All about converts

Novell Credit Analysis – May 5, 2005

Using 82 vs. $5.79 and 30 vol. I get implied credit of about 250 over Libor using the Bloomberg model. These converts are senior unsecured. NOVL is a good convert arbitrage candidate because the credit is safe and the equity is valued like an option. I think the credit is safe for the following reasons:

1)      NOVL has $1.7B in cash, $600M in debt, and should continue to generate $50 to $100M in free cash flow per year. The software model is not capital intensive and management is committed to remaining profitable and free cash flow positive.

2)      Management is dedicated to retaining 5 years worth of cash because customers buying products from a software company want to make sure that there’s enough cash to last through a product cycle. CEO- “If you consider a product cycle to be 5 years, then they want to make sure we have enough cash to last 5 years if the worst things happen to us.”

3)      The equity acts as an option because NOVL’s new Open Enterprise Server (OES) product is not valued highly by investors but has the potential to be a major success. OES was launched in March 2005 and early results are still inconclusive. NOVL’s $2.91 net cash provides cushion to the downside.

4)      The major risks are NOVL making a major acquisition, their legacy Netware software decline faster than expected or the ramp of their new products is slower than expected. I do not see NOVL credit at risk even if the above possibilities occur.

Business Profile

Novell has transformed from a dominant company with 70% share in networking software in the early 1990s to a niche player with several growth opportunities. Over that time, Microsoft, UNIX and Linux have eroded NetWare’s share considerably. The company’s strategy is to bundle Netware with Linux and offer new applications for Linux. Today, Novell derives its revenues from 59% software and 41% services.

The company’s strategy is to migrate its remaining NetWare customers to a new software called Open Enterprise Server (OES) that combines NetWare with Linux. NetWare has been declining at a 14% annual rate for the last few years but still acts as a cash cow for the company as NOVL no longer invests R&D on the product. 

Software Model

The beauty of the software model is that software companies can stay free cash flow positive and live off maintenance revenues for years after a product starts its decline. The typical software model charges the customer a license fee per user and an annual maintenance fee that equals 20% of the license fee. After adopting a software, IT managers are reluctant to switch platforms and will continue to pay the maintenance fees every year.

Despite its problems, NOVL still generates about $100M in free cash flow per year. Many software companies such as NOVL, SEBL andBEASnow trade near cash levels, which combined with their large cash balances and dependable cash flow streams, make good take out candidates. So far, it hasn’t been the LBO takeouts but rather acquisition by larger software companies (PeopleSoft by Oracle, Rational by IBM etc)

Another positive for NOVL is that customers will require software suppliers to be healthy before committing to a purchase. NOVL’s CEO said on the last conference call that customers buying products from a software company want to make sure that there’s enough cash to last through a product cycle. If you consider a product cycle to be 5 years, then they want to make sure we have enough cash to last 5 years if the worst things happen to us.

Consulting Model

This segment remains free cash flow positive even with utilization at 56%, which implies a low level of risk. Going forward, this unit will focus on driving sales of NOVL products. To a large degree, the success of this business will depend on the company’s software performance. However, these projects are very short-term which allows the company to adjust its cost based on sales. There is speculation that the company will sell its management consulting business, which could be worth up to $200M.

Recent performance

There are two schools of thought about NOVL’s recent performance, which in Q1 was lower than expected. The bulls believe that customers were waiting for the new March launch of OES, which caused them to postpone buying the existing products. NOVL says that OES has drawn significant interest through beta tests and downloads so far.

Bears say that NOVL’s products are in secular decline and the new products are unproven. Additionally, bears feel the new OES product actually gives customers an opportunity to migrate off Netware to another platform.

Overall, 2005 has been a very bad year for software companies so far. Sales cycles are getting longer and buyers are very tight with budgets. Many companies have pre-announced or guided down results (Siebel, Sybase, Veritas)

NOVL reports earnings during the week of May 23. I do not have a good feel for the quarter but my thesis on NOVL does not rest on this quarter’s results. I think NOVL’s stock is protected on the downside and there is potential for upside.

Equity Valuation

At $5.87, NOVL trades at 2x net cash of $2.91. The stock is cheap based on 0.7x EV/Sales but expensive when based on 65x PE. The market is implying that NOVL is not worth much more than its hard assets. The valuation is probably $2.91 in net cash and $2.96 in option value if new products ramp quickly.

Risks

NOVL makes a big acquisition with their cash

In the past NOVL has made acquisition in the $50M to $300M range. It bought SUSE for $211M in 2004 and Ximian for $41M in 2003. The company will focus any acquisition on the Linux or identity management space. Since these are emerging segments, it is unlikely that NOVL can use more than $300M on any single acquisition. The likihood of a string of small acquisitions is also small because it is very difficult for companies to integrate software offerings and management already has enough on its plate. Also, management has committed to retaining 5 years worth or cash on hand to comfort software buyers.

Netware deteriorates faster than expected

Netware declines picked up in Q1 to 14% after several quarters of smaller declines. It is possible that these declines will accelerate. However, even if Netware declines faster than expected, the company will still have a significant amount of cash even if cash flow goes down.

Adoption of NOVL’s new products is slower than expected

The new OES product was recently launched in March 2005 so it is too early to tell if the product will be successful. Even if the product is not successful, NOVL will have enough cash to formulate a new strategy.

Financials

NOVL has $1.7B in cash and $600M in debt (all convertibles). The large cash balance was build up recently from a $450M cash lawsuit settlement with MSFT and the recent $600M convertible bond offering. NOVL generated about $100M in free cash flow in the last 12 months. The company should be able to remain cash flow positive for the next few years.