriately pointing out, are we managing the older, the more mature businesses in that fashion and the answer is, yes that’s the intention. We also have to continue some developments there to justify those revenue streams. So, as case in point, one of the developments that we have underway is -- with OES as an example is getting Cypress out the door with that release and we're working through that. And at the same time, as Dan appropriately pointed out, we are making incremental investments in getting other investments for R&D up and going so we can get that parallel function occurring, so that we can ultimately manage our total cost as a business.

Kirk Materne - Banc of America Securities

Okay. And just one final question, I guess Ron when you look at what you guys are attempting to do here and given the history with Novell of spending and never really providing a return back to shareholders. Have you considered just taking this company private because I am -- I mean it's difficult, I think for investors to, I think while your initiatives are obviously pretty -- I think you placed them up and front of what you want do but it's hard to -- I think it's hard for investors to give you guys credit upfront for some of these incremental investments you are making in terms of the payoff, and I guess can you quantify what the payoff is, if you are going to spend 20 to 25 million, what kind of long-term run rate savings are you targeting with these kind of investments?

Ron Hovsepian

Yes. So, we have come out and said our direction for getting to that 12% to 15% operating margin in Q4 '08 is our commitment and we are staying to that commitment. That's where I do see the longer-term return. In terms of the individual investments that we have identified and some of which we've started, each one of those has tagged with it a return -- appropriate return for the shareholders investment that we would make there. So, each one of those -- we are not releasing the dollars until we see the appropriate plans that support that. But there is a timeliness in the market of getting all of these things done in an organized manner connecting up to different pieces here of what we want to get done. I do agree with your assessment that we haven't necessarily shown our shareholders returns over the years for some of those investments. I don't have all the details. What I can tell you is focusing on it and analyzing in a lot of detail the last five months, the part that I really leaped out to me was the linkage issue of integrating the strategy with the model, with the operational execution. That to me was the big missing piece of it. And what you are hearing this leadership team tell you is we are very focused on tying those three pieces together. So, to that end to your first question is around taking the company private, all options will be considered in the normal course of looking at our capital structure on a regular basis.

Kirk Materne - Banc of America Securities

Okay. Thank you.

Operator

Your next question comes from Katherine Egbert with Jefferies.

Katherine Egbert - Jefferies

I have a few questions around Microsoft. First one is, can you tell us what the go-to-market strategy is with the coupons? And what are the chances do you think that you just windup recognizing this upfront after 12 months? I think it's 36 million in revenue, that’s probably bookings somewhere around 20 million for '07, that didn’t seem like a lot?

Dana Russell

You kind of broke up there a little bit, Katharine. Can you just restate last part of your question?

Ron Hovsepian

In particular the numbers got a little gobbled.

Katherine Egbert - Jefferies

You had the bookings for or I think you guided to revenue with your Microsoft looks like 4 million to 6 million for '07, which would imply bookings somewhere around 20 million when that is correct, so that seems awfully low. The general question is -- are you going to windup recognizing a lot of these coupons at the end of the year upfront rather than having Microsoft be a viable [resource] channel?

Ron Hovsepian

So, let me give you two part answer. One is on your go-to-market question. We've already put in place a 30, 60, 90 day go-to-market plan with them. We've been meeting regularly. We have a standard cadence by which we go through and layout the review of items. And as I shared with you, we're focused on a pipeline right now that I did share with you of building a pipeline up of 150 customers and getting 20,000 of these certificates out there in the market through that particular channel. So, additionally, they have dedicated sales force to this as well that our carrying quota and are dedicated to this relationship out in the field. And then finally, we are finishing up the integrated marketing plan at the end of this month.

So in terms of go-to-market elements, which I would traditionally break into marketing and sales functions, all those pieces are either underway or in place and most importantly, there is a standard cadence by which we are measuring and managing that collectively. And then in terms of the revenue recognition and the pipe, I am going to turn that over to Dana, so that I think everybody needs to understand some of the subtle pieces of the revenue recognition as we go through this.

Dana Russell

Yeah, Katharine, I think your question on the 4 million to 7 million that we said would come in as a result of the subscription revenue. So obviously you look at this deal and you say, you have got $240 million that’s going to paid to you upfront. We've already said that that’s going to be reported in deferred revenue and would be recognized as we see this get into the hands of customers. Now, we believe that’s what's going to happen. We believe these coupons will get into the customers' hands and then we will see ratable revenue recognition over these service periods.

