Novell F1Q07 (Qtr End 01/31/07) Earnings Call Transcript

Mar. 1.07 | About: Novell, Inc. (NOVL)
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Novell, Inc. (NASDAQ:NOVL)

F1Q07 Earnings Call

March 1, 2007 5:00 pm ET

Executives:

Bill Smith – Vice President of Investor Relations

Ron Hovsepian - President and Chief Executive Officer

Dana Russell – Chief Financial Officer

Analysts:

Mark Murphy - First Albany

Katherine Egbert – Jefferies

Brendan Barnicle - Pacific Crest Security

Aaron Schwartz - JP Morgan

Brent Thill – Citigroup

Kirk Materne - Banc of America Securities

Jason Maynard - Credit Suisse

James Gilman – Soleil-Cross Research

Denny Fish – J&P Securities

Presentation:

Operator

Welcome to the Novell first quarter ’07 financial earning release conference call. Our lines have been placed on mute to prevent any background noise. After the speaker’s remarks there will be a question and answer session. If you would like to ask a question during this time, simply press *, then the number 1 on your telephone keypad. If you would like to withdraw your question, press * then the number 2 on your telephone keypad. Thank you Mr. Smith. You may begin your conference.

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Bill Smith

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 Boston, Massachusetts are Ron Hovsepian, President and Chief Executive Officer and Dana Russell, Chief Financial Officer.

We’re here this afternoon to discuss Novell’s financial preliminary results for the first fiscal quarter 2007. 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 March 9th. A telephone replay of this call will also be available 2 hours after the conclusion of this call at telephone number 1-800-6421687 and will run through March 6, 7, 8 and will run through March 9.

You should note that the results we are announcing today are preliminary financial results for the first fiscal quarter ending January 31, 2007. These financial results are preliminary because Novell, during the first fiscal quarter 2006, began a self initiated self review of the company's historical stock based compensation practices and related accounting impact.

The financial results today reported do not take into account any adjustments that may be required in the completion of the stock based compensation review and should be consider preliminary until Novell files its 10-Q for the first fiscal quarter end of July 31, 2007, form 10-K report for the third fiscal year ending October 31, 2006, and form 10-Q ending January 31, 2007 following the conclusion of their review.

This review may result in the reporting of recorded non-cash stock compensation charges and related cash effects. Novell does not know whether any such compensation charges would affect the preliminary financial results for it's third fiscal quarter 2006, fourth fiscal quarter 2006, full fiscal year ended October 31, 2006, or first fiscal quarter 2007, or would be deemed to be immaterial and require the company to restate previously issued financial statements.

It is possible that as a result of the ongoing options review, Novell may not file its quarterly report and form 10-Q for first quarter ending January 31, 2007 on a timely basis.

I should also note that during the call, we are not making statements that are historical in nature and that they be characterized as forward looking statements. You should be aware the Novell's material results may vary from those contained in the forward looking statements which are based on current expectations of Novell management who are subject to a number of risks and uncertainties, including factors described in Novell's annual report on 10-K filed with the Securities and Exchange Commission on January 10, 2006. Novell disclaims any intents or obligation to update any forward looking statements as a result of developments occurring after the date of this call.

On that I'll turn the call over to Dana.

Dana Russell

Good afternoon everyone. Novell's preliminary first fiscal quarter 2007 financial results were released a short time ago. For the quarter, the company reported net revenues of $230 million. The GAAP loss available to current stock holders of continued operations was $20 million, resulting in a loss per share of $0.6. The non-GAAP loss available to current stockholders of continuing operations, which includes, I want to emphasize this point, includes approximately $6 million extrapolated compensation was $3 million or a loss of $0.1 per share. The non-GAAP loss excludes restructuring expenses, gains on sales of investments, asset impairments, and voluntary stock option revue expenses.

Our internal revenues were $230 million which declined 5% from the quarter a year ago. We're very encouraged by our Linux platform business which saw revenue growth of 46% and invoicing increase over 650% from the quarter a year ago.

However, contributing to the overall declines or expected declines were workgroups at IT consulting. We also experienced some decline at Identity and Security Management, and System and Resource Management, although invoicing for both of these business grew at or above market growth rate.

We realize the company's reporting in the four product related business units which is consistent to manage our business through our products, moving away form a geographic focus. The company's business unit segments are open platforms for systems and resource management, identity and security management, and workgroup. Systems and resource management is the segment separate from identity and security management, through which different market dynamics and growth rates apply.

In addition to these four business units, we also conduct a business consulting segment which is our UK and Swiss consulting units, both of which mostly connect general consulting activities.

As a result of these changes, we've included a new schedule in our press-release this quarter which is on page 12. This schedule reports selected key financial information by business unit and it includes revenue, gross margin, and product development expenses. Also note that the business unit revenue information on page 12 include related services revenue.

The category of "Global Services" includes consulting, technical support, and training, related to each business unit. So this gives you a full picture of the total revenue contribution for each business.

The highlights of some of the quarterly business results refer to the business unit schedule on page 12, as well as the revenue schedule on page 13. The revenue schedule on page 13 remains relatively unchanged for prior quarters in order to maintain comparability.

