Novell's SuSE Buy and $50 Million from IBM May Be the Fix Novell Needs

Novell’s early November $212 million surprise purchase of the Linux server distributor, SuSE looks like a stunningly brilliant move with the potential to vault the Salt Lake City firm back into the top ranks of networking vendors. The announcement IBM would make a $50 million investment in Novell stock, coming at the same time, was icing on the cake.

On paper, Novell is now a leading, full-service Linux distributor.

Wall Street thinks so. It sent Novell’s stock price and market cap soaring. In early December, Novell’s stock was trading at about $9.50 per share (close to its 52-week high of $9.82), a gain of 64 percent since it announced the SuSE deal. The company’s market capitalization stands at $3.58 billion. The SuSE deal alone could net Novell $40 million in new 2004 sales.

Now comes the tough part: Novell must execute. For starters, that means melding two wildly disparate corporate cultures, convincing the industry the Novell brand name is still viable, and constructing a compelling, cohesive product strategy and marketing campaign. That’s tough for any firm, especially Novell, which has a long history of botched acquisitions and aborted strategies. Remember WordPerfect and UnixWare?

In the past decade, NetWare lost market share to rival Microsoft Windows server operating systems and its stature as a networking industry leader has been in steady decline. Indeed, the phrase that best sums up Novell in the last ten years is: “Desperately Seeking a Strategy.”

In the last decade, Novell has changed its executive management team at least four times and embarked a new, new strategy on a yearly basis.

The company’s embrace of Linux is its last and best hope of a renaissance.

Market Impact
The SuSE acquisition comes 3 months after Novell's August purchase of Ximian, a well-known supplier of Linux client software. It gives Novell a strong portfolio of OpenSource and Linux desktop and server solutions. SuSE, based in Nuremberg, Germany has approximately $40 million in annual sales and is the second largest Linux distributor after RedHat. Novell’s acquisition of SuSE pressures RedHat and should further spur competition in the already red-hot Linux market. IBM’s $50 million investment in Novell convertible preferred stock adds credibility. Novell and IBM are negotiating extensions to the current commercial support agreements between IBM and SuSE. The German firm’s Linux offerings currently run on IBM's eServer and middleware products. This could further tip the Linux scales in Novell’s favor should IBM opt to shift business from Red Hat to Novell.

Historically, high-tech industry mergers and acquisitions have a higher percentage of failures than successes. In particular, Novell’s history of successfully leveraging its acquisitions has been spotty to poor over the last decade. Its financials are slightly down, although it has a clean balance sheet with more than $500 million in cash.

In its fourth quarter, Novell reported revenues of $287 million, compared with sales of $300 million from the same quarter in 2002. The company is also still in the red with a net loss of $109 million, which is less than the $155 million earnings shortfall in 2002.

Since 1999, fewer than one dozen financial brokerage firms have covered Novell. A snapshot of 10 financial houses covering Novell reveals seven—including Goldman Sachs and Preferred Capital Markets—downgraded the stock. Most recently, in July 2003 Roth Capital initiated coverage with a Strong Buy rating.

Vendor Winners and Losers
Novell is both a potential winner and loser. Linux may resuscitate Novell and help it be a top-tier Linux player and put pressure on Microsoft and Windows. That’s not a given.

The company’s track record on acquisitions is not good. In the late 1980s, it bought two firms, Excelan and Kinetics specifically to get the industry’s best TCP/IP stack, and then it stubbornly refused to make TCP/IP the default NetWare protocol, to the detriment of NetWare wide-area performance. Novell similarly made a shambles of its WordPerfect, Digital Research, Sirius, and USL purchases. Its UnixWare strategy came to naught and the company sold Unix System V copyrights to SCO in 1995. The more recent acquisitions of Cambridge Technology Partners, a consulting and systems integration firm in July 2001 and the 2002 purchase of Silver Stream, a Web Services and portal vendor, have yet to produce significant revenue or make a perceptible impact in their respective markets.

In short, Novell has had the opposite of the Midas touch.

Losers

• Red Hat. The SuSE and Ximian deals put the most immediate pressure on Red Hat and Sun. Red Hat’s position as the dominant Linux distributor is now in doubt because Novell can field both a desktop and server offering as well as its own management and security offerings to complement the Linux portfolio. IBM’s $50M Novell investment suggests that Big Blue will increase its Novell business at Red Hat’s expense. Novell’s strong and deep reseller channel further stresses Red Hat.
• Sun is struggling. Its midrange Solaris systems are experiencing heavy defections to Linux. In addition, it is attempting to transition from a hardware vendor to a services model. This puts more pressure on Sun to accelerate that move.

Vendor Recommendations

• Novell must move swiftly and decisively to meld two disparate corporate cultures, architect a cohesive marketing strategy and provide specific details of its product, marketing, and channel strategy.
• Novell must reach out to the ISV community to spur development of the all-important applications.
• Novell should diversify and promote both network services and value-added tools, like Borland is doing, to spur Linux enterprise adoption.
• Novell should clearly define a Linux indemnification strategy. Quite apart from the ongoing SCO lawsuit, Novell owes its prospective Linux customers a strong warranty that protects them in the event of third party lawsuits.

• Microsoft should emphasize its indemnification policy and offer competitive deals. Windows has yet to experience serious erosion in its market share despite some well-publicized defections like the city of Munich. However, corporations and government organizations—particularly foreign governments and municipalities—are serious about Linux. Microsoft is well advised to heed the warning signals and offer licensing price breaks and incentives.

• Corporations should drive hard bargains. They should demand at least partial indemnification and ask for additional service and support including discounted, or free, on-site help with new Linux deployments.