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12.24.07

Novell’s Annual Report 2007 – Quick Analysis

Posted in Antitrust, Courtroom, Deals, Finance, GNU/Linux, Identity Management, Intellectual Monopoly, Interoperability, Linspire, Microsoft, NetWare, Novell, Patent Covenant, Patents, Red Hat, Ron Hovsepian, SCO, Servers, SLES/SLED, Turbolinux, Virtualisation, Windows, Xandros at 2:02 am by Dr. Roy Schestowitz

We have just made local copies that were taken from the public material at the SEC’s Web site. It’s Novell’s annual report for 2007.

Here is a quick rundown. The full report is about 130-pages long, excluding enclosures. We will comment on bits that stand out in this report and we shall begin with the following text:

Development of translators to improve interoperability between Microsoft Office and OpenOffice document formats; and

Although these translators are intended to work with OpenOffice.org, ODF is not “OpenOffice document formats”. it’s an international (ISO-approved) standard. This subtle mistake can be deceiving and be used against ODF, so Novell must be careful.

Additionally, during fiscal 2007, Novell and Microsoft announced a collaboration to deliver MoonlightTM, a Silverlight-compatible framework-based technology for hosting Silverlight interactive applications on Linux. Silverlight is a cross-browser, cross-platform plug-in for delivering richer user experiences on the Web.

Mind the collaboration (Microsoft is formally involved), the trademark on Moonlight (probably owned by Novell), and total lack of attribution to GNU (this is consistent throughout the report),

Major Customers

No single customer accounted for more than 10% of our revenue in fiscal 2007, 2006, or 2005. During fiscal 2007, we received $355.6 million from Microsoft related to the Microsoft agreements discussed above, which is being recognized over future periods.

Why is Microsoft listed under this heading (“Major Customers”)?

Although we have a significant amount of deferred revenue recorded on our consolidated balance sheet, included in this report, the majority of this amount relates to maintenance and subscription contracts and the Microsoft agreement, which is recognized ratably over the related service periods, typically one to three years, and do not pertain to unshipped product.

There is a simpler way to put this. Microsoft’s cash infusion accounts for some of of the things that make up the majority of the amount in this annual report. It’s a noticeable potion, so you are advised to recall Novell's issue with the bank in Forgo. More on this later, when backdating gets mentioned.

Primary competitors for our Linux and platform services solutions include Microsoft and Red Hat.

Isn’t it funny that Novell has partnered with a “primary competitor”, according to its own definiton?

It proceeds:

The two companies also agreed to provide each other’s customers with patent coverage for their respective products.

Didn’t Novell state on numerous occasions that this was not a software patent deal? Ron Hovsepian, the company’s chief, insisted that it was all about interoperability.

It proceeds:

We will continue to be competitors of Microsoft, but it is our goal that through this set of agreements, Microsoft will serve as an important indirect source of channel sales for Novell’s Linux sales.

Talk about a fox watching the hen house.

Novell proceeds to talking (almost raving about) patents and intellectual monopolies, also known as “IPR”.

Copyright, Licenses, Patents, and Trademarks

We rely on copyright, patent, trade secret, and trademark law, as well as provisions in our license, distribution, and other agreements to protect our intellectual property rights. Our portfolio of patents, copyrights, and trademarks as a whole is material to our business but no individual piece of intellectual property is critical to our business. We have been issued what we consider to be valuable patents and have numerous other patents pending. No assurance can be given that the pending patents will be issued or, if issued, will provide protection for our competitive position. Notwithstanding our efforts to protect our intellectual property through contractual measures, unauthorized parties may still attempt to violate our intellectual property rights.

More brow-raising portions are included here (particularly the latter part):

In the event of an adverse result in any such litigation, we could be required to expend significant resources to develop non-infringing technology or to obtain licenses to the technology that was the subject of the litigation. There can be no assurance that we would be successful in such development or that any such licenses would be available.

In addition, the laws of certain countries in which our products are or may be developed, manufactured, or sold may not protect our products and intellectual property rights to the same extent as the laws of the U.S.

Novell later talks about legal issues.

