Novell F2Q07 (Qtr End 4/30/07) Earnings Call Transcript

May.30.07 | About: Novell, Inc. (NOVL)
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Novell, Inc. (NASDAQ:NOVL)

F2Q07 Earnings Call

May 30, 2007 5:00 pm ET

Executives

Susan White - Director, Investor Relations

Ronald W. Hovsepian - President, Chief Executive Officer, Director

Dana C. Russell - Chief Financial Officer

Analysts

Aaron Schwartz - JP Morgan

Kirk Materne - Banc of America

Katherine Egbert - Jefferies & Company

Brendan Barnicle - Pacific Crest

Terry Tillman - SunTrust Robinson Humphrey

Mark Murphy - First Albany Capital

Denny Fish - JMP Securities

Brent Thill - Citigroup Global Markets

James Gilman - Cross Research

Brent Williams - KeyBanc Capital Markets

Presentation

Operator

Good afternoon. My name is Robert and I will be your conference operator today. At this time, I would like to welcome everyone to the Novell second quarter 2007 financial earnings release conference call. (Operator Instructions) Ms. White, you may begin your conference.

Susan White

Good afternoon, everyone and thanks for joining us. I am Susan White, Director of Investor Relations for Novell and with me today from our executive offices in Waltham, Massachusetts, are Ron Hovsepian, President and Chief Executive Officer; and Dana Russell, our Chief Financial Officer.

We are here this afternoon to discuss Novell's financial results for the second fiscal quarter 2007. There is a live webcast of this call taking place on the investor relations page of our website at www.novell.com/company/ir. The call will be archived on the website. There will be a telephone playback through midnight Eastern Time June 8th. The toll free replay number is 800-642-1687. Replay listeners must enter conference ID number 7709752.

I should note that during this call we will be making statements that are not historical in nature and that 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 fiscal 2006 annual report on Form 10-K filed with the Securities and Exchange Commission on May 25, 2007.

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 will now turn the call over to Dana.

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Dana C. Russell

Good afternoon, everyone. Before I highlight Novell's second fiscal quarter 2007 financial results, I would like to note that the financial results for our U.K.-based Salmon consulting business have been excluded from Novell's continuing operations for income statement purposes and are recorded as income or loss from discontinued operations in all periods presented.

As we have said, for the quarter the company reported net revenues of $239 million. Continuing operations were approximately break-even on a GAAP basis. Non-GAAP income available to common stockholders from continuing operations was $16 million, or $0.05 per share. The company benefited from a one-time tax adjustment which favorably impacted income. On a net basis, this contributed $0.02 to our total $0.05 per share of income from continuing operations.

Non-GAAP income excludes stock-based compensation, restructuring expenses, voluntary stock option review expenses, and income from discontinued operations.

I would like to emphasize that we have changed the format of our non-GAAP numbers to exclude stock-based compensation to be more in line with the financial community.

The overall tone that we are expressing for this quarter is positive. We feel good about our modest revenue up-tick and improved profitability. Our Linux and Identity businesses contributed to our revenue growth and Workgroup had a smaller-than-expected decline.

Lower spending was mainly a result of cost control but there was some degree of overlapping or transformational spending. As a result, we expect some increases in operating expenses in the second half of the year as we continue to work on changing our sales and research and development models.

Now I’ll highlight some of our quarterly results by business unit. Last quarter, we presented P&L results by business unit and we continue with that presentation. I will refer to the business unit schedule on page 11 and the revenue schedule on page 12. Let’s begin by turning to page 12 in the press release.

Within Open Platform solutions, Linux platform products had another strong quarter with revenue of $19 million, increasing 83% year over year. Linux platform product invoicing was $29 million. That’s up 114% over the prior period, which was largely due to the strength of the Microsoft agreement. We had encouraged customers to take advantage of this partnership and we’ve oriented our sales efforts to promote this agreement and to accelerate and expand our footprint in the market.

Customer deals associated with the Microsoft relationship accounted for 25% of Linux platform product revenue.

Now turning to page 11 of the press release, gross margin for Open Platform solutions was 65%. That’s up from 54% in the year-ago quarter. The improvement in gross margin was driven mostly by strong revenue growth and resulting economies of scale. Product development expenses were 34% of OPS revenue. That’s down significantly from 76% a year ago due to increased leverage in the model.

Turning back to our revenue schedule on page 12 within our Identity and Security Management business unit, Identity and Access Management revenue was up 5% on a year-over-year basis. Year-over-year invoicing increased 22%, which is double the market growth rate of 11%.

As seen on page 11 of our press release, gross margin for ISM was 46%, up from 40% a year ago. The increase was due to improved profitability from our consulting contracts. Product development expenses were 30% of revenue. That’s up from 27% in Q2 due to increased investments to enhance our product offerings and overlapping expenses from our product development initiatives.

Turning back to page 12 of the press release, our Systems and Resource Management revenue and invoicing were down 4% and 5% respectively, and on a year-over-year basis customers have been anticipating a refreshed product offering, which we expect to release this summer.

Total Workgroup revenue declined 4%, which was much better than the expected results due to several factors. They include increased demand for our bundled offering, Novell Open Workgroup Suite. Within our Workgroup category, the combined OES and Netware-related revenue was down 14% on a year-over-year basis, which is in line with our expectations. Year-over-year invoicing declined 4% for total Workgroup and declined 15% for the combined OES and Netware-related products.

On a non-GAAP basis, we achieved an operating margin of 3%, up from approximately break-even a year ago. We’ve worked hard to control costs and remain focused on continuing a reduction of expenses and improving our operational efficiencies. During the quarter, cost of sales and operating expenses before other one-time items were $240 million. That’s relatively unchanged from the year-ago quarter. Gross margin increased to 71%, up from 67% a year ago due to improved profitability from our consulting business and lower royalty expense.

Sales and marketing expenses were lower compared to the prior year due to tighter expense control and product development expenses are higher than the prior year, mainly as a result of transformational activities and data center automation initiatives.