The other side of that, the complete opposite of that would be that none of those get into customers' hands and that we have the full amount of that recognizing revenue after 12 months. Our particular model anticipates that a large portion of this is getting into customers' hands and that we are going to see that ramp up significantly in 2008. So when you look at this $48 million, if you take the 240 million divide it by five years, you are saying there is a potential, if this is completely even per year, 48 million per year. And so if you do the math on that, 2008 is going to be a very good year and we believe that the estimates for 2007 are conservative.

Katherine Egbert - Jefferies

Okay. And then a follow-up on Kirk's question, the [Asia] targeting like Identity Management, data center automation and some others are pretty fractured market. So, can you just tell us a little bit about how you plan to get bigger in those markets? And then do you think you can develop your way or do you need to acquire? And then conversely, I know as the resource management area was weak, may be it was just the area you're comparing was hard, but any consideration in existing any of these business?

Ron Hovsepian

I just respect -- I've got the existing part, I just missed the middle part, broke up a little bit, I don’t think anyone in the room heard it. Kath, I think you --

Katherine Egbert - Jefferies

Yeah, okay. I just picked up by head --

Ron Hovsepian

-- resource management. Okay. So Katherine, let me pop through and answer those for you. First and foremost, in terms of assets and pieces within that market in that fragmented market, it's actually the DCA market. The data center automation market is very young in the corollary, and the linkage to us is the following. One, is the Xen virtualization piece of it. The Xen virtualization is directly linked to the discussion that we're having in the interoperability discussion with Microsoft. So, what we have is a level of exclusivity with Microsoft over the next three years to be their exclusive partner in around Linux for distributing Linux coupons -- distributing Linux with virtualization and interoperability. That’s really what drove the core of the relationship.

On top of that what we announced last week at the Gartner Data Center conference was our Xen orchestration product and several other components to go with that, which is the ability to now manage a virtualized world in Linux, Windows or UNIX. And that was a really key part, that’s the second step that we had laid out as a team in the first five months here to make sure that we've got done and out the door as part of this piece of the announcement.

Now, to your next part of your question around the ZENworks, which is ZEN, so I apologize. We have ZENs that I highlighted, Xen is a virtualization technology in the open source community, ZEN is part of our product family. The ZENworks product set fits together because that is mostly desktop management with some server management. And what we're doing is now tying all those pieces together in a holistic manner to take advantage of how virtualization may play on all those different scales. That’s the core of the strategy. In terms of looking at other assets that sit within our portfolio that do not fit into these core Linux and the management services what we called enterprise management service, all of those are things that we are looking at right now and doing the traditional cost benefit so type analysis.

Katherine Egbert - Jefferies

Okay. Thank you for that answer, Ron. One last thing, Dana did I hear you are right, did you say you had 100% rate tax?

Dana Russell

Yeah, you heard that right and I look at Ron, maybe I'll turn that back over to him to explain that. There is some unusual thing. So we are not trying to get into all of the accounting here, but I will give you a couple of bullet points that will explain that. When we're close to breakeven as we announced that we were going to be in 2007, there is -- one of the major components that drives tax is our stock-based compensation expenses, which for book purposes you have to take a deduction for, it's an expense, but you don't take that for tax purposes. It's not immediately realizable and it may not ever be realizable. So, that's a significant difference that drives that number. We've also got a situation where we have a full valuation allowance against our tax assets. So once again, we're kind of getting some accounting issues here, but anytime that we have losses in any jurisdiction where a company normally would be able to capitalize that and put that on the balance sheet and utilize that in a future period lowering the tax rate, we can't do that. And so we're realizing the impact of that in the current year.

And then there's one other particular point that I would make is that with our consent solicitation, that for tax purposes was deemed as the redemption of debt and we had a gain on that for tax purposes. I know it sounds a little screwy, but that's the way that works. And so there's a significant tax impact associated with that. We won't actually pay cash out the door because we were utilizing some NOLs and things to offset that, but it will show up in our provision and that's what's driving the unusually high tax rate.

Katherine Egbert - Jefferies

And what would be a normalized tax rate save -- too early.

Dana Russell

I would suggest something closer in the 45% range.

Katherine Egbert - Jefferies

Okay. All right, thank you.

Operator

Your next question comes from Mark Murphy with First Albany.

