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Novell, Inc. (NASDAQ:NOVL)

Q3 2008 Earnings Call

August 28, 2008 5:00 pm ET

Executives

Susan White - IR

Dana Russell – Sr. VP & CFO

Ronald Hovsepian – President & CEO

Analysts

Abhey Lamba - UBS

Aaron Schwartz - JP Morgan

Katherine Egbert - Jefferies & Company

James Gilman - Cross Research

Operator

Good afternoon. At this time I would like to welcome everyone to the Novell third quarter 2008 financial earnings release. (Operator Instructions) I would now like to turn the call over to Ms. Susan White, Director of Investor Relations.

Susan Walker 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 Ronald 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 third fiscal quarter of 2008. If you don’t yet have our press release, you can access it by visiting our Investor Relations web page at www.novell.com.

This call is also being broadcast on our website and will be available on our website and for telephone playback through September 12, 2008. The domestic toll-free replay number is 800-642-1687, and the international replay number is 1-706-645-9291. Replay listeners must enter conference ID number 56398624.

Before I turn the call over to Dana, I would like to take a moment to say that we will be providing non-GAAP financial measures during today’s call. We believe that these measures enhance an overall understanding of our current financial performance and prospects for the future and enable investors to evaluate our performance in the same way that management does. We’ve included reconciliations of these non-GAAP measures to their most directly comparable GAAP measures in our earnings release. As I mentioned a copy of that release is on our website.

Finally please note that during today’s call we may make forward-looking statements. You should be aware that our actual results could differ materially from those contained in the forward-looking statements, which are based on current management expectations and are subject to a number of risks and uncertainties, including but not limited to factors described in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on December 21, 2007 and in the press release we issued earlier today.

Any forward-looking information that we provide on this call represents our outlook as of today, August 28, 2008 and we do not undertake any obligation to update our forward-looking statements except as required by the securities laws.

With that we are ready for our CFO, Dana Russell.

Dana Russell

Hi everyone, Novell’s third fiscal quarter 2008 financial results were released a short time ago. The company reported net revenues of $245 million, income from operations was $1 million, non-GAAP income from operations was $24 million, and non-GAAP net income was $21 million or $0.06 per share.

Foreign currency exchange rates positively impacted revenue by $7 million and negatively impacted operating expenses by $7 million but did not materially impact operating income on a year-over-year basis.

We were pleased with our performance. This marks the sixth consecutive quarter exceeding top and bottom line consensus estimates. We continue to manage our cost structure while achieving revenue growth. Product revenue increased 11% year-over-year driven by double-digit increases in our three growth businesses. Product invoicing was up 12% year-over-year with growth across all business units.

Non-GAAP operating margin was 10% this quarter compared to 6% a year ago. Now I’ll highlight some of our quarterly results by business unit. You can see the results on the revenue schedule on page 10 of our press release.

Within Open Platform Solutions, Linux Platform Products revenue was $31 million, increasing 30% from the year ago quarter. Linux invoicing was $51 million, up 36% year-over-year. We are pleased with our results this quarter which we’re growing substantially above market growth rates.

Our Linux business continues to be dependent on large deals which may result in some fluctuations of quarterly invoicing levels. In addition we had strong results in Q7 2007 that may lead to difficult compares in Q4 2008. But our plan for 2008 which exceeds market growth rates remains well on track and we expect to continue to grow above market growth rates next year.

Our expanded relationship with Microsoft provides further confidence in our long-term outlook. Last week we announced that Microsoft has committed to purchase up to $100 million in prepaid SLES certificates. We expect to receive the first $25 million cash payment in our first fiscal quarter 2009.

When these certificates have been distributed Microsoft will purchase another $25 million of certificates and so on. Like the original agreement revenue will be recognized ratably over the life of the contract.

Within our Identity and Security Management business unit, Identity and Access Management had a strong quarter. Revenue was $34 million; up 22% from the year ago quarter and invoicing increased 16% on a year-over-year basis.

Systems and Resource Management revenue was $47 million, up 25% from the year ago quarter and invoicing was up 29%. Workgroup revenue of $92 million was down 1% from the year ago quarter and invoicing increased 4% year-over-year.

Within our Workgroup category the combines OES and [netware] related revenue was $54 million, down 4% from the year ago quarter and combined OES and netware invoicing was flat year-over-year.

