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For Novell, Linux Means New Life

Investors are slowly waking up to the new Novell (NOVL). The old Novell, which boasted about a 70% market share in corporate networking software in the 1980s, has struggled to reinvent itself for the past 10 years as it lost more and more of that market to Microsoft's (MSFT) Windows. Novell's NetWare product still has loyal fans, but their numbers dwindle each quarter. By March, 2003, the financial community had all but given up on the stock, which then traded at just above $2 with only one analyst covering it.

Since then, Novell has turned itself into a play on Linux, the open-source operating system that's gaining market share both in the corporate arena and among makers of consumer electronics. It's a remarkably ambitious strategy, which has produced a rapid -- and to some extent, unexpected -- turnaround.

At first, analysts worried that Novell's Linux plan -- which entails distributing the free operating system plus selling a spectrum of high-end applications and services to go with it -- was more marketing spin than substance. But after doing two major acquisitions to build its Linux portfolio and coming up with what at least one analyst calls a "clear roadmap" for moving its NetWare customers to Linux, Novell is winning credibility as a Linux player.

"MORE THAN JUST HYPE." At its "BrainShare" user conference in late March, Novell went a long way toward persuading the remaining skeptics about the viability of its plans. It announced new deals with Hewlett-Packard (HPQ) and IBM (IBM) to bundle its Linux offerings with their hardware. IBM is also investing $50 million in Novell.

And it has agreed to open up some of its proprietary software so the open-source community could enhance it -- an important step in gaining marketplace credibility, say analysts. "People are seeing this as a lot more than just hype," says Brendan Barnicle, an analyst with Pacific Crest Securities, who rates Novell a buy.

Indeed, the recent announcements are signs that Novell can deliver results, argues Vice-Chairman Chris Stone. "The strategy is in place, and now it's about execution," he says. "It's a pretty exciting place to be, and it's up to us to make it work."

GRUDGING UPGRADE. More Wall Street analysts (eight now cover Novell, according to First Call) are starting to see the light at the end of Novell's tunnel. The stock suffered from a brief bout of investor skepticism after the company posted its fiscal first-quarter earnings on Feb. 23. Revenues came in at $267 million, up just 3% from the prior year and a little below consensus. Net income was just $10 million, or 3 cents a share, and management made some cautious comments about the corporate tech spending environment. The stock, which had briefly surged to $14 in early February, had slipped back to $9.50 by mid-March.

However, the positive news at Novell's user conference, combined with the cheaper stock price, spurred analysts to get on board. On Mar. 24 analysts from Prudential and Decatur Jones upgraded the stock. Prudential's endorsement was somewhat grudging, as it noted that disappointment with the first quarter had "largely been played out and is reflected in the current share price."

Merrill Lynch analyst Jason Maynard, who rates the stock a buy, was less than effusive as well. On Mar. 23, he quipped in a research note that CEO Jack Messman's cry of "Novell is back," could have been expressed more precisely as "Novell is back from the dead."

HALO EFFECT. Decatur Jones analyst Dion Cornett has been more positive. In an interview, he praised Novell's strategy and management. "This is not the same Novell management team that bungled so many initiatives through the 1990s," he says. Although he thinks it "still has a couple of mediocre quarters to work its way through," Cornett expects fiscal 2004 sales to reach $1.18 billion, up 6% from $1.11 billion in 2003.

While that's a modest increase, he thinks the stock will get a boost from broader adoption of Linux -- particularly on the desktop, as some big companies migrate away from Windows. "The impact will be a huge positive for the stock," says Cornett.

Indeed, Novell got a shot in the arm when competing Linux provider Red Hat (RHAT) posted surprisingly good results on Mar. 23. That company sold many more software subscriptions than expected and posted earnings of $5 million, or 3 cents a share, proving that it's possible to make money distributing free Linux software. Novell's stock closed on Mar. 30 at $11.38.

NOT QUITE PHOTOGRAPHIC CLARITY. Analysts' median price target for it now is $12, but several argue that Novell remains a good buy -- if somewhat speculative -- at current levels. "It's still being valued based on its legacy NetWare business," says Barnicle. "It's not as cheap as when we initiated coverage at under $10, but we still think it has a pretty compelling valuation."

Novell could still face difficulties, of course. "The challenges are in pulling all this together," says Stephen O'Grady, a senior analyst with industry research firm RedMonk, in Bath, Me. Yet so far he has noticed "startling" enthusiasm from Novell's NetWare customers for its Linux strategy -- and he applauds Novell for "filling in a lot of the detail" about its plans. "But are they at the photograph level of clarity in terms of the road ahead? No," he says.

For investors, that adds up to a risky bet on a major turnaround. But for the first time in a long time, the momentum at Novell seems to be heading in a positive direction. By Amey Stone, senior writer for BusinessWeek Online in New York

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