Mark Murphy - First Albany

Thank you. With the inclusion of the Microsoft coupon payments, I'm just curious why the FY '07 earnings guidance appears to be close to zero, at least at the operating income line? And just observing the financial structure of the business, you're already spending $2 in sales and marketing for every $1 that you bring-in in license revenue. So you're twice as inefficient as the rest of the software industry. And now you're choosing to spend more instead of less. I'm just curious why was the decision not to cut the fat first and get the business stabilized second and then decide to spend more money?

Dana Russell

Well, let me take a crack. This is -- answering the question, this is Dana. So, when we looked at the expense structure, we weighed very heavily and considered for a long time what we would want to do with the expense structure of the company. We understood the issues that we're faced with, we understand the high rate of sales expense to new licensing. Those are metrics that we're very familiar with. So, all the actions and activity that we're taking here, which we are going to touch every organization in the company are set about to address those issues and we really feel like the more appropriate way to do this, to go about this is, to make those investments where we don't disrupt some of the things that we're doing. So, we've got two businesses out there, our open source business, which is growing at 30% plus rates today on an invoicing basis and it will grow faster with this partnership we have with Microsoft. We've also got the situation with our Identity and Access Management business that we don't want to disrupt. That's a very strong business for us, and so we really feel like -- we feel like the easier thing would be to go chop a bunch of expenses out and we think that's negatively going to impact our momentum in these businesses.

Ron Hovsepian

What I would add to that is also analyzing it historically, when you look back at the cuts that have been made, without changing the models and doing some of the other things, all that's happened is we've had continued erosion in the business. So, we could get the quick hit. We talked about it an awful lot internally, as Dana had highlighted, but the fundamental fact is that if we're going to get to 12 to 15 in 2008 and we're going to be sustainable, we felt making these investments and getting after it appropriately in terms of changing the model around sales and around R&D and around the back office is the absolute right path to building a sustainable company for us. Now, short-term, to focus on getting organic revenue to flat or near flat while we're doing all this, I think is a monumental task the team is taking on right now. So we've signed up to get a number of things done here, to get this positioned for good profitability and good sustainable revenue growth. So taking that on, while it wasn't our first choice, it's the right choice for the company and for our shareholders in the long run because it will get us that sustainability. And that to me is really what drove it. So, when you look underneath it, we're saying we're going to give you near flat while we absorb that continued 15% to 20% that Dana had highlighted in our mature businesses and we're going to focus on getting the growth businesses in place while we shift and change the sales model, and then we're going to additionally add another key indirect channel player to the mix. And then we're going to wake up at the end of the year and we're going to take out those overlapping expenses and make sure this thing is running right as we go into the '08 to deliver the growth that we want for '08 for profitability and get to that 12% to 15%. That's what it's going to take. Those are the hard, ugly conversations we've been having here in mapping out a game plan on making that commitment and making that commitment a sustainable one.

Mark Murphy - First Albany

Okay. Thank you for the explanation. Just as a follow-up, I am just curious to try to understand a little deeper your definition of exit run rate on operating margins. So I'm curious if you are able to achieve a 12% to 15% exit run rate operating margin by Q4 of FY '08, is there any way you can help us to estimate what would that imply for the full year FY '08 operating margin?

Dana Russell

I think -- once again, this is Dana. I think that our full year is going to be somewhere around 10 to 11%.

Mark Murphy - First Albany

Okay. Thank you very much.

Operator

Your next question comes from Aaron Schwartz with JP Morgan.

Aaron Schwartz - JP Morgan

Good afternoon. If I look at the revenue guidance for FY '07, it's roughly flat with the non-GAAP number for '06 and you use that to get to 5 to 7%. I'm wondering if you can help us out with your expectations for top-line growth in FY '08 to exit to get to your 12 to 15% margin target?

Dana Russell

Let me talk about that a little bit. Top-line growth in '08. What we talked about was having an impact of $4 million to $7 million this year from our subscription revenue associated with the Microsoft partnership. If we look out and extend that into '08, we know that we're going to have substantially more revenue than that, in the $40 million to $50 million range. And so that's going to be a key driving factor in getting to that percentage that we're talking about. In addition to that, we believe that the company will be in a much more efficient operating model where our cost structure will be lower. And as a result of those items and as a result of the continued growth in our Identity and Access Management business and also the other open source revenue outside of the Microsoft partnership, we believe that's a realistic model, not a gimme, by any means, but certainly a realistic model that we can execute on and that we can deliver.

Ron Hovsepian

The only thing I'd add to that on the revenue piece is that getting to the 12 to 15 is a blend of the revenue and the expense efforts that we're making and some more of those projects will obviously roll off and start to generate benefit on the expense side in the '08 -- in the '08 year as well as after that. So, those pieces together are what are going to allow us to get to that operating income. As Dana said, it's going to require revenue as well.