Now on to our expenses, on a year-to-date basis total non-GAAP cost of sales and operating expenses are down compared to the prior year. The full effect of our cost management activities is partially offset by the acquisition of PlateSpin and the negative impact of foreign exchange rates on our expenses.

Our expense run rate will decrease further as we enter 2009 due to the restructuring activities planned for the fourth quarter. We have incurred $11 million in restructuring charges through the third quarter and expect total restructuring charges for the year to be at the high end of the $15 million to $25 million range that we gave you.

Now turning to the balance sheet and cash flow, cash and short-term investments declined to $1.4 billion from $1.8 billion year-over-year mostly due to the acquisitions and the repurchase of a portion of our shares outstanding and debentures.

During the quarter we used $45 million of cash to repurchase shares and $27 million of cash for the debentures. To date we have used $58 million of cash for our share repurchase program and $142 million of cash to repurchase a portion of our debentures.

Cash flow from operations for the quarter was $30 million compared to $25 million a year ago and total headcount at the end of the quarter was approximately 4,100 down from 4,200 last quarter primarily due to restructuring activities.

Now I’ll turn the call over to Ronald for an update on our business units as well as a progress report on our strategic initiatives and milestones.

Ronald Hovsepian

Thanks Dana, I’m very pleased with our results and optimistic about our prospects for the future. When we started the company’s transformation seven quarters ago, we outlined a plan to achieve long-term sustainable profitability.

Since then we have seen steady improvement as we have met or exceeded our financial goals. Year-over-year product revenue is up 11%, operating margins have expanded to 10% from 6%. Our results are due to our execution on our key strategic initiatives; improved management discipline and focus on cost containment.

Our transformation over the last two years positions us well to focus on sustained growth in 2009 where we expect to increase total revenue and achieve double-digit operating margins. During today’s call I will review each of our business units and provide an update on our strategic initiatives and milestones.

Let me begin with our business unit review. Within Open Platform Solutions, Linux Platform Products had another strong quarter. Our core business grew significantly above industry growth rates, driven by our strong performance in the Americas.

SUSE Linux Enterprise also achieved an important milestone, we now have more than 2,000 independent software vendor applications certified on SUSE Linux, an increase of roughly 8x compared to a year ago.

Our effort to increase ISV certification has clearly paid off and we expect to continue to make strides with this program. We recently announced an extension of our relationship with Microsoft by expanding our original $240 million agreement. This is an indication of our mutual satisfaction of our agreement and the strategic benefit it is providing customers.

To date we have invoiced $176 million or 73% of the original $240 million five year deal. On to Identity and Security Management, we continue to grow faster then the industry in Identity and Access Management. The Americas region showed particular strength with several significant wins contributing to the results.

And our partner channel is also starting to pay dividends as we saw new license growth driven by partners. Our products continue to be recognized for the technical innovation. Gartner has positioned Novell’s Identity and Access Management products in the leaders’ quadrant for user provisioning further strengthening our position as the industry leader.

The improvements in the Americas, the continued strength of our products and the momentum of our partner relationships position Identity well for future growth.

Now turning to our System and Resource Management, SRM had another solid quarter. The integration of PlateSpin continues to track on plan as customers react positively to our cross platform virtualization and workload lifecycle management offerings.

Earlier this month we released ZENworks Configuration Management Service Pack 1, an update of our original release a year ago. This new release focuses on scalability and includes many features our enterprise customers need for deployment in their environments.

This is the most extensively tested version of ZENworks ever released with wide approval from customers, partners and technical sales staff. SRM also continues to receive industry recognition. Recently [VAR] business named Novell as the overall winner and Company of The Year in systems and network management; a testament to the strong partnerships we are building.

Workgroup had another quarter with better then expected results. We improved performance due to several factors including our bundled product, Novell Open Workgroup Suite, and continued group wise performance and focused efforts from our telesales team.

Turning to our strategic initiatives, this year we have four strategic initiatives focused around our sales model, R&D processes, back office optimization, [inaudible] and are tracking on plan. Our services initiative continues to drive more profitable product revenue while leveraging our service capability internally and through partners.

While consulting revenue has declined faster then expected, product revenue continues to grow. We will continue to aggressively manage our services business.

In order to track our initiatives we have five milestones for fiscal 2008, these are:

To achieve revenue of $940 million to $970 million. Based on our revenue of $712 million year-to-date this goal remains well within target.

