BARRON'S Article
Monday, March 23, 1998
There's Life for Some Network Companies, Even After Microsoft. Just Ask Novell.
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By Eric J. Savitz
Novell lives. For some people, that may be hard to believe. After all, Novell has been through a hellish stretch of product delays, inventory woes, disastrous acquisitions, deep job cuts and a nearly complete overhaul of top management. Many on Wall Street now view the company as just one more victim of the Redmond juggernaut, expecting to see Novell's flagship NetWare network operating system software steamrolled by Microsoft's Windows NT. Certainly, you'd be hard pressed to find a company with an uglier stock chart -- Novell shares have been losing value almost continuously for five straight years, having retreated steadily from $35 in 1993 to under $7 earlier this year. Novell's chart has the look of a stock headed for oblivion.
Or maybe not. For at long last, Novell shows signs of life. The first step in the turnaround really came 11 months ago, when it named former Sun Microsystems technology chief Eric Schmidt to succeed Ray Noorda as CEO. After a year of serious repairs, Novell now appears to be inching forward again, and the Street has slowly begun to take notice. Late last month, Novell reported better-than-expected results for its fiscal first quarter, ended January 31, earning four cents a share. It was Novell's first profit from operations since mid-1997. Bolstered by the encouraging news, investors have bid the stock back up to around $10. There could be considerably more where that came from.
As Schmidt conceded in a recent interview with Barron's, his first year at the helm at Novell has been more difficult than expected. Three days after he started work last April, Schmidt discovered that the Provo, Utah-based company had an inventory glut in the hands of its distributors. Fixing the problem required a variety of stern measures, including an 18% work force reduction, and a temporary halt in product shipments.
Says Schmidt: "It was a serious hit on the head. I went around and asked CEOs whom I respect, 'What do you do in this situation?' They came back with: 'Make the business square, fix whatever is wrong with inventory, and very quickly.' We worked hard to get everything done by July, and we appeared to have succeeded."
Cleaning up the inventory mess left Schmidt several months behind on an even bigger problem: sprucing up an aging product line. "We needed to deliver new products, to reignite excitement about the franchise," Schmidt recalls. "We had to get rid of the viability questions. We put together a hearts-and-minds campaign, for employees as well as customers. The stock had dropped as low as 6 and change. People said we would be sold -- there were rumors that IBM would buy us. Now there's a sense that the business is stable, a viable franchise. We started delivering new products in September, at least one good solid product every month since, giving salesmen a reason to go back and visit accounts. There's a real buzz now in the technical community. Customers had been waiting patiently for a new generation of products, many of which were very late."
That's particularly true of NetWare version 5.0, code-named Moab. The product, now beta-testing, and targeted for midyear release, is at least a year behind schedule. Schmidt thinks the new version of the software will give Novell a big jump toward its goal of being a serious player in the infrastructure of the Internet. That's one reason Novell has decided to move away from a set of longstanding proprietary protocols to the TCP/IP standard used by the 'Net.
"When I started, I said that by this summer, we would be a leader in the Internet, as well as intranets," he says. "And that comes from the shift under way to TCP/IP. We know the Internet is one of the fastest-growing things on the entire planet, as important as radio and TV were to predecessor generations. It's important for us to be seen as a leader in the Internet. It's where the growth is. This is what I came here to do. It's the defining opportunity for the next 10 years." In short, Schmidt says, the new version of NetWare should have Novell growing again.
While Schmidt has crafted a sleeker, leaner Novell -- though the world's fifth-largest software maker, Novell has trimmed down to 4,500 employees, from a peak several years ago of 10,000 -- he admits there's a lot left to do. For one, Schmidt says, Novell has to establish stronger industry partnerships, to encourage the development of applications that take advantage of NetWare's features. Toward that end, Novell established a $50 million fund to invest in software startups working on server-based applications written in Java. Novell also has to persuade both customers and the Street that NetWare has advantages over NT as a network operating system, particularly for large enterprises. "We're not trying to compete with Microsoft," says Schmidt. "We're trying to co-exist." Novell also has to update software more regularly. "One reason Moab was at least a year late is that it was too ambitious," Schmidt says. "The strategy has to be evolution, not revolution. The architecture is well-designed for that, going forward." The next major revision of the software will target the debut of Merced, the new 64-bit microprocessor from Intel, expected in 1999.
For value investors, Novell has attractive characteristics, including $3 a share in cash. Schmidt intends to guard the stash jealously. He says Novell will make acquisitions over time, but cautiously, given the company's long history of disastrous deals, like its unhappy pairing with WordPerfect. "I like to think of the cash as an option on our future," Schmidt says. "Plus, valuations are kind of high right now. You use the cash to buy small companies who can't afford to build the distribution channel we have."
Mary McCaffrey, an analyst at BT Alex. Brown, believes "Novell is finally getting there," though she admits it's taken longer than expected to straighten the company out. "I was optimistic when Eric Schmidt joined Novell," she said. "I didn't anticipate the channel problems they had to fix, but now they seem to be meeting all the milestones they're setting up. That hasn't happened for years at Novell. Basically, by the fall he got the company in shape, pulling the strategy together. Morale is significantly better, the layoffs are pretty much behind them."
McCaffrey cautions that Novell still needs to come up with complementary products for Moab, and to expand into areas like Internet infrastructure, security, and network management. At the same time, with the new version of Windows NT not due until sometime in 1999, McCaffrey says, "Novell has a window. They should be able to accelerate growth." She's looking for revenues for the October 1998 fiscal year of $1.08 billion, up 7%, with profits of 22 cents a share, versus a loss of 22 cents in fiscal 1997. For next year, she expects 15% revenue growth, to $1.24 billion, with earnings of 34 cents a share. "And it could be better than that," she adds. "There's still room for margin expansion. In the past, Novell has been able to keep costs under control."