Aaron Schwartz - JP Morgan

Okay. I'm wondering if you could help us out with margins for just the open platform division with the Microsoft revenue coming on. Does that bring the inflection point into the first half of '08 in terms of material margin expansion there for just that business or is it late '07? Can you help us out with a time frame there?

Dana Russell

Yeah, I think in terms of '08 revenues around our open source business, we will have better margins throughout the year. I can't give you specific numbers quarter by quarter, but I can say that it won't be something that we're going to see right at the end of '08, it's going to be more of a ratable even recognition through the year.

Aaron Schwartz - JP Morgan

Okay. And then I had a question on the sales model. Ron, you talked about more of an indirect contribution there. It also sounds like the direct focus is on new business relative to renewal business and I'm just wondering if you can comment on your expectations for attrition there?

Ron Hovsepian

In terms of -- in terms of the attrition, what I did state was we do plan to take out 50 to 100 basis points at the end of the year while we shift around and reallocate our expenses in 2007. So, we're building up these global strategic partner teams. We're taking our sales force right now, a whole segment of our sales force has been taken -- the renewal part of their business -- their renewal measurement is no longer part of their metrics. They're only measured on new software sales. The other thing we also have to take into account is our model is tilting more towards a subscription model. Not all of our products are in that pricing structure, but our revenue begins to look more like a subscription model, so we do look at it a cost of sales as a sales expense as a percent of revenue in totality because of the shift in our business and the way it's going. So, right now, what we're trying to do is really focus in on skill specialization. I'm not going to give the details on this call. We do have targets set for specialization, which you should read into that. People dedicated to particular business units that are focusing on selling that through to direct or indirect; and then secondly, the reallocation of the direct and indirect expense as it migrates through the year was another thing that we will share as part of our metrics with you so that you can start to track us against that shift.

Aaron Schwartz - JP Morgan

Okay. And lastly, as you transition the sales model, do you expect to make any account coverage changes with your direct sales teams?

Ron Hovsepian

In terms of account coverage change, that's constantly being reviewed in terms of the account coverage. What I would say at a broad level is that we have identified a certain set of accounts a, at the very top that we are the large traditional global 2000 type, that we are focused on for our direct model and one of our challenges is we still have too much direct coverage in our mid-sized and small market and emerging customer segment. And that's one of the areas where we have to develop more indirect channel capabilities is where we're lacking right now.

Aaron Schwartz - JP Morgan

Okay. Thanks for taking my questions.

Ron Hovsepian

Thank you.

Operator

Your next question comes from Jason Maynard with Credit Suisse.

Jason Maynard - Credit Suisse

Hi, guys, good afternoon. I have a question on your growth assumptions around the Linux business and the relationship with Microsoft. Some folks in the open source --

Dana Russell

Hey, Jason, we're having a little bit trouble hearing you. So, I’m not sure if the phone or --

Jason Maynard - Credit Suisse

Can you hear me okay now?

Dana Russell

Yeah. That's better.

Jason Maynard - Credit Suisse

Alright. Basically, I'm just trying to get a read on what your assumptions are around the Linux business post the Microsoft relationship. I mean some people in the open source community have taken I think a pretty heavy stance against your move. I mean you've even been called the new scow in certain circles. I mean, how do you think this negative open source community feedback impacts your growth prospects outside of the revenue recognized for Microsoft?

Ron Hovsepian

We take our different constituencies very seriously, and wanted to have the relationships there. I think as you talk about the open source community, you will find different segments of beliefs within the community, and all of them are very grounded in their positions. In terms of the relationship to what we are trying to get done inside the business, I do expect us and Microsoft to deliver on our commitments to each other and we plan on continuing to execute against that as part of our focus, which is really around the customer, Jason. Because the customer, as the community keenly -- keenly is aware, is the one that feeds both us and all the other people who support the open source community. These things that we have done with our business are in support of it and it’s a function of the customer being satisfied. So, if you look there has been some recently written articles just hit them today and yesterday around on CNET, I saw one that specifically someone came out and just said, hey look it. This is really good for the customer, here is why.