Grow product revenue at or better then market growth rates for Linux, Identity and Access Management and Systems Management. Year-to-date revenue growth has exceeded market growth rates in each business unit and we are well positioned to achieve this milestone for the year.

Achieve Workgroup product revenue of at least $285 million to $300 million. Workgroup has over performed this year. We feel that this over achievement is a good indication that Workgroup is showing signs of stabilization.

Expand relationships with one to two global strategic partners. During the year we have deepened our relationships with SAP and HP, and this quarter we have expanded our relationship with Microsoft. While we have achieved this milestone for the year, we will continue to focus on GSP at it provides good leverage and value to our customers.

Achieve non-GAAP operating margin income of 7% to 9%. With our focus on product growth and cost containment we have improved operating margins this year. Based on our performance year-to-date and our outlook for the full year we are raising our operating margin guidance to 8% to 10% for the year.

In closing I’m very pleased with our results this quarter, product revenue was up 11%, product invoicing was up 12% and operating margins were 10%. We have executed on our strategic initiatives and we are well positioned to transition the company into its growth phase in 2009.

Now I’ll turn the call back to Dana to review our guidance.

Dana Russell

Thanks Ronald, I want to finish the call with a review of our 2008 guidance. We’ll provide 2009 guidance on our fourth quarter call. Starting with revenue, we continue to expect fiscal 2008 revenue to be between $940 million and f$970 million with our revenue mix heavily weighted toward product.

As we stated at the beginning of the year services revenue will decline year-over-year as we realign the service business to drive more profitable product revenue. While service revenue has declined fast then expected, product revenue has increased and gross margins have improved.

We will continue to manage services to optimize total revenue, product revenue and profitability. In Q3 services revenue was $37 million. We expect Q4 service revenue to be at a similar level; it could be slightly weaker.

We’ve raised our fiscal 2008 non-GAAP operating margin guidance to 8% to 10% from 7% to 9%. Operating margins are ahead of plan due to focused cost management and product revenue growth. We continue to expect to enter next year with double-digit operating margins.

This quarter interest income of $7 million was down significantly compared to last year and last quarter due to a smaller cash balance and lower interest rates. Assuming no changes to our cash balance I expect a similar figure in Q4.

We expect the non-GAAP effective tax rate to be between 32% to 37% and as a result of our share repurchase program we expect diluted shares outstanding to be in the range of 345 million to 350 million for the fourth quarter.

With that, I’ll open up the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Abhey Lamba - UBS

Abhey Lamba – UBS

Has the decline in the Workgroup business fully stabilized or do you think this is a function of a slower economy and it could reverse when the economy turns around?

Ronald Hovsepian

At this point I could anticipate a little bit of that having a positive effect on us, however I’m confident and feeling more confident as we continue to migrate our customers over to OES and what OES 2 in particular brings. I’m hopeful that that customer base will continue to show the same level of stabilization that we’ve seen to date. We’ll ship that product, the one we’re focused on Service Pack 1, October of this year. So from my perspective that as we look out into next year, once we get through those first two or three quarters that a key product release from my perspective on the stabilization. I’ll hopefully give you a little more color then at that point.

Abhey Lamba - UBS

Any update on the [inaudible] rate margin 12% to 15% and how should we think about next year’s upgrading margin in light of that given the out performance you have had?

Dana Russell

I think given the guidance that we have here, moving from 7% to 9% to 8% to 10%, we still feel very good about the way that we’re exiting the year. We feel very good about how we’re entering 2009 and I expect those exit rate discussions that we previously had to still be on track.

Operator

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

Aaron Schwartz - JP Morgan

On the services or consulting revenue, I know that’s certainly a planned decline, is that sort of the baseline we should think about going into next year because its certainly offsetting a lot of the progress you’re seeing on the product growth and then is the cost of that revenue out of the model yet or do you still think there’s more cost to come out related to the services revenue?

Dana Russell

I think we’ve talked about this a bit, as we started the year off and we’re giving guidance in Q4 of 2007 we talked about a significant decline in services and the declines has been a bit ahead of where we had expected. But we have seen a resulting increase in our product revenue that’s been very favorable, it’s been very favorable to margins. We do have some expenses in the run rate that are ahead of the decline, that are impacting us and so we have some things to take out if in fact we don’t see more services revenue.