Let's begin by turning to page 13 in the press release.

The (inaudible) for platform solutions are Linux platform category had revenue of $15 million. That's an increase of 36% over the prior year's quarter. Early in the quarter we announced several major customer gains through our partial ownership with Microsoft which contributed to our revenue growth and Linux platform product invoicing of $91 million with an upper record of 659% growth over the prior year's period.

Let me put this level of invoicing into context. Invoicing this quarter exceeded our total invoicing of all of last year by almost 50%. We built up a very strong basis of differed revenue in this category that is only starting to contribute to higher recognized revenue. Differed revenue is so activated with Linux platform products that at the end of the quarter there was $121 million which is up $160% from the prior quarter and that is almost 300% year over year.

We experienced strong momentum from our agreement with Microsoft. And while these new customer deals did not contribute a material amount to recognized revenue this quarter, they did contribute $73 million to Linux invoicing. Excluding these deals, invoicing was up 50%.

Now turn over to page 12 of our press-release.

Gross margin for the open platform solutions business was 64%, which compares to 60% in the quarter a year ago. Keeping our strategic focus on enterprise customers, we've invested in the services business. Hard development expenses were 52% of open platform solutions revenue and these expenses are higher than a year ago due to investments in Real-Time Linux, Linux Desktop, and Virtualization.

Turning back to our revenue schedule on page 13, looking at the identity and security management business unit, identity and access management revenue was down 7% on a year over year basis. For the quarter revenue was impacted by weak invoicing last quarter that we talked to you about as well as disappointing sales execution in the Americas. However, year over year invoicing, workings rather increased 16%, which is below our expectations of 30% but exceeded market growth rates.

As seen on page 12 of our press release, security management for identities security management was 30%, similar to the quarter of the last year. This business has a lower gross margin contributing to these business units because there is a high component of services revenue which dampens gross margins. The access to our solutions will be invested in our services as compiled of our offering. As this market matures, fewer services will be required. Going forward we'll try to transition the services opportunities to partners as we continue to build out this business.

(Inaudible) expenses were 32% of revenue. We've invested heavily as we've also (inaudible) on this set of products in order to achieve aggressive growth and market scale.

Turning back to page 13 of our press-release, our systems and resource management was down 3% on a year over year basis, driven mainly by weakness in the media. We saw our desktop management product delayed in next release which has also contributed to this decline. Once again, however, year over year invoicing in this category increased 7% which is in line with market growth rates.

Within our workgroup related category, combined (inaudible) and net related revenue was down 13% on a year over year basis. As we stated before, we expect year over year declines of 15-20% in this category over the next year. Year over year invoicing declined 19% for our combined (inaudible) and network related products.

The internet call last quarter outlined three key initiatives in sales, R&D, and back office, which were to reduce costs and improve operational efficiencies. We've stated that these initiatives would require temporary investments of $20-25 million in 2007 to reach improved profitability in 2008.

Overall material expenses, excluding stock-cased compensation were $158, up 6% from the year ago period, and up 5% from Q4 ‘06.

The marketing and product development expenses are higher in the prior quarter, mainly as a result of timing differences, overlapping expenses, and model changes that we’ve previously discussed. G&A expenses increased due to higher legal costs.

I’ll shift to the balance sheet for a few items. Cash and short term investments of $1.8 billion were up 24% from the prior quarter, primarily due to the $348 million received from Microsoft during the quarter.

(Inaudible) decreased $39 million from the same period a year ago, primarily due to comparisons which included (inaudible), which we sold in the third fiscal quarter of 2006. We had sales outstanding of 57 days, that’s down from 59 days compared to a year ago. Last term we had third revenue of $728 million, that’s up 98% year over year, also primarily due to the completion of the Microsoft agreement.

So the head count at the end of the quarter was approximately 4,600. Let me turn the call over to Ron for an update on our business units as well as a progress report on our strategic initiatives.

Ron Hovsepian

Thank you. I’d like to discuss three topics on the call today. First, I’ll update you on our business units, next, I’ll discuss our progress we’ve made on our strategic initiatives, and finally, I’ll review our key milestones that were outlined in our call last quarter.

Business unit update - Open Platform Solutions: Our Linux products had a very exciting and encouraging quarter. Our results were positively impacted by our relationship with Microsoft, a partnership that is off to a strong start, where we are executing ahead of plan.

Customer reaction to our collaboration agreement is robust as evidenced by our record Q1 results. On a year-over-year basis, we recognized Linux revenue growth of 46%, Linux invoicing grew by over 650%, and Linux activated deferred revenue was up almost 300%.

Additionally, we recently published our joint Novell Microsoft technical collaboration roadmap, filling an important technical milestone. This roadmap provides additional direction on the subjects and timing of our technical collaboration agreement, in support of our shared vision of interactability between SUSE Linux Enterprise and Windows.

Last quarter, we established two sales milestones to measure our success against the Microsoft agreement. First, we said, we would ship 20,000 certificates. We have greatly exceeded with over 40,000 certificates activated at the end of Q1.

The second milestone we established was a pipeline of 150 enterprise customers. We closed the quarter with 100 enterprise customers in the pipeline as we made the strategic decision to focus on closing fewer larger deals.