So, it’s a mixed review right now. We are very sensitive to it. We are not taking it lightly but at the end of the day, what's most important for us is the customer and driving that interoperability because that’s what the customer needs and the community is being great about rallying around things that will make Linux ultimately successful. And so from my vantage point, as we explain some of the deals we may have lost in the past to Microsoft, we now have a greater opportunity to win those deals. I think that’s all positive, because I can think of four deals specifically that I was involved with where we lost these deals because we couldn’t get the customer ultimately comfortable. Now we can get the customer ultimately comfortable.

Jason Maynard - Credit Suisse

Right. And you are talking about ultimately comfortable in terms of not being sued for patent infringement?

Ron Hovsepian

Ultimately comfortable with the issues around interoperability and taking away any other objections that they may have.

Jason Maynard - Credit Suisse

Okay. Well, let me ask you this then, if I back out say 45 million in revenue from Microsoft in FY '08, will you be able to grow total revenue, say, 5% to 10% organically?

Ron Hovsepian

We didn’t get into any of that future forecasting in any other sub categories and at this point, we are not ready to do that.

Jason Maynard - Credit Suisse

Maybe just at a high level, I mean, can you grow this business, Ron, without the coupons from Microsoft? I mean, do you see enough demand for your core products to generate respectable levels of revenue growth?

Ron Hovsepian

Yeah. I mean, what we've just got through saying is that we are going to drive the business to a point of being near flat. So, the answer is, yes. We have to grow multiple product sets in order to do that. And we are saying in '08 that we have to see that revenue uptick. Whether it's a Microsoft deal, an IBM deal, a Dell deal, we all use these indirect channels to get more latitude and leverage out of the model. So, it's core to our go-forward model to get more leverage out of our indirect partners around the globe. And we are going to continue to do that and as I've said in my comments, we are focused on getting another one to two added where we can drive that.

Jason Maynard - Credit Suisse

Maybe and last question is with the Microsoft deal you did pick up some cash. Your cash balance continues to grow. What sort of the thought right now in the management team about what to do with some of the excess cash that you have on the balance sheet?

Ron Hovsepian

We are constantly looking at that on a regular basis through our normal cadence with the Board and the management team, and we are going to continue to look at using that capital across all the different things that we have talked about in the past, whether those are acquisitions, buybacks, et cetera.

Jason Maynard - Credit Suisse

Okay. Thanks for your time.

Ron Hovsepian

Thanks, Jason.

Operator

Okay. Your next question comes from Brent Thill with Citigroup.

Brent Thill - Citigroup

Thanks. Ron, just as it relates to senior management team, you've had just over the last month some fairly big changes ahead of the Asia Pacific, ahead of the Americas, ahead of the services business. Are most of these positions now stabilized? Or then those groups underneath that leadership can also feel stable, or are we going to see more changes here in the next couple of months?

Ron Hovsepian

I feel very good that we've got a good leadership team now in place and all the key positions and as you've seen, we have made some movements here. If you look at our numbers, in particular if you look at the Asia Pacific numbers, those did not perform to the level we had hoped that they would have last year and the changes there were necessary. We've got a great executive now there in Martin and then in building up this Microsoft relationship, we've taken one of our executives and put them over that, Susan, to make sure we build up this GSP game plan. So the different moves within the company are pretty much done at the top level here. I can't think of just -- I'm saying that casually, because I'm thinking out loud. There's nothing -- there is nothing that I can think of at this point.

Brent Thill - Citigroup

Okay. And just curious, if you saw any impact out of the Oracle Red Hat announcement from what customers have come to you and any thoughts off of that?

Ron Hovsepian

Yeah. And just one last thing on your prior question. I do want to point out that we did do an employee engagement survey as part of a regular cycle we do through the month of September. And what I do want to share with you is it did have a significant percentage improvement. I don't want to get into all the details publicly, but it did have a significant percentage improvement. I don't want to get into all the details publicly, but it did have a significant percentage improvement for the direction of the company and the management team and under a term we called -- we measure regularly. It's been consistent for six, seven years, what we call the engagement level of the employees. We had a very significant improvement there. So -- I shared that with you because your question was around stability and leadership and I do want you to leave the call with the impression that the team feels good about the direction we're going. The team feels confident in the team that's put in place here to help guide the business. I did want to get that in as part of our conversation here so you feel good about what the employee reaction is, because we know as a senior leadership team we can't take this thing anywhere without the 4700 people. So, I just want to point that out.

