Barron's Cover Story Part 1 ... Novell.com
How a nearly dead company transformed itself into an Internet play
By Richard Evans
F. Scott Fitzgerald once wrote that "there are no second acts in American lives," and the same might be said of American technology companies. Right now Apple Computer is struggling to regain its former glory, as is Hewlett-Packard. You could even suggest, as Barron's has, that Microsoft's best days are behind it. But one company that has startled Silicon Valley by recovering from a near-death experience is Novell, the software outfit that is now cashing in on the Internet craze.
With 'Net stocks such as Yahoo and Amazon.com trading at crazy levels, investors are casting about for 'Net plays that look less risky and less expensive. A growing number think they have found just that in Provo, Utah-based Novell. The stock has nearly doubled in the past year, to a recent 20, and the company's most ardent fans argue that the shares could surpass $80 in the next five years.
Just over a week ago, Novell reported its sixth successive quarter of impressive results. Profits doubled on a 13% rise in revenues. It was especially significant that sales of Novell's newest software, which allows companies to link all kinds of computers into one network, jumped by 50%.
"We are not only not dead, we are really excited about this," crows Eric Schmidt, Novell's boyish 43-year-old chief executive officer. "The worst problems are now behind us." Schmidt, former chief technology officer at Sun Microsystems, is widely viewed as the man who has brought Novell back from the grave.
Founded in 1983 in Provo, Novell was a pioneer in creating systems that allowed computers to talk to one another. But Novell tried to slug it out with Microsoft and nearly got knocked clean out of the fight.
Novell's problems began in the early 'Nineties when founder and CEO Ray Noorda blew $1.5 billion acquiring companies such as WordPerfect and Borland in an ill-advised assault on Microsoft's core strengths: software for personal computers and operating systems. Then nearly 70 years old and reportedly in ill health, Noorda became obsessed with beating Microsoft CEO Bill Gates.
Distracted by this grudge match, Novell by 1995 had fallen behind in its core networking business and almost missed the Internet revolution. Then came Bill Gates' deadly counter-offensive: Microsoft launched its Windows NT operating system, which allowed users to make computers work together in networks. NT had a devastating effect on Novell, whose share of the market for network operating systems fell to 27% from over 50%. Microsoft's share, meanwhile, jumped from 2% to 36%.
The lowest point came in the summer of 1997, when Novell reported a loss of $122 million. Half the company's senior managers quit or were fired. Rumors circulated that the firm would either go under or be taken over. "It was pretty awful to watch," remembers Robert Sakakeeny, group vice president of network services at the Aberdeen Group, a Boston-based technology research outfit. "Between 1994 and 1997 Novell did almost everything wrong."
That included going through leaders: first Noorda; then Robert Frankenberg from Hewlett-Packard, and lastly, Joseph Marengi, Novell's former head of sales.
In Novell's darkest hour, the spring of 1997, the company's executive board had the sense to hire the youthful and energetic Schmidt as the new CEO. Renowned as one of the founding fathers of Java, the first computer language devised specifically for the Internet, Schmidt was as brainy as he was inexperienced. But with Novell dying on its feet, he had to learn fast.
"When I first arrived I thought, 'How bad can things be?' " Schmidt recalls with a wan smile. "Later on I thought 'Wow, things really are pretty bad.' "
Schmidt moved quickly to cut costs, slashing the employee count by almost 20%. He focused all his top technical talent on creating a new Internet-friendly version of Netware, the company's main product for getting computers to run together in a network. This release, called Netware 5.0, has been a tremendous hit with corporate customers since being released last September. As a result, Novell's earnings have spurted and its share price has surged.
Trading at a recent 20, or 43 times expected earnings for the current fiscal year, the stock may look pricey. But compared to most Internet stocks, or even compared to Microsoft, with its price-to-earnings ratio of 60, Novell qualifies as a bargain.
Some folks on Wall Street think the stock has a lot farther to run. "Schmidt has done an admirable job of turning things around and getting the company focused again," declares Stephen Dube, top technology analyst for Wasserstein Perella in New York. Dube thinks Novell's stock will hit $30 by the end of the year. The reason? The company is now well positioned to cash in on the explosion of Internet business over the next few years. Dube is predicting that Novell's earnings will nearly double, from 29 cents a share in the fiscal year ended in October to 55 cents for the current fiscal year.
"Novell is going to be a very tough competitor from here on out," says Dube, who labels the stock a "strong buy," his highest rating. "Virtually the whole management team is new. Don't expect to see mistakes like in the past."
One of Schmidt's undoubted achievements has been to raise Novell's profile among big corporate customers. In the old days, the company's network backbone technology was widely respected among the nerds in the computer center, but it remained largely unknown among top executives.
Schmidt has changed that, flying at least 250,000 miles and once visiting five cities in one day, all the while making his case as to why Novell products can help customers create new business opportunities, increase profits and reduce costs.
"It's basically like a political campaign, and I'm on the campaign trail, trying to win as many votes as I can," Schmidt muses.
Novell's success comes in part at the expense of Microsoft. For once, it's Bill Gates who has made a few mistakes. Stung by criticism that Microsoft's Windows NT is not robust enough to handle big corporate networks running hundreds of computers, Gates' technical wizards have spent the last four years developing Windows 2000, a much-vaunted upgrade. But it is no simple fix. Windows 2000 ranks as the biggest commercial software project ever undertaken, with more than 30 million lines of code. The project has been excruciatingly hard to pull off. It's now reported to be running at least two years behind schedule. Many analysts doubt that the new product will be shipped before the end of this year. Some think it won't happen until the middle of next year.