G&A expenses increased due to higher legal costs.

Our restructuring charges of $4.5 million this quarter were slightly below our projections. However, we continue to expect total charges of $35 million to $45 million by the end of the fiscal year.

Now shifting to the balance sheet, cash and short-term investments of $1.8 billion were unchanged from the prior quarter. Net receivables decreased $41 million from the same period a year ago, primarily due to comparisons which included Celerant, which we sold in the third fiscal quarter of 2006.

Day sales outstanding are 64 days. That’s down from 66 days compared to a year ago.

Total headcount at the end of the quarter was approximately 4,500.

Now, 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.

Ronald W. Hovsepian

Thanks, Dana. I am pleased by our results this quarter. Our Linux business delivered another strong quarter, Workgroup performed better than expected, and Identity is recovering, though it is still below plan. We are heading in the right direction, though we still have a lot of work ahead of us.

Today I will provide an overview of our business units, an update of our strategic initiatives, and close with a review of our progress toward our key milestones.

Let me begin with the business unit update, starting with Open Platform Solutions. Within our OPS business unit, our Linux platform products had another strong quarter. On a year-over-year basis, recognized revenue grew 83% and invoicing increased over 100%.

An important component of our go-to-market strategy is strengthening our relationships with our global strategic partners to expand our ecosystem. We announced two major Linux partnerships this quarter with SAP and Dell.

Our expanded relationship with SAP will offer joint support solutions for customers who run their SAP applications on SUSE Linux Enterprise Server, SLES. In addition, SAP is recommending SLES as a preferred platform for customers who want to deploy SAP applications on Linux. This makes SUSE Linux Enterprise the only Linux distribution that is recommended in the market by both SAP and Microsoft. These endorsements are important because customers not only rely on the performance and scalability that SUSE Linux Enterprise delivers, but also on the interoperability and integrated support that we deliver with leading software vendors.

Our second announcement was with Dell, who is the first major systems provider to join our business collaboration with Microsoft. The combination of Novell, Microsoft and Dell provides a unique and compelling value proposition on hardware and software interoperability for the customer.

Our relationship with Microsoft continues to deliver strong results. We announced several key customer wins earlier this month, many of which were in Europe. In the two fiscal quarters since signing our agreement with Microsoft, we have invoiced $91 million, or 38% of our five-year $240 million agreement and activated over 49,000 certificates. We believe the most meaningful measure to track our progress is the percentage of invoicing over the contract life, and so going forward we will no longer report the number of activated certificates.

Additionally, as our joint sales efforts with Microsoft mature, it is becoming increasingly difficult to distinguish Novell only sales efforts from joint efforts with Microsoft. We encourage our respective sales teams to share leads with each other in order to expand the size and scope of deals.

While Microsoft certificates may account for a material portion of Linux invoicing in any quarter, activation of these certificates is a joint effort by both Novell and Microsoft teams.

Now let’s turn to our Identity and Security Management business unit. In this business unit, Identity and Access products posted invoicing growth of 22%. The execution issues we experienced in the Americas last quarter are being addressed and this region exhibited growth.

We also announced a new dedicated GM for the Identity and Security Management who brings both strategic and business experience to drive the growth of this business.

With respect to our Systems and Resource Management business unit, our strategy is to provide a complete desktop to data center offering with leadership in virtualization for both Linux and mix-sourced environments.

Within the change in configuration management market, which is projected to grow substantially over the next several years, Novell's revenue has been relatively flat as the market has been anticipating our refreshed product offering. This summer we expect to ship our newest offering, ZENworks Configuration Management. This will be architected to be cross-platform, which will allow us to expand our market opportunities to fully attack the addressable market beyond our install base.

Data Center Management is the other market we are targeting. We announced our product offering for this market at our user conference, BrainShare, in March. We estimate this market to be $1.3 billion today, growing 29% compounded annually to $2.9 billion by 2010. We continue to make strides with our data center automation initiative.

On the last call, I announced that we had just completed phase one, early adopters. Today we are in phase two, select availability. We currently have over 60 customers and five partners participating, up from the four customers and four partners last quarter. This offering remains on track for general availability by the end of the year.

Turning to our Workgroup business unit, Workgroup performed better than expected this quarter, with invoicing declining only 4% year over year, which compares to the double-digit declines in the last 12 months.

While I am pleased with these results, I caution that it is too early to conclude that this performance is a trend. The better-than-expected results are due to several factors, including strong demand for our bundled offering, Novell Open Workgroup Suite.

We continue to enhance our product offerings with strategically focused efforts. We have two new product releases planned for the near-term, Open Enterprise Server 2 and Teaming + Conferencing. We expect to release OES 2 later this year, which will address critical customer needs in the areas of storage, interoperability and server consolidation. We have over 70 active enterprise customers in a closed beta and the feedback from the customers has been positive.

Our second release will be the addition of the Teaming and Conferencing capabilities to enhance our Groupwise offering. We will provide a full featured beta this summer and expect to ship later this year.

Moving to our strategic initiatives, we have three major initiatives underway to help us achieve our target exit rate operating margin of 5% to 7% by the end of this fiscal year. Let me provide you with a brief update on each of these.

Initiative one, sales model. 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 our efficiency of our sales force through specialization.

Our Teleweb initiative is an important component of transforming our sales model. This effort is slightly behind plan. Last month we hired an experienced executive to lead this initiative. While we are still in the planning process, I am confident our Teleweb services will be in place by the end of year.

We continue to make progress regarding our overall sales model changes and we’re on track to meet our sales expense targets.

Initiative two, R&D. We intend to lower our product development expense margin by 100 to 200 basis points by the end of the year by improving the cost and productivity balance between on- and off-shore R&D locations.

Last quarter we were behind in our hiring plan. We revised our plan and we are back on track with our hiring initiatives.

We have also made progress in our integrated product development initiative, which will improve our product lifecycle management process to assure our products are addressing the market needs.