The benefits of this focus are affected in our higher revenue and invoicing results. Q1 certificates were activated by major world class companies. During the quarter, we announced four key customer wins: WalMart, Credit Suisse, AIG, (inaudible) Bank. All four named interoperability as a key factor in selecting SUSE Linux Enterprise.

Moving forward to Q2, we anticipate our positive Linux format to continue. Our Linux strategy to providing enterprise-wide solutions has been validated in the market. For example, we recently announced an important customer win. PSA Peugot Citron, a new customer for Novell, signed a multi-year contract to deploy up to 20,000 Linux desktops and up to 20,000 Linux servers.

This is an important deal, which demonstrates our desktop to data capabilities. In addition, our award winning SUSE Linux Enterprise 10 passed a historic milestone earlier in February, it’s one-millionth download. This occurred in just six months of our product launch in July. It is our fastest time to a million downloads for any Novell product.

Relations with the members with the Linux and Open Source community remain strong. Our free community addition of Open Soussa continues to be well received. According to Distrowatch, Open Soussa enjoyed the second highest number of downloads over the last 12 months, still ahead of Fidora.

Some competitors have raised issues regarding our ability to distribute SUSE Linux Enterprise. I would like to reiterate, what is now fairly common knowledge; our agreement with Microsoft is compliant with GPL2. GPL3 is a work in process, and Novell is an active participant in the drafting of version three of the GPL. It is premature to comment on GPL3 until the next version is published.

Identity and Security Management: Turning to our identity in access business, we had an increase of 16% which exceeded the market growth rates that lagged our aggressive growth target of 30%.

These results reflect some invoicing weakness from last quarter as well as disappointing sales execution in the Americas. Moving forward, we continue to believe that we can outperform market growth rates to achieve our target.

We’ll enhance our product portfolio with our planned relief of significant new enhancements for our identity manager and business solutions during the first half of this year. During our Brain Share conference later this month, we will showcase these new releases.

Systems and resource Management: In Our Systems and Resource Management Unit we are making strides in our data center animation initiative. Branded under the family, this initiative is in the support of our Linux desktop-to-data center strategy.

During the call last quarter, I told you we announced our first offerings around data center automation. I am pleased to announce the initiative is on track. We have completed phase one, with four customers and four partners participating.

Soon we will move to phase two and select availability in which customers would be charged for the product. We expect several more customers to be added over the coming months. We’ve also started to train our sales force and technical support teams. We expect to the general release of the solution to be at the end of the year, which should position us with a good growth opportunity in 2008.

We will be showcasing our data center automation offering at our Brain Share conference.

Workgroup: Dana shared our financial results in this category, which are in line with our expectations. We continue to focus on our improvement in the areas of program, channel, and product enhancements.

Our release of Open Enterprise Server Two is still target for the middle this year, which we believe will deliver significant value to our install base.

Now I’d like to update you on our strategic initiatives. In our continuing efforts to reduce costs and optimize the organization, I have outlined three important initiatives last quarter. As you know, these initiatives require temporary investments this year and we believe these investments are necessary to change our business model. By making these investments today, we will be well positioned to ensure long-term revenue growth and ultimately sustainable profitability.

Let me now provide you with the progress of each initiative. In our sales model initiative, we plan to reduce our sales expense margin by 50 to 100 basis points. We will achieve this by shifting some of our resources toward an indirect model as well as improving the efficiency of our sales force through specialization.

We are in the early stages of implementing our tele and web sales initiatives, which is the foundation of our indirect model. We recently completed the planning stage. Today, we have not progressed as quickly as I would have liked on our execution, but we remain committed to our model changes and timing.

The new position of products sales specialists has been created to focus our resources on our growth businesses. We have made good progress on this transition. At the end of fiscal 2006, only 10% of our sales force was in the business units’ specialized roles.

Today, that figure is 30%, of which 81% is focused on Linux and Identity. We are on track to reach our objective. We are in various stages of execution regarding our sales model changes and we remain on track to meet our sales expense target.

Initiative Two – R&D Prophecies: We tend to reduce product development expense margin by 100 to 200 basis points at the end of the year by improving the cost and productivity balance, and off-shore and on-shore R&D locations. We have laid out an aggressive plan to leverage our existing off-shore locations, and have identified primary location where we will dramatically expand our presence.

This year, we plan to hire several hundred people. Unfortunately, we were off to a slow start in the quarter and we only hired 68% of our Q1 target. We have aggressive hiring targets for Q2 ‘07, which we believe we will achieve. We recently hired an experienced executive responsible for this initiative, and we remain confident we can achieve our product-development expense target.

Initiative three, back office.

We have targeted reduction 50-100 basis points for G&A expense margin. We will achieve this through a shared service model from many of our back-office functions, such as accounts payable, T&E, and payroll. We have completed a detailed plan to centralize these activities, and we are only in the initial stages of rolling out these operations.

I remain confident that we will meet our G&A expense target. While we are in the early stages of implementing our strategic initiatives, we have made good progress. For the most part, we are finishing the planning stages and moving into the execution phase. I remain confident that we will execute according to plan to meet our expense targets.