The thing that I think we want to point out here is that we are really trying to drive profitability. We are trying to drive operating margin improvement and focus on that product revenue and so we don’t know exactly the level at which the services are going to even out. We certainly want to conscious, we talked about before, of moving services to partners and allowing them to do those things that they do best and we think that that overall creates the benefit for our product revenue.

I think for the time being we can plan on about the level that we’re at. We may see a little degradation in the fourth quarter from the $37 million that we talked about but that’s about what we’re expecting to see as we go forward into 2009. But that’s something that we’re still trying to monitor and watch closely.

Aaron Schwartz - JP Morgan

But its fair to say if that is the baseline and you saw a faster decline then you expected, there are still some costs that can come out related to that as well?

Dana Russell

Well there are still some costs that could come out yes, and like I said we could see some erosion from the $37 million that reported in the third quarter. I don’t expect a lot of erosion but there is still potential for that to go down a bit.

Aaron Schwartz - JP Morgan

On the Open Platform segment, you’ve had the new renewal capabilities in that product for about two years now and I’m just wondering if as you’ve seen the renewal activity related to that, I know you don’t provide renewal rates but can you talk qualitatively about what you’ve seen on renewals for licenses that have shipped with that renewal capability in there?

Ronald Hovsepian

What I would be wiling to share is really more of our large account renewals which obviously are things that we all pay very close attention to and in that space I feel very good that we’re capturing and tracking the majority of those larger renewals that we would want to keep a special eye on as you can imagine. Other then that, as I said, we’re not going to get into the renewal rates and those sort of things but I feel good that our telesales function is very focused on that and that we’re paying attention to that piece of it as well as, as we continue to migrate that base of SLES 9 as you’re referring to and SLES 8, the older versions of it to SLES 10.

Aaron Schwartz - JP Morgan

Can you provide an update on the sales force in the Americas, obviously a lot of change in the beginning of the year; did you see any improved execution here in Q3?

Ronald Hovsepian

Yes, it was something that I was looking at very closely to be candid, as we made a lot of those changes. That took some time to shake out in the first half of the year and what I was tracking for Q1 and Q2 was, was the pipeline building? Great, it was. So that gave me hope. And then what you saw in the Americas as you look at their numbers was Q3 invoicing from the Americas was a lot stronger in some key categories, Identity and Linux in particular. So they translated that pipeline over to booked business which to me was very important to see that team continue to do that. That’s one quarter, now you owe me the next quarter. So we’ve got to continue to mature our way through that but it was a good early sign that things are stabilizing there.

Operator

Your next question comes from the line of Katherine Egbert - Jefferies & Company

Katherine Egbert - Jefferies & Company

Can you walk us through this Microsoft agreement, does the fact that they’re going to purchase an additional $25 million in coupons in Q1 mean that you expect by that time to be completely the $240 million coupons or is this for a slightly different set of products, how does this program sync with the old program?

Dana Russell

The old program as you know it was a $240 million purchase of certificates and we are about 73% through that program. This program is similar to that from the standpoint that there is a commitment to purchase up to $100 million. It’s instead of it all being purchased up front, they’ll purchase it in tranches of $25 million and that will be as those particular certificates are consumed. So it is not anticipating that the full $240 million of the first agreement is going to be all distributed. But we continue to plan on the same kind of momentum that we’ve had and the same kind of activity that we’ve had and this is just a further expansion of that arrangement.

Katherine Egbert - Jefferies & Company

It’s for the same products right? For SLES?

Dana Russell

Yes it is.

Katherine Egbert - Jefferies & Company

On your revenue guidance for the year you had obviously $7 million boost to revenue for this year, but yet you kept the $940 to $970 million for the year, are you expecting some kind of rebound in the dollar or some kind of FX headwind going into Q4?

Dana Russell

I think just reaffirming the revenue guidance, what we were trying to say was we gave that revenue guidance before and then we’ve talked about the services revenue and the fact that service revenue was down, but we also wanted to say, yes, product revenue is up and we still are very comfortable with that plan, the $940 to $970 million, and believe that everything that we’ve seen as a decline in the services area we’ve made up for more so in the product area and in fact, because we’re selling higher margin revenue its helped us on profitability. I think that’s really the statement that we’re trying to make, that we didn’t want to give any indication that our revenue would drop because we’re seeing a little more weakness on that service side.