In the next several weeks, we expect to roll out some additions to our current baseline tools and processes and I’m confident we can achieve our expense margin goal.

Initiative three, back office. We have targeted reductions of 50 to 100 basis points for our G&A expense margin. We will achieve this through a short service model which will provide a standard and centralized and automated platform for many of our back office functions. The majority of this transition will be in the third and fourth quarter of this year.

I continue to believe that we will execute according to our plan and to meet our G&A expense target.

Now these three initiatives are in various stages of planning and execution, I remain confident we will reach these expense objectives.

Finally, I want to discuss our progress on our six key milestones for 2007.

Number one, deliver revenue that is or near flat on a year-over-year basis. In order to achieve this goal, it requires substantial growth in our Linux and Identity businesses to offset the declines of our legacy business. Halfway through the year, we have seen our revenue mix change, with stronger-than-expected results from Linux, offsetting shortfalls in Identity. We still expect to achieve our top line revenue target.

Milestone two, increase the growth of recognized and invoiced Linux revenue from fiscal 2006 levels. Our Linux business has exceeded our expectations. In just the first half of fiscal 2007, invoicing is almost twice full year 2006 levels, while recognized revenue is 75% of our 2006 total revenue. We have achieved this milestone for invoicing and based on our deferred revenue numbers, I am confident we will reach this goal for recognized revenue.

Milestone three, sustained growth of 30% for recognized and invoiced identity revenue. This is an aggressive goal, targeting to grow nearly three times faster than the market. While recognized revenue and invoicing growth improved this quarter, it is unlikely we will achieve this milestone based on our results for the first half of the year. While I am disappointed that we will not meet this goal, I am still pleased that we achieved invoicing growth that was twice as fast as the market growth rate this quarter.

Milestone four, expand global strategic partner relationships. At the beginning of the year, we set out to expand our relationships with two to three GSPs. Microsoft was the first such relationship and I’m pleased that we have achieved this goal with the announcements of our expanded relationships with SAP and Dell.

Milestone five, improve operational efficiencies and milestone six, achieve the exit rate operating margin of 5% to 7%. We are making progress toward our strategic initiatives and I continue to believe we can achieve these margin improvements. This quarter we saw several opportunities to reduce cost which resulted in significant operating margin expansion.

However, we are currently in the execution phase of our strategic initiatives which entails significant overlapping expenses. As a result, we expect quarterly expenses to increase, which may result in fluctuations of these margins, though we still expect to reach our target exit operating margin of 5% to 7%.

In closing, I am pleased with our overall results this quarter. We had revenue growth on both an annual and quarterly basis. Our Linux business continues to perform better than planned, which I believe will continue.

Our Identity business improved over last quarter and invoicing grew at twice the market growth rate. We will now reach our aggressive growth targets set for the year. We continue to execute on our strategic initiatives according to plan. The next several quarters will be important ones as we transform our cost structure to meet our exit rate operating margin of 5% to 7%. I remain confident we will achieve this.

I will now turn the call back over to Dana for his comments on our stock option review and financial guidance. Dana.

Dana C. Russell

Thanks, Ron. We have concluded our self-initiated voluntary stock option review. The audit committee, together with its independent outside legal counsel, did not find any evidence of intentional wrongdoing by any former or current Novell employees, officers, or directors. However, we utilized an incorrect measurement base for some of the stock-based compensation awards granted during the review period, which was November 1, 1996 to September 12, 2006. As a results, we’ve revised certain measurement dates and recognized additional stock-based compensation expense of $19 million over the review period.

Approximately 90% of this expense resulted from adjustments to measurements based in periods prior to fiscal 2001. This did not have any material impact on our historical financials and they remain unchanged.

On May 25, 2007, we filed our quarterly reports for Q306 and Q107, and our 2006 annual report with the SEC and we are now current with our financial filings.

We are adjusting our revenue guidance due to the divestment of our U.K. consulting business, Salmon, which we sold during the quarter. As we previously mentioned, we are focusing our business on products and services that are directly related to Novell solutions and we are exiting businesses that are not in direct alignment with this strategy. Our original fiscal 2007 revenue guidance of 945 to 975 included projected revenue of approximately $20 million from Salmon. Since we’ve divested this business, we need to exclude it from our guidance. As a result, we now expect revenue of $925 million to $955 million in fiscal 2007. This change in guidance is due solely to the divestment of Salmon.

We reiterate our guidance of an exit rate operating margin of 5% to 7% by the end of fiscal 2007 and 12% to 15% by the end of fiscal 2008.

I will stop there now and open it up for questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Aaron Schwartz.

Aaron Schwartz - JP Morgan

Good afternoon. I had a question on the Identity business. I was just wondering if you could, either qualitatively or quantitatively, talk about the 3.5 release and maybe the timeline around seeing that impact in the bookings going forward.

Ronald W. Hovsepian

Aaron, I want to make sure I understood that. So one would be the upcoming product release of 3.5, and what was the second half of it?

Aaron Schwartz - JP Morgan

Just how you expect that to impact the bookings growth going forward, if you’ve seen some pause around that release or not.

Ronald W. Hovsepian

Yes, in terms of that schedule in the product, as what we’ve stated, is still in the market right now and it is shipping now, so that part’s there.

I think in terms of the bookings piece of it, it was really a sales execution issue in my opinion from Q1 and Q2. Therefore, the efforts we’ve put in place to focus on that I believe should stay in alignment in terms of improving for the rest of the year, from my point of view in terms of our invoicing there. I hope to still outpace the market growth rate at this point.

Aaron Schwartz - JP Morgan

Okay, and on the sales model, the changes that you’ve put in place with more of a focus on new product revenue, I was just wondering if you could update us on how you are seeing that progress with maybe a pipeline build, et cetera, just to have an update on how that’s working.