Milestones:

Finally, I want to discuss our progression toward the key milestones we expect to achieve as we exit Q4, fiscal 2007. These milestones are a means to track our progress on the initiatives. These milestones are:

1. Deliver revenue that is, or near, flat on a year-over-year basis. Given our first-quarter invoicing performance, and four-year targets, I am reiterating our four-year revenue guidance.

2. Increase growth of our recognized and invoiced Linux revenue from fiscal 2006 levels. We achieved record recognized and invoiced Linux revenue this quarter. To date, we have exceeded this milestone, and the momentum from our Linux sales and marketing initiatives remain strong.

3. Sustain growth of 30% for recognized and invoiced identity revenue. I am not satisfied with the quarterly results of this group. However, our year-over-year invoice and growth of 16% exceeded industry growth rates, and we are focused on achieving our aggressive goal.

4. Expand the global strategic partner relationships. We remain focused on strengthening our relationships with our global strategic partners. The success of the Microsoft agreement underscores the importance of strong, meaningful partnerships. While the confidential nature of our discussions precludes us from going into detail, we are encouraged by our conversations with existing and potential partners.

5. Improve operational efficiencies.

6. Achieve an exit rate operating margin of 5-7%.

These last two milestones are interrelated, so I will discuss them together. We have completed the planning stages, and begun the execution of our strategic initiatives. We are currently in the investment phase, and as a result, operating expenses are higher this quarter, and we expect them to continue to be at these levels, or higher, for the next few quarters.

These overlapping investments are temporary, and will come out of the model by the end of the year. We remain committed to achieving our efficiency and margin milestones. While we've only completed the first quarter, I am pleased with the progress we have made towards achieving our milestones.

In conclusion, our overall results this quarter were mixed. We have very strong momentum in our Linux business, executing well ahead of the plan and exceeding our metrics. I am very pleased with the results of this group, and believe it will continue.

Our Identity business did not perform as aggressively as we planned, and we are taking measures to improve our performance in this category. I continue to believe that the company is headed in the right strategic direction. We are investing in growth markets while leveraging our position in more mature markets and we remain focused on reducing costs and achieving sustainable profitability.

I believe that business is on track, and I am confident of our success. Now I can turn it back over to Dana.

Dana Russell

Thanks, Ron. Yesterday we filed a form 8K. Some of you have probably seen that. We filed that at the SEC, and it's related to our restructuring plan for the year as we previously discussed.

We outlined an estimated restructuring expense of $35-45 million for the year. This figure includes the cost of severance and other cash expenses associated with the facility closures.

Once again, I want to state we're firmly committed to becoming more efficient. This restructuring plan that we've outlined represents our current best estimate, and we'll look to reduce further costs if it's appropriate.

And finally, in regards to guidance, we're reiterating our financial guidance provided on our Q4 ‘06 earnings call on December 5, 2006, which is included in our press release.

With that, I'll stop there, and we can open it up for questions. Operator?

Question-and-Answer Session

Operator

At this time, if you would like to ask a question, please press *1 on your telephone keypad. That's *, then the number 1 on your telephone keypad. We'll pause for just a moment to compile the Q&A roster.

Your first question comes from the line of Mark Murphy with First Albany.

Mark Murphy - First Albany

Thank you. I have a question on the ebb and flow of the Microsoft-driven part of the Linux business. Does it feel as though you had an initial explosion of activations based upon low-hanging fruit, which could then be followed by a slower period in the remainder of FY07, in terms of activations? Or would it take some time to maybe educate customers and build the pipeline, which could imply that the quarterly activations would possibly move to a higher level?

Ron Hovsepian

This is Ron. From my point of view, it's proceeding along plan, as slightly ahead in terms of some of the early activations because we did focus on some larger customers. I feel good on the pipeline that I referred to you of large-enterprise customers, and that's why we shared that with you. And I feel good that this is heading in the right direction for the overall business.

I would share with you that a lot of the deals that we worked were obviously customers that we had in our pipelines to begin with. The benefit that we saw from the relationship was some acceleration of some of that, and that's reflected in some of the numbers here. So that's the good news. I view that as all positive, from my point of view, and I feel the relationship continues to work stronger.

There's a lot of opportunity from my point of view, also, on the partner side of it, as we've focused on the enterprises to begin with, primarily in North America shifting now to EMEA, so we've still got EMEA and AP to work with from a large-enterprise anchor perspective. And then the whole partner piece really hasn't geared up yet.

Mark Murphy - First Albany

Okay, Ron, so the 40,000 activations in the quarter, that is unlikely to be a high-water mark for the year: Is that a fair statement?

Ron Hovsepian

I wouldn't want to speculate on the exact number of activations, but I do feel your core question of is there a good market here for us to continue to grow? The answer is yes.

Mark Murphy - First Albany

OK, and Ron, as customers are activating these Microsoft Novell Linux coupons, presumably they're not flying blind with respect to what price they will pay when they renew a year later, can you share with us anything quantitatively in terms of what we should expect a year from now, or three years from now as customers renew?