Brian Barish, portfolio manager with Cambiar Investors, a Denver firm with about $2 billion under management, has piled up nearly five million Novell shares. "It has an attractive risk-reward proposition, lots of cash, no debt ... You could liquidate the company for about $8 a share, so the economic risk is virtually nonexistent. They also have a large installed base, which gives them a valuable franchise, and makes them an attractive acquisition candidate. If Eric can't get this ship turned in the right direction, the board would sell to somebody. And it would be worth more than $10 a share."
(That's presuming the current board stays in place, of course. Late last week, the trust held by the company's largest individual shareholder, retired chairman and chief executive, Ray Noorda, issued a statement calling for the ouster of all but one of Novell's nonemployee directors. But Ralph Yarro, who wrote the statement on behalf of the trust, told the Salt Lake Tribune that the effort's intent is not to cast a bad light on Eric Schmidt, and that Noorda believes Schmidt has advanced the company's position since his arrival.)
In any event, Barish stresses that Novell is not going away. "People look at this company, and they think Apple Computer, a once-hot company which is now totally irrelevant," he says. "But in Novell's case, that's wrong. Unfortunately for the shareholders, the company lost its focus badly in the early 'Nineties, with a misguided attempt to take on Microsoft directly on the desktop. They got unfocused on their networking business; they were tardy with new products. At $10 a share, the market is saying Microsoft will run these guys over, that it's just a matter of time. But the reality is different." Barish sees real value in Novell's vast installed base, given how difficult it is to change network operating systems. "If you're a network administrator at a big corporation, you'd rather have several root canals," he says. "Think of changing your desktop operating system from Windows 3.1 to Windows 95. It's a total pain. Some things don't work. It's just a messy process. Changing networking software is similar, but with hundreds or thousands of machines."
Barish contends that Windows NT works fine in a Microsoft-only environment, but not so well in one made up of a heterogeneous environment, with a variety of computer systems wired together. He also believes Novell will benefit from widespread adoption of IP-based networking, which effectively blocks Microsoft from dreaming up a proprietary standard of its own. "It means Microsoft can't run Novell off the railroad," he says. "I don't think Schmidt would have taken the job if Microsoft had successfully rolled out a proprietary networking protocol."
The next big event for Novell will be the debut of NetWare 5.0. With the software employed on more than 70 million desktops, Barish notes, the potential for upgrade revenues is "quite enormous. They have a lot of earnings power. They have a remarkable opportunity to earn more than people think they can."
Once upon a time, Novell's chief rivals included Banyan Systems, which offers a rival networking software package called Vines. However, Vines has withered, and with it Banyan's stock-over the past five years the shares wilted from 26 1/2 to under 2. And for good reason. Revenues last year plunged to $74.3 million, from $105.4 million in 1996. The company lost $17.4 million in 1997, following a $27 million loss in 1996.
But the stock has shown some new signs of life in recent weeks, doubling to just over $5. Like Novell, Banyan has been restructuring, cutting costs, and trying to return to profitability. And, in fact, Banyan earned 14 cents a share in the year's final three months, its second straight profitable quarter. Also like Novell, Banyan has new management.
But what's really got the stock going is Switchboard, the company's highly successful Web site. Switchboard provides directory services -- online White and Yellow Pages. The site also provides free E-mail, free Web pages, and a directory of Web sites. In January, according to the Web site tracking firm Media Metrix, Switchboard.com was the 10th most-visited Web site among those visited by home users. Media Metrix ranked the site among the 10 fastest growing in 1997, and among the top 25 destinations in 1997 for both home and business users. In short, Banyan is a sleepy software company wrapped around a red-hot Internet site.
Rich Spaulding, Banyan's CFO, notes that the company has taken drastic steps to fix its base business, reducing its cost base by more than 30%, by cutting the work force and trimming its overhead. Spaulding expects revenues to stabilize this year at around the same level as 1997, but this time with a profit. While software revenues this year will decline again, Banyan has been building up its services arm -- Spaulding expects service revenues this year to grow in excess of 20%. And Switchboard revenues should grow strongly off a modest base.
Is Switchboard making money? Not yet. Until the second half of last year, Banyan hadn't really focused on generating revenues from Switchboard -- the site has been losing as much as $1.6 million a quarter, masking the improved bottom-line performance of Banyan's base business. A lack of profits for Switchboard, though, doesn't hurt the value of the business. What matters on the Internet right now is attracting eyeballs. And Switchboard has certainly been doing that, with more than nine million "lookups" a week.
At $5, Banyan has a market cap of roughly $100 million. Even if you assume the network software business is absolutely worthless, which is undoubtedly an exaggeration -- they have 3,000 current customers for Vines, with seven million users -- you get a highly popular Web site for a small fraction of what you have to pay to own a piece of Yahoo! or Excite, or CNET, or Amazon.com. Yahoo! last year acquired Four11, another Internet directory site -- without Yellow Pages listings -- for about $95 million in stock. So what's Banyan really worth? A lot more than the current price, we'd bet. And we're not alone: Banyan recently sold a 13% stake for $10 million to HarbourVest Partners, a Boston venture-capital firm.
As Spaulding confirms, Banyan is considering taking steps this year or next to split into two companies -- Switchboard, and network software. That would have the dual effect of making Banyan's profits look better, and realizing the value of Switchboard. Meanwhile, Banyan will keep building Switchboard, among other steps providing directory services for other countries. Says Spaulding: "We're clearly looking to expand the business."
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E-mail: savitz@barronsmag.com
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