It starts by discussing its backdating of options.

Between September and November of 2006, seven separate derivative complaints were filed in Massachusetts state and federal courts against us and many of our current and former officers and directors asserting various claims related to alleged options backdating.

Then comes Microsoft (see this letter of complaint to the US DoJ).

On November 12, 2004, we filed suit against Microsoft in the U.S. District Court, District of Utah. We are seeking treble and other damages under the Clayton Act, based on claims that Microsoft eliminated competition in the office productivity software market during the time that we owned the WordPerfect word-processing application and the Quattro Pro spreadsheet application. Among other claims, we allege that Microsoft withheld certain critical technical information about Windows from us, thereby impairing our ability to develop new versions of WordPerfect and other office productivity applications, and that Microsoft integrated certain technologies into Windows designed to exclude WordPerfect and other Novell applications from relevant markets. In addition, we allege that Microsoft used its monopoly power to prevent original equipment manufacturers from offering WordPerfect and other applications to customers. On June 10, 2005, Microsoft’s motion to dismiss the complaint was granted in part and denied in part. On September 2, 2005, Microsoft sought appellate review of the District Court’s denial of its motion. On October 15, 2007, the U.S. Fourth Circuit Court of Appeals affirmed the District Court’s ruling, thereby allowing Novell to proceed with the remaining claims against Microsoft. While there can be no assurance as to the ultimate disposition of the litigation, we do not believe that its resolution will have a material adverse effect on our financial position, results of operations or cash flows.

The remainder of this section covers SCO litigation, which is beyond the scope of this site and our sight.

Further down the report you’ll find this footnote:

In the first quarter of fiscal 2005, we recognized a gain of $447.6 million on a litigation settlement with Microsoft to settle potential anti-trust litigation.

Here is the bit about claimed Linux growth, which is apparently a case of cooking the books, confirmed by those in Novell who are responsible and involved.

Within our open platform solutions business unit segment, Linux and open source products remain an important growth business. During the year we established and expanded relationships with several strategic partners to increase the reach of both our server and desktop products. Revenue from our Linux platform products increased 69% year-over-year in fiscal 2007. The strength of our revenue growth was due in part to our agreement with Microsoft which was signed in November 2006.

There are further details about NetWare and identity management, but these segments are not explored here, mainly for brevity.

Further down:

Microsoft Agreements-related Revenue

On November 2, 2006, we entered into a Business Collaboration Agreement, a Technical Collaboration Agreement, and a Patent Cooperation Agreement with Microsoft Corporation that collectively are designed to build, market and support a series of new solutions to make Novell and Microsoft products work better together for customers. Each of the agreements is scheduled to expire on January 1, 2012.

Once again, Novell talks about “Patent Cooperation Agreement with Microsoft Corporation”. This does not align with Novell’s claims that this was not a patent deal. Its annual report simply contradicts this.

We’ve also just found out why no coupons were involved in the Xandros, Linspire, and Turobolinux patent deals. The report states:

Microsoft agreed that for three years following the initial date of the agreement it will not enter into an agreement with any other Linux distributor to encourage adoption of non-Novell Linux/Windows Server virtualization through a program substantially similar to the SLES subscription “certificate” distribution program.

Then comes the part which we mentioned the other day (the day this report was actually released). It talks about how Novell passes Microsoft ‘patent money’ based on its sales volume of Free software and GNU/Linux. It’s very discomforting indeed.

Mind the fact that Microsoft is covering the expenses of all this charade. That ought to explain those Windows-run Web sites which promote this deal.

The contractual expenditures by Microsoft, including the dedicated sales force of $34 million and the marketing funds of $60 million, do not obligate us to perform, and, therefore, do not have an accounting consequence to us.

Novell then talks about “goodwill” assets.

Long-lived Assets. Our long-lived assets include net fixed assets, long-term investments, goodwill, and other intangible assets. At October 31, 2007, our long-lived assets included $180.5 million of net fixed assets, $37.3 million of long-term investments, $404.6 million of goodwill, and $33.6 million of identifiable intangible assets.

After the deal with Microsoft, Novell truly ought to rethink its definition of “goodwill”. The deal was selfish, and even Novell admitted this.