Ron Hovsepian

In terms of the renewal piece of it, we have consciously drawn into the agreement and into our marketing and sales efforts to make sure that we balance the renewal rates as we look at how we get customers to renew. And part of our promotions and those things that we are working with Microsoft on are to make sure that we do gather three-year type of agreements that give us sustainability over time, which is important to us.

Because the whole goal of this relationship was to get customers. That was the whole intention, from a Novell perspective, was to gain customers, and obviously revenue in return for our shareholders. But we needed to make sure we're getting customers out of this relationship to measure success, and I do believe we're getting that.

Now, the renewal piece of it, I believe, will be part of it as we roll forward with those customers, because we have one and three year type of agreements, which we'll be tracking those as we go forward. And I feel confident, as the customers experience the high quality of this SUSE Linux enterprise, and the features inside of it, I think we'll be fairly well off.

Mark Murphy - First Albany

OK and then one last one maybe for Dana. Can you help us to think about what would be a meaningful operating cash flow result from the quarter? I guess presumably if we would back out what you received from Microsoft but then add back in whatever portion of that was legitimately tied to the Q1 increase in deferred (inaudible, I'm not sure if that makes sense, but is there anyway that you can help us kind of normalize that number?

Dana Russell

Mark, are you asking for operating cash flow for the quarter without Microsoft's impact? Is that what you're asking for?

Mark Murphy - First Albany

That's correct.

Dana Russell

Yeah. So Microsoft's impact, you know, we told you that Microsoft generated $348 million of cash in the quarter, and that's roughly equivalent to the cash flow that we had for the quarter. As you've seen in past quarters, you know, through past years, we've fluctuated significantly in our cash flow from operations depending on the ins and outs of the cash from operations in terms of what's put in there. But I would suggest to you that we would be somewhere in the range that we were in last year in terms of total cash flow if you're looking at it on a year-over-year perspective. But for this quarter specifically, without Microsoft's impact, cash flow from our operations would have been zero.

Mark Murphy - First Albany

OK. Good. Thank you.

Operator

Your next question comes from the line of Katherine Egbert with Jefferies.

Katherine Egbert – Jefferies

Yeah. Just a couple of quick follow ups on the field of WalMart and the AIT. Were they competitive first off? And did Microsoft lead you into those deals? Or I thought I heard you say that they were in your pipeline and Microsoft accelerated them. Can you talk about that?

Bill Smith

Hey Katherine, you broke up a little bit. I apologize. I don't know if you have a speaker or if you could get closer to the mike. It just was very vague.

Katherine Egbert – Jefferies

OK. Is this better?

Bill Smith

Excellent. Thank you.

Katherine Egbert – Jefferies

Yeah. Sorry about that.

Bill Smith

Yeah. No problem.

Katherine Egbert – Jefferies

So the question is on WalMart and AIG. Were those, first of all endorsements and were those two competitive? And second, I thought I heard you say those deals were in your pipeline and Microsoft helped you accelerate them. Is that the case? Or were you lead into them by Microsoft?

Ron Hovsepian

Obviously they vary by each one so I can give you examples of ones where we were in there, selling already, to one of the accounts, to several of the accounts actually, and working through it for example at a credit switch, they had already selected us as the standard from their technical group and we were working through the certification and those pieces of that. But that's a longer migration trail for it and this obviously helped accelerate that and validate their decision from the acceleration stand point. Because just because you're picked with a technical platform doesn't mean you get ruled out the next day by any way shape or form. This helps accelerate that capital in example.

Others were helped accelerated like WalMart, and were absolutely earlier in the pipeline in the sales process and were competitive situations. All of them were competitive situations as I reflect on them. So you know we saw the normal competition that you expect to see there and they absolutely helped drive the deal.

Now Pujero of PSA, that was one that's been in our pipeline we drove from start to finish ourselves without any assistance obviously. And from that point of view, you know, we're still going to pursue those types of arrangements.

Katherine Egbert – Jefferies

OK. Pujero is not getting any coupons from Microsoft? Is that right?

Ron Hovsepian

Correct.

Katherine Egbert – Jefferies

OK. Fair enough. And then you know I have to ask, you have a lot of cash to roughly half the market capital, and I know you can't do a buyback right now but is there any chance that you could commit to a buyback at some point in the future when you're able to execute it?

Ron Hovsepian

You know, just some of this cash piece, and I absolutely acknowledge that the $1.2 billion of net cash is a substantial amount of cash. That being said, as we look at this on a regular basis and we review what the strategic alternatives are, what we're trying to get done, we are absolutely looking at all those alternatives from the strategic acquisitions through the buybacks on a regular basis. At this point I do not have a buyback program to announce today and that's really the end of it.

Katherine Egbert – Jefferies

OK. And then last one for Dana. You wrote off some goodwill. Can you tell us what that was related to?

Dana Russell

Yeah. So that's actually the intangible assets in catching with that was we have a general business consulting segment which we acquired a few years ago. We've entered into a letter of understanding to divest that. And so we evaluated the intangible assets. Or our asset against the purchase price and that's what that write off is. I think it just, you know last quarter as well we talked about divestitures and general business consulting in Japan which we also divested, and I think this is a similar arrangement.

Katherine Egbert – Jefferies

OK. Thanks a lot, Dana.