All this has provided Microsoft's competitors with a (pardon the pun) window of opportunity. In perhaps his most clever move so far, Schmidt unbundled from Netware 5.0 a key software element known as the Novell Directory Service. This software allows corporate administrators to locate and manage all of the thousands or millions of "objects" in their systems, meaning the computers, servers, routers, programs, files and human users. As computer networks grow larger every year and make more use of the Internet, directories are becoming ever more important.
Fortunately for Novell, NDS is widely regarded as the best directory product on the market, partly because it is able to manage up to eight million network objects simultaneously. A new release of NDS called SCADS (Scalable Directory Services), due out this month, will reportedly be able to manage about 100 million objects, making it by far the most powerful network directory ever built. Novell is scheduled to make an announcement about SCADS on March 8, and some analysts speculate that the company will disclose that SCADS can actually manage up to 500 million objects.
Microsoft's Active Directory, the improved network management tool that is to be part of the Windows 2000 release, is said to be capable of handling something like 10 million objects.
Network administrators like Novell's directory because it enables them to allocate software use, set security levels, transfer files and solve problems on individual desktops from a single central location. This can make for huge savings in time and costs. It also allows human users to carry their network "identity" around with them, from computer to computer or even from country to country. By simply keying in an identity code, they can transfer all their E-mail, project files and applications programs over the Internet to wherever they are working. This is a distinct advantage in today's increasingly mobile business world.
"Novell's NDS is extremely useful and can help reduce the costs of managing networks significantly," says Laura DiDio, senior analyst with the Giga Information Group. "It is also a much better product than anything Microsoft is likely to come up with. For once, Microsoft has come up short."
DiDio says some corporate users have told her that they can cut their network management costs by as much as 50% by running Novell's Netware and NDS rather than Microsoft's NT. Officials at a New Jersey-based health-care organization recently said they would need to hire five times more network administrators to manage their network if they switched from NDS to NT.
One of the chief reasons NDS performs so much better is that CEO Schmidt and his team have redesigned the product to easily accommodate computers running different operating systems. So a Unix file server can feed data to personal computers running on Microsoft Windows or to an IBM mainframe. By contrast, Microsoft products function smoothly with one another but not so well with programs made by other software houses.
The past few years have seen a significant shift away from the idea that optimum performance is best achieved by replacing disparate computer systems with a single standard package from a single supplier such as Microsoft or IBM. The creation of the Java language and other recent developments mean that it is now far easier to link different software and hardware systems into a common network. Programs written in Java, for instance, can run on any computer, regardless of the underlying operating system.
"There has been a real power shift over the last two years," remarks Giga's DiDio. "Nobody now accepts that you should buy all of your software from a single source." The new paradigm, DiDio and other analysts believe, will help Novell compete more effectively against its giant rival.
Novell and Microsoft are not alone in the race to cash in on the growing need for Internet directory services. Netscape Communications, recently acquired by America Online, is also a capable player. But the companies that provide Internet services, which are expected to be among the first big customers to use directories like NDS, may worry about buying technology from Netscape, which is one of their biggest competitors. That could hinder Netscape's drive to win market share and acceptance.
While investors and analysts are just starting to write and talk volumes about network directories, such devices have actually been around for years. Most computer systems include at least some kind of basic directory describing all of the different elements. What has been lacking is a powerful "full service" directory like the new version of NDS, which allows users to link all their directories together and manage a vast network from a single workstation.
Rather than fight Microsoft as Novell did in days gone by, Schmidt prefers to try to quietly outflank the firm's old enemy. Realizing that he could not ignore Microsoft's millions of customers, Schmidt and his team created one product, called NDS for NT, that is specifically designed to work well with computers running the Windows operating system.
"I want to coexist with Microsoft," Schmidt declares. "We can help them by networking their products together and making them perform better. That's our job." Perhaps that attitude explains why Schmidt has remained silent throughout the acrimonious months of the Justice Department's antitrust case against Microsoft.
That said, Novell has been moving quietly and steadily to entice Microsoft customers to convert to NDS. One incentive: Novell has slashed the price for the software package from $55 per set last summer to an average of around $13 today, after discounts. Novell's goal is to sell NDS at knockdown prices, or even give it away free, to boost market share before Microsoft can retaliate with Windows 2000.
"What Novell has created is essentially an Internet operating system, and a really good one at that," opines Liam Burke, who holds Novell stock in the Flag Investors Communications Fund, which he runs for Alex. Brown Investment Management. "Novell has now got the right products and strategy to take a nice piece of the market."
Another institutional investor goes further: "Microsoft does not offer a complete solution for the Internet. In fact, they are nowhere close. And meanwhile, the market for directory software is going to double in size every month."
Critical to Novell's ambitions of cashing in on the market for network directory products and other Internet management gadgets will be the company's ability to convince other providers of Internet backbone equipment to adopt NDS technology. Particularly important in this regard are the companies that make routers, which help guide data over the Internet and move information coherently from one corporate network to another. Since last November, Schmidt has gotten Nortel and Lucent Technologies to integrate NDS software into their network administration products. |