In revenue breakdown, Novell adds the following (all solid numbers are worth omitting here, but they can be seen in the full report):

Revenue from our open platform solutions segment increased in fiscal 2007 compared to fiscal 2006 primarily due to increased Linux platform products revenue, which increased approximately 69% due to the impact of the Microsoft transaction. In addition, open platform-related services revenue increased approximately 81% in fiscal 2007 compared to fiscal 2006. Software licenses within the open platform solutions segment decreased as most of the revenue in this category is sold under subscriptions and upgrade protection contracts, which we classify as maintenance and subscriptions. Because much of the revenue we invoice is deferred and recognized over time, we consider invoicing, or bookings, to be a key indicator of current sales performance and future revenue performance. For Linux platform products, invoicing increased 200% in fiscal 2007 compared to fiscal 2006, including the impact of the Microsoft agreement.

Novell fails to mention the effect of coupons that are bound to run out. Additionally, as stated earlier, Novell might be changing the definition of “open platform solutions”, thereby putting revenues in buckets that give an illusion of growth in more critical areas (strategic shift to Linux and open source).

The effect of the Microsoft cash injection is only mentioned later on:

Deferred revenue

We have total deferred revenue of $767.7 million at October 31, 2007 compared to $427.0 million at October 31, 2006. Deferred revenue represents revenue that is expected to be recognized in future periods under maintenance contracts and subscriptions that are recognized ratably over the related service periods, typically one to three years. The increase in total deferred revenue of $340.7 million is primarily attributable to deferred revenue from the Microsoft agreements of approximately $307.8 million.

According to a recent report from Maureen O'Gara, this might be the reason for the SEC’s suspicion and consequent probe. In page 40:

Open platform solutions increased primarily due to higher related revenue and the related economies of scale, due in part to the impact of the Microsoft transaction.

Later on you can find some bits about the antitrust settlement:

Gain on settlement of potential litigation in fiscal 2005 related to an agreement with Microsoft to settle potential antitrust litigation related to our NetWare operating system in exchange for $536 million in cash. On November 18, 2004, we received $536 million in cash from Microsoft. The financial terms of the NetWare settlement agreement, net of related legal fees of $88 million, resulted in a pre-tax gain of approximately $447.6 million in the first quarter of fiscal 2005.

It then returns to Microsoft’s effect (looking at financial figures again):

Investment income includes income from short-term investments. Investment income for fiscal 2007 increased compared to fiscal 2006 due to higher interest rates and increased cash balances primarily due to $355.6 million of cash received from the Microsoft agreements.

[...]

Net cash provided by operating activities in fiscal 2007 included the receipt of $355.6 million in cash in connection with the November 2006 Microsoft agreements. Net cash provided by operating activities in fiscal 2005 included the receipt of $447.6 million in cash, net of legal fees, in connection with the November 2004 Microsoft settlement.

It is worth stressing that the Novell/Microsoft agreement lasts not 5 years, but 5 years and 2 months. This fact repeated a few times, including in page 67:

On November 2, 2006, we entered into a Business Collaboration Agreement, a Technical Collaboration Agreement, and a Patent Cooperation Agreement with Microsoft Corporation that collectively are designed to build, market and support a series of new solutions to make Novell and Microsoft products work better together for customers. Each of the agreements is scheduled to expire on January 1, 2012.

Notes about Novell payment of ‘patent tax’ to Microsoft are included in page 68:

We will recognize the revenue ratably over the respective subscription terms beginning upon customer activation, or for subscriptions which expire un-activated, if any, we will recognize revenue upon subscription expiration. Objective evidence of the fair value of elements within the Patent Cooperation Agreement and Technical Collaboration Agreement did not exist. As such, we combined the $108 million for the Patent Cooperation Agreement payment and amounts we will receive for the Technical Collaboration Agreement and are recognizing this revenue ratably over the contractual term of the agreements of 5 years. Our periodic payments to Microsoft will be recorded as a reduction of revenue.

Page 128 contains references to Microsoft-related exhibits. You can view the entire report here.

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