Operator

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

Brendan Barnicle - Pacific Crest Security

Thank you. Ron, you've had virtualization now in (inaudible for a while. I was wondering what impact you see in terms of closing deals and as you think more about virtualization, what you see it doing to over all kind of OS sales and distribution sales?

Ron Hovsepian

OK. I apologize. Someone else heard that complete question. Could you restate it?

Brendan Barnicle - Pacific Crest Security

What is virtualization doing?

Ron Hovsepian

Brendan, just want to make sure I heard it right. What is virtualization doing for sales?

Brendan Barnicle - Pacific Crest Security

Yeah, exactly. What is virtualization doing on that, and then what you see it doing to the industry as a whole? And some speculation that it’s going to result in Q over S sales over time?

Ron Hovsepian

Ah. OK. That is the part I missed at the end. OK. In terms of virtualization, I think we're at the beginning of a good market cycle of virtualization. Right now you've seen software limitation with virtualization and you've seen a shift first from Linux with a Linux virtualization that takes advantage of the hardware appropriately. And then to that end, I think the market place is ready for it and is taking advantage of it, particularly in the Americas and in Mia, a little less so in Asia at this point in time. So that's a market kind of point of view.

And then in terms of your second half of the question at how it will impact operating system sales quote unquote as some of these consolidations occur, I don't see it dramatically affecting positively or negatively for our Linux business, given the nature of some of the enterprise agreements we go into with those larger customers.

Now if I was on a per-license only model, like some of the other industry vendors that were their operating systems that might be a broader challenge to highlight consolidate those OSs. But coming from where we are, with higher impacts until now, what we're doing is CC-Linux. I do not anticipate that to be a revenue issue for us.

The second piece is that I do see strength in our relationship with Microsoft from the virtualization piece of it. As you may know that we announced the virtualization piece of it, that's gotten very good feedback from the customers because of the bidirectional nature of virtualization and a heterogeneous system of management parts that go along with that announcement. So I think as Microsoft anoints the market further, you'll get further acceleration of virtualization in the total market.

Brendan Barnicle - Pacific Crest Security

Great. And then a follow up on the interoperability agreement with Microsoft. You know, what are some of the first things that we should watch for? I know you've laid out a whole plan that you guys put press releases on, but what are the first successes to watch for?

And second is, how does that interoperability become exclusive to you guys in, say, like a Linux environment that is essentially an open source environment? What are the things that locked you guys in Microsoft that prevented from being interoperability with a bond to or RedHat, or any other versions that are out there?

Brendan Barnicle - Pacific Crest Security

OK. in terms of the major pieces of what we announced and what we've gotten accomplished is the virtualization piece of that, that's the interoperability between Microsoft Virtual Server, the Windows server which is long run, and CC Linux Enterprise. So what that means is that I would be able to run a host Windows environment with a CC guest and then also reciprocally I'd be able to run Windows as a guest on top of CC-Linux, so that's the major virtualization piece of the relationship.

Additionally, and even outside we've given a road map with dates and where we have the bits and pieces that are associated with that. I don't want to delay the call with that but we can get you the detailed stuff, but basically data for Longhorn on sleds, it is the first half of '07 and data longhorn on sleds10 in terms of some of the virtualization of Windows Server is also in the second half of '07, so all of these things are basically hitting in '07 from our perspective.

Brendan Barnicle - Pacific Crest Security

But does it....on the virtualization piece, can you not run a Windows Host and then run a Vontu Guest or a Vontu Host and a Windows Guest?

Ron Hovsepian

Regarding the technical pieces, how I would answer the question is the physical hype of the virtualization is stuff that is absolutely shared with the community and we will continue to do that.

The parts where we’re trying to differentiate ourselves for our customers and with Microsoft would be through areas like testing and the management components that would go with that, and how you optimize the performance of the platform as you use it.

So, the way we’ll differentiate ourselves will be through the performance, management and the support-type relationships that we have between the platforms.

Brendan Barnicle - Pacific Crest Security

Great. Seeing anything from the Oracle Linux offering?

Ron Hovsepian

We haven’t really seen much market impact yet and it’s really targeted at Red Hat.

Brendan Barnicle - Pacific Crest Security

Thank you

Operator

Your next question comes from the line of Aaron Schwartz with JP Morgan.

Aaron Schwartz - JP Morgan

Good afternoon, I had a question on the SUSE business. Excluding the 48,000 from Microsoft, could you talk about whether you saw it as a halo affect or more customer dialogue in that business because of the announcement?

Ron Hovsepian

Absolutely. I personally have been on a number of calls around the globe and literally some of the phone calls that our team has gotten been along that line of “hey, could you add more here on the technical collaboration agreement”, “hey, could you add more here?”.

People were very enthusiastic that Microsoft was trying to reduce some of the workload for the customer in the inoperability between SUSE Linux and Windows in the marketplace. So we think that’s all goodness. The conversations have absolutely been positive and increased from the customers.

Aaron Schwartz - JP Morgan

Okay great, and another question. Now that the anniversary of SUSE Linux, what do you expect on renewal rates? I know you had the activation part of it that went into affect with that release. Do you have an increase in your assumptions for renewal rate improvements in the rest of the plan?

