Merger Speculation: What Will Novell Go For?

Includes: NOVL, RHT
by: Value Bulldog

Novell has a long and semi-illustrious history as a software company. NOVL had an early lead in network management (Netware) and collaboration software (Groupwise) but over the course of the 1990's lost their lead in both of these markets. Widely seen as a victim of Microsoft's success, the company has languished for over a decade with stagnant revenue growth, weak operating margins, management turnover and ineffective M&A. Needless to say the shares have not performed well over this time. The company has enjoyed some success, including establishing its SUSE Linux package as #2 in the market behind Red Hat, but overall the company remains a confusing jumble of tangentially related software products and poor execution. Fortunately, recent events have given shareholders hope that there is light at the end of the tunnel. On March 2nd hedge fund Elliott Associates bid $5.75 for the entire company. Novell promptly rejected the bid and hired J.P. Morgan to advise it on strategic alternatives. The stock continues to trade around the rejected bid price.

Simple Valuation
On the face of it, Novell's valuation does not look particularly compelling at 1.3x EV/TTM revenue, 8.7x EV/TTM EBITDA and 20x forward earnings. However, I believe that there is significant earnings potential at Novell that is not being realized due to wasteful opex spending by current management. While the company may not exactly be killing it on new license sales, given its long history Novell has a long list of customers who pay for software maintenance nearly automatically every year. Much of Novell's $850M in revenue is maintenance, which requires little new sales and marketing and is virtually 100% gross margin. Novell's corporate disclosures provide a clue for just how profitable a legacy software maintenance stream can be, as its Collaboration Solutions Division had a 47% operating margin in the first six months of fiscal 2010, while the rest of the business is being run at less than breakeven despite also containing a great deal of legacy maintenance revenue. As a general rule of thumb, private equity buyers are willing to pay 3x EV/maintenance revenue for a sticky software maintenance revenue stream, and PE firms are exactly the firms rumored to be lobbing in bids. A simple 3x Novell's $588M in FY 2009 maintenance revenue plus $980M in cash yields around $7.75 per share with approximately 350M diluted shares outstanding, or upside of 33%.

A More Granular Sum-of-the-Parts Look
Clearly, the market does not agree with me or Novell would not be trading around $5.80 per share. Assessing the potential bid price for the company must not be so simple. On one hand, some of the legacy maintenance streams may be declining and not worth 3x. On the other hand, Novell's Linux business may be considered strategically valuable. The below table details my sum-of-the-parts calculation for Novell's valuation range. I assumed cash was worth the balance sheet value, although there may be some discount warranted for the fact that some of it is offshore. I assumed the Linux business was worth 3 to 5x revenue to the right strategic acquirer (from half of Red Hat's multiple to just shy of it). For other maintenance revenue I took a range of 2x to 4x (keep in mind many of Oracle's acquisitions such as PeopleSoft and Siebel were more like 7-8x maintenance revenue). I further assumed other new license revenue was worth 1 to 2x, while the services revenue was worth 0.5x to 1.0x. Below is the table detailing my calculations, which yield a range of $7.36 to $11.50. Revenue numbers are from the most recent 10-K, while balance sheet cash is from the most recent 10-Q.

Multiple Value Per Share
Item Amount Type Low High Low High Low High

Cash & CE $980 Bal Sht 1 1 $980 $980 $2.74 $2.74
Open Platforms (Linux) $174 Revenue 3 5 522 870 $1.46 $2.44
Other Maintenance $484 Revenue 2 4 968 1,937 $2.71 $5.42
Other License $117 Revenue 1 2 117 234 $0.33 $0.65
Services $87 Revenue 0.5 1 44 87 $0.12 $0.24
Total $1,842 $2,630 $4,107 $7.36 $11.5
Upside 26.5% 97.5%

Conclusion and Timing
Clearly, the market does not agree with me on the potential valuation of Novell, or it thinks that a transaction is not all that likely. Perhaps Novell is too complex and needs too much restructuring for a strategic bidder, or management will try to hold on to its paychecks to the detriment of shareholders. While it is hard to handicap the actions of the potential financial and strategic bidders, as well as the company's board, from the news reports leaking out I believe that a transaction is reasonably likely and the value may be substantially more than the market is currently giving Novell credit for. I suspect any deal will be above the low end of my range, perhaps in the $7.50 to $8.50 range. If the above-linked WSJ article is correct about preliminary bids being due around May 20, I would expect that the top bidders are doing due diligence as we speak and a deal could be announced before the end of July.

Oh, and did I mention that hedge fund maven John Paulson's Paulson & Co. bought 25 million shares in March? Before John Paulson got famous shorting subprime, his firm was primarily known for merger arbitrage.

Disclosure: Long NOVL