Ronald W. Hovsepian

At a macro level, what I would share with you is that we are seeing the focus of the sales force shift to the license and the new customer and the new revenue focus. What I would say is we don’t go sharing any of the pipeline data publicly, so that’s something I won’t get into. But I will tell you that the focus is definitely occurring and the shift is definitely occurring in terms of where the sales teams know they get driven from a compensation perspective.

Aaron Schwartz - JP Morgan

Okay, and on the consulting business, the improvement in profitability, was there anything specific there or did that have to do with the divestiture of Salmon?

Dana C. Russell

I think, Aaron, that we have really focused in trying to drive better margins and a more profitable business there, so I think it is a combination of things. We have talked about some of the things that we have divested of in the past but Salmon is not one of them that is driving the profitability improvement.

Aaron Schwartz - JP Morgan

Okay, I will hope back into the queue for now. Thank you.

Operator

Your next question comes from Kirk Materne.

Kirk Materne - Banc of America

Could you talk first of all now that the option investigation is over, just your thoughts around the current capital structure and what you are thinking about that, to the extent possible?

Ronald W. Hovsepian

We’re glad to have the stock option review behind us and in terms of going forward, as we’ve stated in the past, we do plan on focusing on some acquisitions, as well as consistently looking and comparing that to doing any buy-backs from a capital structure perspective. So we will continue to look at that and balance those two pieces as we look at where it’s best, where we get the best return.

Kirk Materne - Banc of America

Okay, and then secondly, I think one of the points you brought up last year around SLES was not having the information in terms of renewals, some of the renewal information you needed to get a higher rate of renewal on some of those products. Where do you stand now qualitatively, just in terms of getting renewals on SLES these days? Do you feel good about how that’s trending and the kind of information you have in your systems now?

Ronald W. Hovsepian

Good question. In terms of the -- A, the product is shipping, SLES 10 is shipping with that renewal capability in it so I do feel very good about that product and our ability to track that product and have them go through the registration process.

At this point, as the information matures, we will -- we have not -- we are reviewing when, if and when we can share renewal rate information publicly with you as we get through the cycle. We are just really coming up on the one-year anniversary in June or July, actually, for the SLES 10 shipment, so we are just coming up on that cycle but the parts are all there so I feel better about that piece of the business going forward, especially with the up-tick in the invoicing of the customers. That’s all good for the out year as well, most importantly.

Kirk Materne - Banc of America

Last question for me, on the Workgroup piece, you said there are a number of factors helping it out a little bit this quarter that you weren’t going to count on. You noted the bundled offering. Was there anything else in particular that stood out? I think you just mentioned the bundled offering. I was wondering if there was anything else that sort of stood out in terms of one-time customer events or something like that we should keep in mind.

Dana C. Russell

I think there are a number of things like you mentioned, Kirk, in terms of the bundle, which had a significant impact. We were up significantly in our licensing in Groupwise. You can see that in the press release schedules. We focused on some things that were renewal and client related as well, so all of those factors I think contributed to growth in Workgroup.

Kirk Materne - Banc of America

Thanks very much.

Operator

Your next question comes from Katherine Egbert.

Katherine Egbert - Jefferies & Company

Good afternoon. So it looks right now, Dana, the buy-back would be dilutive. Is my math right? If so, then does that mean you are more likely to do acquisitions, at least for the short-term until the margins improve?

Dana C. Russell

Katherine, could you just -- I had a hard time hearing the first part of that.

Katherine Egbert - Jefferies & Company

It looks like the buy-back would be mildly dilutive at this point, very mildly and I noticed you did not announce one as soon as you were able to execute one, so does that mean that you are likely to do more acquisitions short-term?

Dana C. Russell

I think as we look at that, we feel like there is -- we have opportunity in several different areas. I don’t know how you are coming up with the calculation to say that that would be dilutive but we would certainly be evaluating a buy-back against any other potential use of cash and we think we have a number of good opportunities and ways to utilize those resources.

Katherine Egbert - Jefferies & Company

Okay, and then I was a little confused. I think you said there were 49,000 active certificates. Is that right?

Dana C. Russell

Right.

Katherine Egbert - Jefferies & Company

I’m a little confused because you put press releases out before that said something along the lines of 70,000. So what do you mean by active?

Ronald W. Hovsepian

What we gave you was an estimate of a range of active certificates that we thought we could ship in the metric. I think the thing that I would call your attention to is now what we think is a better measurement of our progress is the invoicing, the revenue invoicing against the overall contract. So that was the $91 million of the 240 is what we’ve now invoiced or activated is how to think about that. That is probably a better metric.

So roughly six months into a five-year agreement, we’ve actually executed 38% of that overall agreement. So I feel very good about the progress in six months against a contract of that size and magnitude. I think that’s probably a healthier metric. I know it’s a healthier metric because that’s why we changed it to really give you a good view into that contract life.

Katherine Egbert - Jefferies & Company

Okay, thanks and then the last thing, you know, it seems like the GPL version 3 is getting close when I hear it’s within a day or two of being finalized, and there was some wording in your 10-K regarding your Microsoft relationship possibly being affected by the wording of that GPL V3. Can you comment on that?

Ronald W. Hovsepian

Yes, where we are right now is because we are in that process and we are working with the Free Software Foundation, it is just a draft at this point and we are working through that community process inside of it now. As you said, we are coming down based on their public schedule through that process right now. So from my vantage point, we are just going to continue to work with it because it is a work in progress. Beyond that, there is really not a lot more to discuss until they go to the final draft.

Katherine Egbert - Jefferies & Company

What are the options though if they were to include that -- basically Microsoft would have to expand their patent protection to others using that license. What are your options there if that wording stays in?

Ronald W. Hovsepian

That would be a lot of broad speculation and it could be a whole range of things, so I’m not going to get into that on the call for competitive reasons and it’s completely speculative. So I will avoid that question at this point.

Dana C. Russell

Let me just jump in here for a second. In the 10-K, we do list risk factors. I think you’re alluding to those risk factors that we listed there in the 10-K. One of the risk factors if the language changed, if the grandfather clause was taken out, it certainly would pose some risk. Now, we’re not trying to indicate that that would happen. We don’t know. When we see the final draft, then we’ll have a better way to respond to that.