Ron Hovsepian

The answer is yes, it’s a procured answer. So underneath it, for the products that we just shipped, that had that correction in it you appropriately pointed out. We’re working on the older versions where we put a stop-gap procedural manual approach to that.

So, in terms of sharing a renewal number with you, as that data matures, I will absolutely look to get that out to us. Because I think that that’s a key measurement as we look at the business. It will come easier on my latest release as verses the older ones. So we’ll have to figure out when that data gets mature enough to share on a consistent basis.

Aaron Schwartz - JP Morgan

Okay. Thanks for taking my questions

Operator

Our next question is from Brent Thill of Citigroup.

Brent Thill – Citigroup

Thanks Ron. I think 60% of paid coupons for Microsoft have already passed through. Can you just remind us when you break through the 70,000 the next step, has Microsoft already agreed to re-up or does this enter into a new negotiation phase?

Ron Hovsepian

I’m not sure it was 60,000 but I think your core question is whether we’re up for more and how are the relationship and the contract work going forward. The contract was designed not to have a maximum or a cap placed on it. The contract was designed with floors in mind.

So, our expectation is, those are the floors and our ability to do more certificates through their ecosystem with our support is unlimited.

Brent Thill – Citigroup

Okay. Regarding the restructuring, I think the head count was down roughly 100 sequentially. Would you just talk about the year, and do you expect the head count to stay around 4,600? Where do you expect that to trend?

Ron Hovsepian

We haven’t specifically talked the head count, and when you talk about some of the activities here, the real relevant information that we’re trying to share is around the cost structure. It’s possible if you change activities or do things in a more efficient way, or lower cost locations.

You could actually maintain or even increase head count and still be more effective or efficient in terms of your operating expenses, so, that’s really what we’re focused on.

Brent Thill – Citigroup

Thanks.

Operator

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

Kirk Materne - Banc of America Securities

Yeah, thanks very much. Ron, could you just clarify something for me on the Microsoft relationship, again. And maybe I'm thinking about it wrong. But I think it was an agreement of $240 million in terms of the coupons they would pay you for things like, this quarter you guys invoiced $73 million. So I assume the balance is still what remains under that original agreement... the fair way of looking at it? Or was it the actual number that you guys had negotiated on?

Ron Hovsepian

No, Kirk, you have it right. So the $240 million…$73 million, the math's that simple, you take the 73 off the 240.

Kirk Materne - Banc of America Securities

Okay, that's helpful. And then, Ron, could you just... Obviously, since Microsoft is somewhat subsidizing the front cost of the certificates for customers, I guess, how do you guys approach that from a planning perspective with your customers in terms of a renewal cost with these? I realize you guys are trying to do three-year deals, but obviously I would imagine some of the procurement folks that your customers are trying to figure out what it will cost to renew these. I assume you guys are keeping the price level on renewals, even for the Microsoft certs, you know, in line with your other sales efforts?

Ron Hovsepian

The answer is yeah, we're trying to maintain that price consistency in the marketplace. So that we're definitely doing.

Kirk Materne - Banc of America Securities

Okay. And then this final question is for Dana. Dana, as we look in terms of monitoring your progress against your goals for the exit margin rate, I guess, what should we be looking for now that you guys have give a little bit more granularity about business unit? I recognize that some of that is clearly coming out from the common overhead costs of sales and marketing, should be perhaps coming down over time.

But as I look at the different business units, the gross margins or operating contributions, I mean, is there any one business unit in particular we should see some improvement out of? I'm just trying to get a sense of how to measure you guys, perhaps a little bit more focused on the business-unit performance, from a profitability standpoint, as well.

Dana Russell

Yeah, I think, good question, Kirk. We've got the business-unit information out there. Obviously we feel like there's improvement that we can make in a number of areas and across a number of the business units. I wouldn't point you to anything specifically and say, you know, we're going to move gross margins, or we're move particular categories. But we certainly are aware of market leaders, competitors, etc.

We feel like we need to move the business units in a manner that's more consistent with other market leaders. And we feel like we're on track to be at that 5-7%. And so, I think that's really the answer. This is an annual plan that we're operating to. It's going to take us a while to work through it. I think we've consumed around $3-4 million of the overall expense, the $20-25 million of overlapping expenses that we mentioned last quarter as we talked about this plan. And so, you know, I think we feel like we're on track.

Kirk Materne - Banc of America Securities

And not to jump too far ahead, because it still weighs out, but clearly the going from 5-7% exit rate up to your, sort of '08 target, it's a fairly sizable jump. Is the idea that having enough momentum coming out of this year that there's no... that you're set up to easily get to that? Or is there something in addition that will need to happen again in '08 to get up to that further target?

Dana Russell

Well, yeah, there's nothing that's easy about it, and this is all hard work. I think there are a couple of things. First of all, this plan, the reason we're doing it this way, we really felt like there needed to be a transformation in the business. We needed to have more leverage in the business.

And so, moving from some direct activities to more indirect, and leveraging other ecosystems and infrastructure was important for us. And so that will help. I think there are also other elements where we may have other efficiencies that we'd have to take in the next year. And some of this, obviously, this is a work in process, and we're playing this out as we go along with definitely a defined plan that we're trying to operate to.

