ueling Fools
The Great American Novell
Duel
October 14, 1998
Novell Bull's Pen
by Louis Corrigan
(tmfseymor@aol.com)
Investing in companies that compete against
Microsoft (Nasdaq: MSFT) may seem like the
dumbest thing in the world -- until you look at
Apple Computer (Nasdaq: AAPL). Its stock
has tripled this year and held up just fine as
financial markets have gone to heck. Novell is
not Apple, but it is the world's leading provider
of network software and there are provocative
similarities between the firms, especially since
Novell shares have soared 55% during this
generally disappointing year for tech stocks.
Like Apple, Novell has an enormous installed
base, with some analysts putting the figure at 80
million.
Since one of the cardinal rules of marketing is
that it's much easier to keep a customer once you
have her than to win her over in the first place, a
large installed base is a beautiful asset. And
according to the tenets of Gorilla Game investing,
an installed base is especially valuable in the area
of enabling technologies due to the very high switching costs. That means
that even when you screw up badly (as both Apple and Novell have in the
past), you still have a decent shot at reinvigorating sales. Novell has begun
that process; customers in the latest period included giants such as
Wal-Mart, J.P. Morgan, and First Union.
Like Apple, Novell hit bottom and is now being turned around by a savvy
new leader who's made decisive strategic decisions about the company's
future market opportunities.
In March 1997, Novell brought in Dr. Eric Schmidt, the technology guru
at Sun Microsystems (Nasdaq: SUNW), to revive the struggling
company. Schmidt didn't mess around. He slashed the workforce by
17%, including half the veeps. He saw the sales channel was crammed
with inventories so he just stopped shipping product, swallowing a bitter
$122 million Q3 1997 loss on a measly $90 million in sales so that the
darn company could get better quicker. Most important, he redirected
Novell's product development so that the firm is becoming a pure play
Internet/intranet outfit.
Like Apple, Novell is benefiting from a dynamic new product cycle driven
by the high-performance technology craved by its installed base and, as
yet, unmatched by its formidable competition.
For all the hype about how Microsoft's new Windows NT 5.0 will take
over the corporate server market, displacing UNIX and providing
networking functionality that will leave Novell a mere footnote in the
dustbin of history, Softy has been a no-show. In July, Microsoft
announced it was delaying its second test version of NT 5.0, and analysts
don't expect the final product will be launched until late 1999 or possibly
even 2000. Given the infamous bugginess of Microsoft's new products,
technologists will advise companies to hold off any move to NT 5.0 until
2001.
Novell is now driving a truck through this window of opportunity with its
earlier-than-expected September 14 introduction of NetWare 5, a new
open-standards-based update of its key networking software. NetWare 5
adds fully integrated Web functionality including Java and the best
directory technology in the business. This will enable companies to
centralize management of network applications and all necessary
components (desktop computers, printers, etc.) through a Web-based
approach that should save massive bucks and headaches.
How robust is this product? The Chicago Mercantile Exchange just
purchased it and expects that, in combination with other Novell products,
it will help cut network administration and support time in half. Sales are
expected to be strong as Novell had sent out 350,000 evaluation copies
before the launch and trained 3,500 partners who will help deploy the
software.
NetWare 5 comes on the heels of four consecutive profitable quarters for
Novell, just what folks investing in a turnaround like to see. In the July
quarter, revenues rebounded to $272 million, up 202% from the third
quarter of 1997 and from the $262 million reported in the prior quarter.
At the same time, deferred services revenues have increased to $103
million from $83 million in the second quarter and just $39 million in Q3
1997. Gross margins for the first nine months of the year were 78%
versus 71% for the comparable period of FY97.
Due to the actions taken in Q3 1997, the percentages are a bit misleading.
The hard numbers, however, show the progress. Though revenues during
Q3 1998 tripled, selling and marketing expenses actually fell 4% to $94
million from $98 million. Even with NetWare 5 about to launch, product
development expenses plunged 22% to $54 million from $69 million.
Finally, even with all the activity to prepare for the big rollout, general and
administrative expenses also fell 3% to $33 million from $34 million.
So Novell has restructured its operations to reduce costs, and it's
refocused its offerings to bring to market true Web-enabled networking
solutions. All of this is backed up by a rock solid balance sheet. At the
end of the third quarter, the company had $1.15 billion in cash and
marketable securities ($3.17 per share) and no debt. In June, the board
took note of the situation by authorizing the buyback of up to 35 million
shares (10% of the shares outstanding) by next June. As of July 31, it had
repurchased one million shares at $12 a piece.
Novell carries an enterprise value (EV) of about 2.8 times sales. That's
modest for a company that reported 9.8% net profit margins in its latest
quarter. Backing out the interest income and assuming the 11.1%
operating margins were taxed at 35% would still give it net margins of
7.2%. That would explain the current EV/S ratio a little better except that
sales and earnings should rocket ahead thanks to NetWare 5, again
making the stock look cheap.
Novell now trades at about 25 times the consensus earnings estimate of
$0.46 for FY99 ending next October. Yet analysts' numbers usually prove
conservative if a turnaround really succeeds. Using the high-side estimate
of $0.65 for FY99, we get a forward P/E of just 18. Meanwhile, that
estimate assumes earnings growth of 160% over the next year, which
seems possible as Novell leverages its shrunken expenses while seeing
sales growth return.
At that point, Novell will be the kind of turnaround story that captures
magazine covers. Information technology customers who were sitting on
the fence will take another look at NetWare due to the momentum and
because Windows NT 5.0 will still probably be months off. Assume
Novell grows at the industry's 29% rate from there, and we'd be looking
at FY00 earnings of $0.84 and a YPEG fair value over the next two years
of about $24.
That's the upside. The downside seems limited. While the business isn't
immune to a broad economic slowdown, technology product cycles can
usually trump such broader cycles. That means that, like Apple, Novell
seems like a relatively safe stock for a technology investor who has seen
one sector after another stumble this year. That $1.15 billion in cash in the
coffers adds even further stability.
Next: The Bear Argument
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