Katherine Egbert - Jefferies & Company

Okay, thanks, Dana. Thanks, Ron.

Operator

Your next question comes from Brendan Barnicle.

Brendan Barnicle - Pacific Crest

Thank you. I wanted to follow-up on the Microsoft certificate question as well. Ron, as you mentioned, 38% in six months is a great start. Can you remind us what the provisions are once you get to 100% of that, given that it’s a five-year agreement? Are there additional buy-out or additional purchase clauses that Microsoft has in there or anything?

Ronald W. Hovsepian

That’s a fair question. There is no cap on the relationship, so they can come back and acquire more in the process, which would be great, so there is no upper limit boundary as to what they can put through the contract.

Brendan Barnicle - Pacific Crest

Great, and then also just over on virtualization. Could you just comment on whether you saw that having any impact, any sort of negative impact and have people been concerned about that slowing down Linux unit growth, and what impact you saw, if any, on the Linux? Obviously it looked quite strong in the quarter so it didn’t seem to be a negative versus just market share shifts, or -- what’s the dynamics around virtualization right now?

Ronald W. Hovsepian

You broke up a little bit, so I’ll repeat the question, just look for validation and then answer it. I think your question was as virtualization occurs, there’s natural server consolidation that will go with that, therefore what is your speculation on the impact in terms units that will ship with Linux. Is that correct?

Brendan Barnicle - Pacific Crest

That’s right.

Ronald W. Hovsepian

Okay. Against that backdrop, two things; one, I think you’ve still got the overall market of UNIX in and of itself still migrating over to Linux, and that will continue for some period of time. That’s a very large market so I think there’s plenty of market there from my point of view.

The second piece of it is the virtualization is just beginning its phases here, so as you know we just shipped it last year. We shipped virtualization, the physical virtualization of the hypervisor that came from the Xen community work inside of SUSE Linux. The other part you have to have is then the tools by which you manage it, and that’s what I was referencing that we were doing the 60 customers in the select availability right now. So those are the two parts that you need.

I believe that there’s enough UNIX market of consolidation that I’m not concerned at this point of that becoming an issue. I actually view it as an accelerator of Linux because we can do those consolidations, so the customer will have an opportunity to bring more workload over to a Linux platform to optimize the overall performance.

So I actually am hopeful that are actually more of a catalyst over time, as we look at it. I think it might spell a little more bad news for the Unix part of the market.

Brendan Barnicle - Pacific Crest

Just lastly on that, what do you see as either holes or advantages that the Xen version of virtualization has relative to VMware?

Ronald W. Hovsepian

The question was the Xen virtualization versus VMware? I think the overall major point that I would point out is one is our implementation. Our implementation breaks the hypervisor and some of the tools to operate it into two pieces, so the first part is because ours is an open solution, an open source solution, that gives us a very distinct advantage that everybody can play with the hypervisor where in the VMware world, that’s integrated with the toolset and those are closed APIs for others to work with. So we have the solution that’s accepted by the industry.

The other part of it, because the hypervisor is open source, it is really a lot less expensive, meaning it is shipping with SLES for free, the hypervisor, right now as part of our shipment of SLES. So that component that is the physical hypervisor allows us to ship with the core Linux kernel, and then you just need some of the tools on top of that to help you manage it. So there’s a distinct cost advantage. I think there’s some performance advantages that we get because we’re more hardware oriented inside the implementation, so at a macro level those are a couple of the big differentiators for the Linux marketplace.

Brendan Barnicle - Pacific Crest

Great. Thank you very much.

Operator

Your next question comes from Terry Tillman.

Terry Tillman - SunTrust Robinson Humphrey

Thanks for taking my questions. The first question just relates to for apples-to-apples comparison, in the past when you delineated between the Microsoft driven Linux invoicing and just SUSE Linux invoicing. If I look at it on that basis, am I correct in that it was $18 in the first quarter that was just non-Microsoft related and this past quarter was $11 million? Is that accurate?

Dana C. Russell

Are you talking about invoicing, Terry? I think the numbers -- or are you talking about recognized revenue here?

Terry Tillman - SunTrust Robinson Humphrey

I’m talking about invoicing, Dana. So if I look at the $29 million total invoicing number, the piece -- it’s $11 million, right, that is just SUSE without any Microsoft influence?

Dana C. Russell

I think you can back into the numbers. We didn’t talk about it specifically but of the 240, we said there was about $91 million of Microsoft invoicing so far to date. We said $73 million of that occurred in the first quarter, so really you are looking, if net numbers out here, around $18 million of total invoicing associated with the Microsoft relationship.

Terry Tillman - SunTrust Robinson Humphrey

Right, I’m talking about the inverse. I’m talking about just the SUSE sales business, not Microsoft influenced. So that’s $11 million, that’s the other part of it, so I think I’m right with my number.

Dana C. Russell

Yes, that’s right.

Terry Tillman - SunTrust Robinson Humphrey

-- meaningfully quarter over quarter, and Ron I know you said that increasingly there’s collaboration, what I’m trying to understand is if I’m a SUSE sales person, am I going to be pitted against a Microsoft driven sales force? How am I going to make money if it’s all going through Microsoft?

Ronald W. Hovsepian

Yes, let’s address that question.

Dana C. Russell

Let me just reset the numbers here a little bit. So back -- in the numbers, what we would have actually would be -- one point of clarification I need to just call out. The total invoicing that occurred, there was actually some consulting invoicing that occurred in the first quarter, so when we look at that, there’s actually an additional $2 million, or $2 million plus of invoicing around that that was associated with the Microsoft relationship. If you look at the inside sales activities outside of the Microsoft agreement this quarter, it was actually almost a 50-50 split between Microsoft invoicing and Novell invoicing, so it wasn’t down this quarter compared to a year ago. It was actually slightly up. In fact, we were up about 5%. So I know that may be -- just make sure we set the table there.