Kirk Materne - Banc of America Securities

Okay.

Ron Hovsepian

Just to cut in on your last piece around the '08 piece of it, in terms of getting there. As Dana said, it's hard work, but I do not anticipate us not being able to achieve that at this point. So he answered mostly the '07 part, and I just want to reaffirm the '08 component of it. Because that's why we're doing those strategic transformations we spoke of.

Kirk Materne - Banc of America Securities

Okay. Thanks very much, guys.

Operator

Your next question comes from the line of Jason Maynard with Credit Suisse.

Jason Maynard - Credit Suisse

Hey, it's just one more question on the cash piece of it. Obviously, you can't talk about share buybacks today with the option overhang. Maybe there’s a little insight on size, scope, profitability that you have on, that you might contemplate.

Ron Hovsepian

What I would share with you Jason is that they have strategic markets that would be key piece where we would learn how to use our money.

Other than that, I really don’t want to speculate beyond the data point.

Jason Maynard - Credit Suisse

Does that mean it could be small, medium and large?

Ron Hovsepian

I don’t know what your definition of small, medium and large.

Operator

Your next question comes from the line of James Gilman with Soleil-Cross Research.

James Gilman – Soleil-Cross Research

I have two questions that are more directed towards Ron. In the last quarter you mentioned that you’ve undergone multiple restructuring over the last five years and that you did not want to take a similar one because you didn’t think they were that incremental over long-term.

How was yesterday’s announcement different from that?

Ron Hovsepian

The fundamental thing that both Dana and I observed from looking at the business, and Dana had more years of working from the inside than I did, was as we made these cuts in the past, we didn’t improve the overall business performance in any sustainable manner because we did not change the underlying models of the business.

The second part of it was we had too broad of a focus in broad markets. Why it’s different and why I feel comfortable in speaking with you on this as we press forward, is we are making these model changes so that we have a more sustainable profitability and revenue growth capability to our shareholders in the long run.

The two pieces are linked because there is a model change. If the goal here was just to make a deeper cut and suffer the consequences we could do that and then have profitable short-term but then we may not have done anything to improve the long-term sustainability of the company.

Our opinion on that has not changed in terms of what happened in the past verses where we’re trying to go this round. That’s what’s fundamentally different - the model change.

James Gilman – Soleil-Cross Research

The second question is referenced to, just the general Linux market.

Is it still primarily Unix to Linux migrations? Or do you see that slowing down? Maybe it’s just a general adoption of Linux. Or are you seeing some Microsoft to Linux? Can you give me some color on that please?

Ron Hovsepian

Right now, what I would say is that it has been primarily a growth business built on the back of the Unix migration market statement. I would say there are two stages of that. The first stage is the edged servers in the market. Now that it moves more mainstream into the data centers, I think that’s where they’ll be other support Unixes for other migrations beyond just Unix.

We’re seeing the stock winds, like a PSA Peugo, where we’re able to make some ground against proprietary operating systems in the marketplace. I think there are a lot of segments of proprietary operating systems where we can attack.

James Gilman – Soleil-Cross Research

A follow-up on the Unix to Linux migration, how is Sun’s recent initiatives they’ve had? Have they mitigated some of those migrations off of Solaris?

Ron Hovsepian

I’m quite sure that they’ve (inaudible) some of them down in the market. They’re a particular vendor that helps run their business, so obviously they’re going to listen to those announcements.

I don’t think you can stop the landslide movement for all the Unix platforms over to the Linux environment. The worst is out of the bind

Operator

The final question is from the line of Denny Fish with JMP Securities.

Denny Fish – J&P Securities

A couple of quick questions as you transition the sales for Dana.

Are you seeing any impact on turnover at the field rep level as a result of that, number one on just sort of what your expectations are. Number two, for Dana, you had talked a little bit about a further business consulting divestiture and I just want to make sure I understood that and understand if its contemplated in the guidance or not.

Dana Russell

Right now, all the data that I’ve looked at from a headcount perspective in terms of voluntary terminations or separations from the company is about where its been in past ranges, so I don’t have any indicators that anything has happened there outside that particular data.

We did on some of the maintenance renewals and those things, I would point out that some of that we’ve moved aggressively in terms of using an outsource contractor to help augment that transition and we’ve been aggressive in trying to get some of those things done.

Denny Fish – J&P Securities

OK, thank you. And Dana, on the business consulting divestiture?

Dana Russell

On the business consulting, so right now, as I’ve stated before, the accounting rules make you evaluate the impairment of an intangible once you’ve come to a conclusion or a decision that you would divest. And so, we haven’t got a formal agreement to divest today, I mean we haven’t got a signed agreement, and so our forecast does not have included in it the impact of that and I would say that that impact would be somewhere les than $20 million on revenue and is marginally profitable on an income standpoint.

Denny Fish – J&P Securities

OK, great, thank you that’s what I was looking for.

Operator

That was our final question, Mr. Smith do you have any closing remarks?

Bill Smith

No, you can close off the call, thank you.

Operator

This concludes today’s conference, you may now disconnect.

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