In terms of your second question, I just went blank, I apologize. Somebody help me out. Red Hat-Oracle, thank you. In terms of the Red Hat-Oracle discussion, we've really been focused on what do we need to do for our business and where the customers are going? So we really haven't burned a lot of cycles having discussions there. Where it has come up in conversations with the customers are customers who really want to maintain the dual vendors in the marketplace of us and Red Hat and what they're seeing is a concern that there might be some fragmentation in the market. And therefore, they are interested in talking to us about staying focused Linux vendor in the marketplace. So, we are seeing some uptick as we talk about that from the customers.

Brent Thill - Citigroup

Thanks.

Operator

Your last question comes from the line of Brendan Barnicle with Pacific Crest.

Brendan Barnicle - Pacific Crest

I wanted to get back to the Linux growth questions and did you see any change in UNIX to Linux migration and Linux server growth? And what's your thought on how virtualization might impact that going forward?

Ron Hovsepian

Okay. I think what you said was, UNIX to Linux migration?

Brendan Barnicle - Pacific Crest

Right.

Ron Hovsepian

And then virtualization and how that may impact that?

Brendan Barnicle - Pacific Crest

Right.

Ron Hovsepian

Okay, great. What we do see as I look at some of the studies that we were looking at. We just recently were looking at an IDC study is that directionally, UNIX to Linux -- UNIX to Linux migrations is occurring and that's really fueling a big chunk of the growth of the marketplace. What we also saw in that study was a portion of those migrations were also ending up on a Windows platform and we want to understand why that was happening. The second piece, as we look at the market was we then looked at the customer portion of it, which as we talked to a couple of the customers there, what they pointed out was they wanted the ability to run -- a virtualization for those of you who don't know it, just simply means can I take a Linux operating system and run it as a guest under Windows and in this example with Microsoft doing the opposite, running Windows under a Linux as a guest on virtualization. The answer to your question is I do see virtualization actually really opening up the customers' shop for much greater growth for both platforms. And the reason why I say that is customers right now need to take advantage of moving the workloads between different environments and they want to take advantage of all the processing.

So if you kind of look at it very simplistically, the customer is now receiving chips from Intel and AMD that are dual core, quad, eight-way and at some point, the customer is not going to be able to take full advantage of that with current technology with the way their applications are written right now. Therefore, there's going to be a greater impetus to leverage virtualization to take advantage of those new processing models, new chip sets that are coming into the market, will then end up in the new processors. So it's a little long-winded answer to say, yes, I see virtualization playing a big role here in fueling growth. I do see UNIX to Linux migrations occurring. I saw numbers that had Solaris and AIX, and HP-UX anywhere from a low of 40 to a high of 58 in the migrations from UNIX to Linux, which is good. We view that as positive in consolidating it. And then I see virtualization actually being even more exciting for Linux, because most of Linux's implementation is around physical hardware virtualization versus software and that's got a faster set of performance attributes. So it's going to be very good for the customer, I think in the long run, therefore, if we can take advantage of that, which is really the essence of driving Microsoft interoperability agreement with ourselves.

Brendan Barnicle - Pacific Crest

Great. And then there's been some assertions that the GPL3 is going to create some issues with the existing Microsoft-Novell relationship. What's your view on how folks are looking at changing some of that and how you might be able to maintain that relationship?

Ron Hovsepian

Right now, GPL3 is still in a draft form, so there's not software available under the GPL3 today and final terms of the GPL3 are obviously not known yet. So, it's difficult for us to comment on it. Additionally in January 2006, the free software foundation launched a process for receiving input into the GPL3 draft. Novell has been involved in that process from the beginning and will continue to be involved in GPL3 as it takes its final form. So until GPL3 takes its final form, no one can really say what will be in it or what will not be in it in terms of what the final model will look like.

Brendan Barnicle - Pacific Crest

Okay. Then just lastly, historically you guys have given us what the professional services breakout was. I know you don't have all the numbers, but do you have the professional services contribution that was part of the services and maintenance fees?

Ron Hovsepian

We didn't break out that --

Dana Russell

I'm not sure if you're - which professional services you're talking about. Professional services for the year for 2006?

Brendan Barnicle - Pacific Crest

Just for the quarter because I think I have for the prior quarters.

Dana Russell

Yeah, I think, if you were to look on page 12 of 14 on the press release schedules, you would be able to see that the total services component of our revenue. And so the $245 million in revenue, there was a -- the global services were $81 million.

Brendan Barnicle - Pacific Crest

Perfect, thank you. I missed that. Thank you, that's my question.

Operator

Thank you. We have now reached our allotted time for questions and answers. This does conclude today's Novell's fourth quarter 2006 financial earnings release conference call. You may now disconnect.

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