Ronald W. Hovsepian

I think we might have answered a different question, so I think the clarification is appropriate. I think in the broader scale, as we tap into other companies’ ecosystems, we are going to have to make sure that have -- the term I’d use is channel harmony. We are going to have to work within those channels with our sales force.

So what we’re seeing in the collaboration with Microsoft is us handing leads to them and vice versa, so that we start sharing it. That’s why the right number to look at is total invoicing. It really is very blurry. Having been involved in several of the deals, you really could see the collaboration occurring where we are driving it.

The good news is it actually broadens the size of the deal is what I’m seeing in general, which I am really pleased with. So from that perspective, I think it is all good and we’ll continue to drive things independently as well as in collaboration, but it will get more muddied from my point of view, because now we have Dell as part of the equation and hopefully we’ll continue to bring more into that formation. When that happens, it truly will get a lot more blurred, from my point of view. That’s why I really want to focus on total invoicing, less orientation towards the channel by which it may travel.

In terms of your sales conflict question, we have already addressed that in the sales plan and addressed any sales conflict that could have occurred. That will not happen inside of our sales plan as it is structured today.

Terry Tillman - SunTrust Robinson Humphrey

Okay, thanks, Ron and then in terms of the Dell relationship, it does seem interesting it’s expanding. But could you give us a little bit more color in terms of quantifying how many resources you’re putting to work on this? Is there any kind of incentives in place for them to actually aggressively sell it, and whether there was any benefit in the quarter related to that relationship?

Ronald W. Hovsepian

In terms of the details around the relationship, no, I am not going to comment on that. That was part of our agreement.

On the flipside, what I will indicate to you is that we began a very similar path of focusing on certain sets of accounts to go to work with them, and obviously that’s what’s going to be critical for us to get accomplished in the marketplace.

As you know, that deal just closed recently so it did not have any effect on the Q2 numbers.

Terry Tillman - SunTrust Robinson Humphrey

Okay, and just my last question, Ron, I know you said earlier to a prior question you don’t want to give out pipeline statistics but I think you did say in the last quarterly call that you had built roughly 100-plus enterprise prospects related to the Microsoft relationship, I believe.

Ronald W. Hovsepian

I gave that in the first quarter when I adjusted it down based on our close rate because I focus more on closing, but yes, go ahead.

Terry Tillman - SunTrust Robinson Humphrey

I was just going to ask for an update on that number but I guess you just answered it. I was just trying to understand, is the pipeline continuing to expand around this relationship or is it more around monetizing that initial group of prospects?

Ronald W. Hovsepian

We did focus on monetizing it. What has occurred is we’ve moved that effort to Europe and now into Asia in terms of getting the Lighthouse type accounts in place. That last press release that did the 10 customer references, that had mostly European based customers in it and that was to drive that point home. We’ll continue down that path and I feel good that that plan that we laid out with them is progressing as planned.

Terry Tillman - SunTrust Robinson Humphrey

Thank you.

Operator

Your next question comes from Mark Murphy.

Mark Murphy - First Albany Capital

Thank you. Actually, my question is along the lines of Terry’s first question. I just want to be very clear on this; it looks as though within the Linux business that the Microsoft driven piece in terms of invoicing declined about 75% sequentially, and then for the core non-Microsoft related pieces, that was down about 39% sequentially. Can you just verify whether that is correct or not?

Ronald W. Hovsepian

I’ll let the guys do a little math here to verify some of the numbers, but in terms of math, that first quarter to me was an outstanding, an exceptional, an outstanding quarter for getting the relationship going.

From my point of view, I’m looking at this more on an annual basis. At the half-year mark, the fact that we’ve delivered the kind of growth that we’ve seen of $91 million against a contract of 240, by all definitions I feel very good about the direction and we were able to go attack the market, get going after some of the pieces inside the market that we had in our pipeline and this was able to accelerate it. So I actually feel good about those numbers.

If your real question is do I see some sort of trending off or something happening to that, the answer to that would be no. I see the relationship more getting to a more consistent basis versus that initial burst

Mark Murphy - First Albany Capital

Okay, and then Ron, should we infer from your comments that you are going to no longer provide going forward what the Microsoft contribution is to the total Linux invoicing picture?

Ronald W. Hovsepian

No, what I did was I said activation of certificates, the certificate methodology, we’ve come up with a stronger methodology and a more meaningful one from my point of view, which is I will report again the contract life and our percentage of completion against that activation. So again, the numbers today for the first two quarters of this relationship are $91 million against a 240 contract, and that’s approximately 38% of that five-year contract we’ve gotten done in just two quarters. So that to me is a really good metric for you to look at in terms of measuring the contribution.

The issue with the certificates is you start to get into one year versus three year, so as we’ve learned through the process in the first six months, we really see this as a much better metric for our own business and therefore we think we should share that with you.

Mark Murphy - First Albany Capital

Ron, just as a follow-up, do you generally support what Microsoft is doing in the marketplace in terms of the saber rattling around the patent portfolio? Moving forward, with the exception of this quarter, would you expect that you would be benefiting from that competitively moving forward?

Ronald W. Hovsepian

I think we’ve made our public position known in our open letter to the community and in terms of the agreement, what we’ve really done is focused in on the customer and making sure that all noises, whether they are ours or others, are kept very quiet in front of the customer. I think that is the most important thing.

I’m not going to focus on anything but the customer in our relationship with Microsoft because I think that’s the most important thing for you as you look at our business. So I’m really going to keep our eyes on that as a team.

Mark Murphy - First Albany Capital

Thank you.

Operator

Your next question comes from Denny Fish.

Denny Fish - JMP Securities

Thank you. Just a quick question, not to beat a dead horse on the Linux invoicing here, but can you comment on linearity during the quarter of Linux invoicing?

Ronald W. Hovsepian

Denny, could you move closer to the phone? It’s breaking up a little, or maybe you’re on a headset, I’m not sure.