Katherine Egbert - Jefferies & Company

You talked about additional cost cuts, coming out of the services line, what other areas do you think costs could come out of through Q4 and into next year?

Dana Russell

Well it’s really across the board, as we’ve talked about, we did have a major emphasis in sales which you’ve seen throughout this year. There are, we talked about really changing every wheel on the bus as we entered the year and I think we’ve been doing that. We do have cost reductions planned in almost every line item of operating expenses that we’ve been working on throughout the year. We gave guidance at the beginning of the year saying our restructuring expenses would be somewhere between $15 million to $25 million. We incurred $11 million through the first three quarters. We’re going to have the balance of that $25 million come out in the fourth quarter and think about that at the very high end of that range that we gave you from $15 million to $25 million. So $14 million $15 million of restructuring charges in the fourth quarter.

Operator

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

James Gilman - Cross Research

You mentioned in 2009 in around a growth phase, can you go over the specifics on what you’re talking about on the growth phase, what’s going to be driving that growth? The three main areas or maybe you can give some granularity there.

Ronald Hovsepian

What we’ll do is we’ll get into some level of detail at the next call that will really indicate what we see for 2009 but at a macro level the markets that we serve in Identity are growing at 115 to 13% when you look at IDC type data. Linux is continuing to grow, the growth rate out of IDC there is about 17% over the next three years and when you look inside of our SRM business the desktop part of that business is targeted to grow about 6% to 8% and the datacenter products around 25ish percent growth rates. So when you look at those three key segments, if we stabilize the base business and the services now as we’ve talked about, you should really see nice uptick inside the revenue of the product growth as we’ve been emphasizing. So the three major markets that we serve on that piece are seeing good growth rates as a market so if we can grow at or faster then those markets that should translate to a good business for us as long as we keep the base business in order.

James Gilman - Cross Research

Is it really going to be more, since you’ve been really growing the telesales, is that the growth is going to be coming from more of a partners’ aspect or similar in the past, direct, what are you seeing there?

Ronald Hovsepian

Absolutely a focus on partners, that’s something that as you know takes time to build up those relationships and we’re seeing some good things happen in each of the business segments that I just highlighted. So to that end we will focus on partners and we’ll use our telesales functions and other sales functions to both direct and indirect to work with partners. That is the core strategy that we’re embracing from a sales model perspective to leverage those partner relationships and help drive the demand with those partners. So that is at the core of the strategy and tele and all sales functions will help do that.

James Gilman - Cross Research

On PlateSpin there’s been some reported turnover with some senior level executives there, while that’s probably expected given the acquisition it’s a little bit maybe sooner then I thought, can you give any indication, do you expect some turnover there, people leaving to maybe competitors, other start-ups and what kind of impact do you think it will have on the PlateSpin business?

Ronald Hovsepian

The PlateSpin business continues to track to plan and its on the plan of integration that we had laid out and as you said, both at the industry level and after an acquisition like that there are always is some level of movement that occurs. There’s nothing out of the ordinary there we see that causes us any concern at this point and we’re still very excited about the growth of that business. Very excited about what it has brought in terms of partner relationships and conversations that it’s enabled for us both at the customer and at the partner level. So full steam ahead.

Operator

Your final question is a follow-up from the line of Katherine Egbert - Jefferies & Company

Katherine Egbert - Jefferies & Company

What was the revenue from PlateSpin during the quarter?

Dana Russell

We had and you’ll see this in the Q, but that’s reported in the SRM set of numbers and it was approximately $7 million on an invoicing basis. We’re just under that on recognized revenue; about $6.6 million.

Katherine Egbert - Jefferies & Company

Can you comment on the macro situation, what did you see during the quarter and what have you seen here in August in EMEA and the financial services vertical?

Dana Russell

Well we’ve had some discussions about that before, I think the same indications that I gave you about the general weakness in the economy. We’re concerned a bit about Europe and we’re seeing some weakness there as well. We think that that’s had some impact on our business this year. We do think we’re a little more insulated then some as we’ve been able to continue to grow above market growth rates in some areas that maybe aren’t quite as sensitive to the economy and I think that we’re going to see that continue on through 2009.

Operator

There are no further questions at this time and this does conclude today’s conference call.

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