Denny Fish - JMP Securities

Sorry, I just picked up my handset. I just have a couple of questions. First, can you comment on linearity of Linux invoicing? Clearly Q1 was huge with the Microsoft agreement and then Q2, that settles down a little bit but just linearity of the Linux invoicing?

Dana C. Russell

Obviously the number of very large Lighthouse accounts that were announced in Q1, it is going to be hard to linear. You look at even Q2, there’s some large transactions. So we’re going to continue to have fluctuations and variations in the bookings because as you do these larger deals, that’s going to cause quite a bit of movement. Now, as this spreads out in the marketplace and we begin to see these relationships occur with Dell and others where maybe some of these transactions aren’t as big and it spreads further down the chain, so to speak, then we’ll get more linearity. But certainly as we begin these relationships and we’ve had some of these very large transactions occur, linearity is probably not in the game to begin with here.

Denny Fish - JMP Securities

Okay, well then maybe you could comment a little bit just in terms of customer feedback that you’ve received so far related to GPL version 3, and then also, have you seen any impact related to REL 5 now in the market with virtualization, given SLES had a roughly nine-month head start there?

Ronald W. Hovsepian

I’m sorry, what was the last part of that?

Denny Fish - JMP Securities

Have you seen any competitive impact with REL 5 now in the market that also impacts, given SLES had a nine-month head start?

Ronald W. Hovsepian

In terms of competitive, actually it’s been good because it just further validated our original position on Xen and our early adoption of it. It has given us nicely a leg up in our first service pack to extend some of the capabilities that we put into SUSE Linux, so we feel very good about it.

My reaction is it helped validate the market further, because some of the comments out of Red Hat initially were “we’re not sure” and then it was “in support of”, so there’s some shifting there.

The second part in terms of REL 5, I also view that as a great market opportunity. To Red Hat’s credit, they’ve done a nice job of back-porting in REL 3 and REL 4 a lot of the components. As they customers migrate to REL 5, that’s going to be a big, big adjustment for them to go through as a customer and I view that as a windowing opportunity to have a discussion with a customer.

Denny Fish - JMP Securities

Okay, and then on GPL version 3, are you hearing any concern from customers related to that?

Ronald W. Hovsepian

Low level noise, at best.

Denny Fish - JMP Securities

Okay and then just lastly, on the overlapping expenses, what’s the number you’re at so far of the $20 million to $25 million? How much have you burned through?

Dana C. Russell

So far, first half of the year, we’ve gone through about $10 million.

Denny Fish - JMP Securities

Okay, and then how would you expect that to flow through Q3 and Q4?

Dana C. Russell

Well, we expect to spend the full $25 million of overlapping expenses, so that’s one of the reasons for a bit of an up-tick in expenses here as we enter the second-half of the year.

Denny Fish - JMP Securities

Okay, I mean sort of evenly distributed or more --

Dana C. Russell

I can’t provide you a whole lot more clarity there. I would think that it is going to be fairly evenly distributed.

Denny Fish - JMP Securities

Great. Thank you.

Operator

Your next question comes from Brent Thill.

Brent Thill - Citigroup Global Markets

Thanks. Ron, you put a considerable investment in the desktop. One of your competitors seems to have somewhat backed off of it. Dell recently struck a relationship with Ubuntu -- how do you think the desktop plays out? More importantly, when do you think it starts to pay off in the form of revenue and profitability for the company?

Ronald W. Hovsepian

Two parts of the question there. One, I do think -- let me answer to the market and then I’ll get specific. I do think the market is still early in terms of a big lifecycle in the total marketplace. Again, our strategy was to give, to sit across from the customer and present a desktop to data center story, so that they could pick and choose the parts as they apply to the customer over time.

So my expectation always has been that the server part of the market will take off first, the desktop will follow, but it’s important for the customer to know we’ve got a full value-based offering of thin clients, thick clients, and the server part of the market.

That being said, I’m seeing a lot of interest in the Americas on the thin client. It is still in the early phases again, and I’m seeing good interest in the brick nations as well as some of the European countries around the thicker client pieces of the equation. Again, still early stage. We did have a nice win at PSA Peugeot last quarter of 20,000 desktops and those are important wins for us in the marketplace.

In terms of the Ubuntu part of the announcement, that’s really targeted at a particular set of consumer-based users that are highly technical. We really see open SUSE competing against that Ubuntu offering in the marketplace, not our SUSE Linux desktop.

So the SUSE Linux desktop, the thin client and the thick, are really targeted at that desktop to date center strategy, and that particular offering will have generated out of IdeaStorm on the Dell website. I think it was appropriate for what they wanted to get done for that particular segment.

If you look at Ubuntu, ourselves and Red Hat’s open offerings, you are only at a couple of million users, 3 million users, maybe worldwide, 4 million. Against that backdrop, that’s not a gigantic marketplace in terms of overall revenue. It’s an important marketplace, which is why we have Open SUSE, but it’s a differentiated market from my point of view and it’s outside of our desktop to data center strategy at this point.

Brent Thill - Citigroup Global Markets

Okay, just a quick follow-up for Dana. I guess there’s been some confusion over fiscal Q4 op margin. When you say exit rate, is that for the full Q4 or the exit? And to follow up to that, can you achieve this goal without further headcount cuts? It looks like the headcount has come down about 200 heads year-to-date.

Dana C. Russell

We’ve been pretty clear that the exit rates are really that -- they are the exit rate as we exit the year. So you are taking a look at the annualized expense at the very end of the year compared to the revenue stream and that’s how we’re calculating the exit rate. So it’s not for the full quarter.

Brent Thill - Citigroup Global Markets

Okay, and you can continue to achieve that without further meaningful headcount cuts?

Dana C. Russell

No, I think we’ve announced that restructure, been public about that, $35 million to $45 million in restructuring charges through the plan here, which will end at the end of the year and we will continue to have some of these activities go on. We’ll have some significant restructure charges in the third and fourth quarter. We’ve previously said on calls that we will have restructure charges every quarter this year. We had $4.5 million this quarter. We’ll see more restructure charges in the third and fourth quarter.

Brent Thill - Citigroup Global Markets

Thanks.

Operator

Your next question comes from James Gilman.

James Gilman - Cross Research

Good afternoon. Several questions here; Ron, I wanted to follow up on your statement about customer focus for the rationale for having a partnership with Microsoft and the patent cooperation agreement. It would appear looking at the redacted statements that the customers theoretically receive less protection than they could from an indemnification agreement that might be provided from one of your competitors. Would you care to comment on that?

Ronald W. Hovsepian

I believe that the indemnification and the patent cooperation agreement for the customer are just different components of an overall value package that we offer to the customer. The customers can decide as to which pieces meet different needs for them, so I would not say they are mutually exclusive. I actually think they are complementary to each other.

James Gilman - Cross Research

Okay, and then following up on your reference to possible acquisitions, do we have a timing and maybe sizes that we might be looking at?

Ronald W. Hovsepian

None that we are going to publicly speak about.

James Gilman - Cross Research

Right, I mean are we -- I was more specifically, are we looking at close to $1 billion or somewhere in the hundred million ranges?

Ronald W. Hovsepian

Again, I think it would be inappropriate to comment on that.

James Gilman - Cross Research

Okay, and then in reference to following up on the last question or the previous caller’s question about exit rate, another way to look at it would be better to maybe state that as the first quarter ’08 entry rate versus an exit rate, if we’re not going be able to see it in the financial results?

Dana C. Russell

Yes, definitely going to be an entry rate for ’08, for sure.

James Gilman - Cross Research

Okay, all right. Those are my questions. Thank you very much.

Operator

Your final question comes from the line of Brent Williams.

Brent Williams - KeyBanc Capital Markets

Thanks for taking my question. I believe in last quarter’s call, you talked about the number of customers that came through the Microsoft related deals. Can you provide that? And can you provide some illustration of some of the larger deal sizes that came in through Microsoft?

Ronald W. Hovsepian

We actually spoke a little bit about the Lighthouse pipeline. That’s probably where we might have confused you on that one in terms of customers. I did not give any specific customer numbers on that piece of it but I did share some of the pipeline that we had set as an initial milestone, just to give you a little bit of the feel for it.

What then transpired was during the Q1 development of the pipe, we saw an opportunity to go forward and close more of those deals, so that’s what we had the team’s focus on, which generated the exceptional first quarter numbers that occurred.

That being said, in terms of thinking about the pipe and where we may go with it, we won’t be breaking out the pipe in terms of Microsoft or Dell or any of those other pieces.

Brent Williams - KeyBanc Capital Markets

Right, I understand. I was just looking at what actually got done in the quarter, not necessarily looking forward to the pipeline --

Ronald W. Hovsepian

I’m sorry, you’re right. You did ask that. I apologize. I think probably the best thing to do is look at the press release that we had done this past May 9th I believe was the date. Inside of there, you’ll see about 10 customers that include nationwide, et cetera. It will give you the list of the customers’ names and quotes from them. That’s probably the best indicator to give you a quick view of the customers that we’re willing to go public with our progress.

Brent Williams - KeyBanc Capital Markets

Okay, but in terms of the total contribution from Microsoft, say those 10 customers that came out in the press release, was that a small percentage? Was that maybe half, 30%, 70% of what you invoiced on the quarter? I’m just trying to understand -- is it still at the point where there’s a lot of large customers that you are focused on that are ready to buy, or are there small customers that you are able to get to now but the initial rush has kind of backed off of these mega deals?

Ronald W. Hovsepian

There was a couple of questions buried inside of there. So again, our strategy is to focus on the Lighthouse accounts. That was the goal. Roll that out from Americas into Europe and then into Asia-Pacific, so we are just still marching through that process.

The second phase has been to work on the partner relationships and develop those partner relationships, and that’s right where we are right now, is developing and working those pieces.

So what you should read into it is we are still working those Lighthouse accounts. I think that’s an appropriate spot as to where we are and a logical spot from a performance of where we would want the relationship to build from. And then as you look going forward, I think then you will see us look to spread wider and deeper with multiple partners beyond Microsoft.

Brent Williams - KeyBanc Capital Markets

Great. Bouncing over to the R&D front, you mentioned that you were a little below the hiring plan for presumably for the off-shore movement of some of your R&D operations. Is that a one-time thing of just getting a large scale hiring process in place? Because we’ve been hearing from a lot of people that talent in some of those places is very, very tight -- in some places tighter than in the U.S.

Ronald W. Hovsepian

The initial burst that we referred to in the last quarter was what I would deem more start-up based issues from my point of view. The second thing is we’ve put an executive over there who is very experienced and who has done this before at another large IT company. So that combination of getting the right executive focused on it has made the difference as we rework the plan and now have been attacking it. I feel good that we are going to continue to track against that plan at this point in time. I have a confidence there.

Is the market warming up over there? Yes, it has. The good news is Novell has been there for some 12 years, I believe, and had a relationship in the Indian market for quite some time. So we’ve got a good brand as someone who’s been there for a long period of time that we can leverage.

Brent Williams - KeyBanc Capital Markets

Great, and then last question, you mentioned a renewal process improving for SUSE Linux. Did that result over the last couple of quarters in any catch-up revenue in the mechanics of how late renewals, you can get a little bit of a pop up front in the contract? Was any of that happening to any material degree?

Ronald W. Hovsepian

Not yet, because the automatic renewal part of the process does not kick in actually until after July when we ship SLES 10. It was only in the 10 version, so the 9 and the 8 are still manual and we are still chasing those, so no it has not had that impact yet.

Brent Williams - KeyBanc Capital Markets

Okay. That’s it for me. Thank you for taking my questions.

Operator

Ladies and gentlemen, this concludes today’s Novell second quarter 2007 financial earnings release conference call. You may now disconnect.

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