Editor's note: This Stocks Under $10 alert was originally sent to subscribers April 25 at 2:01 p.m. EDT. It's being republished as a bonus for TheStreet.com and RealMoney.com readers.
In looking for attractive stocks in the under $10 sector, we've found a number of candidates in the software industry. One of these is
, a provider of proprietary software that is a potential turnaround story for risk-averse investors.
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model portfolio, we already have one pure-play software name and another with exposure to the shift toward the Linux-operating system, so we are not adding Novell to the model portfolio.
However, a number of drivers lead us to believe that shares of Novell are an attractive investment in 2007, though not in the top 15 to 20 stocks that make up our portfolio. The company has done a great job revitalizing its prospects by focusing on customers' shift toward open-source software such as Linux.
And even though it's unlikely Novell will ever reach the size and scope of software giants like
, that doesn't mean investors can't make money betting on the underdog.
Fall From Glory
Compared with most firms in the tech space, Novell has a rather long history. The company introduced its original signature operating system, NetWare, in the early 1980s. Over the next decade, Novell gained market share and became a major player in providing software to businesses as they embraced the benefits of large computer networks.
Although Novell ended up being one of the many firms run over by software juggernaut Microsoft, the company has survived and continues to offer an array of infrastructure software and services to more than 50,000 customers.
Ironically, the long-term outlook for Novell got a boost in November after the company announced it will collaborate with Microsoft to enhance the interoperability between Novell's SUSE Enterprise Linux and Microsoft's Windows software. Since that announcement, Novell has inked five major Linux-related deals in conjunction with Microsoft, including adding
as new customers.
Although we don't believe the major deal signings will continue at the same pace, the alliance with Microsoft has put Novell in a better position to compete with
, the leading provider of Linux-based products and services.
Like many other major software companies, Novell's revenue comes from a combination of new-license sales and recurring maintenance and services fees. Its software products include identity- and resource-management software, as well as a stable of Linux platform products, which offer the most promising growth potential going forward.
However, total revenue has suffered because of weakness in the company's NetWare segment, which has been in decline for years and posted a 60% year-over-year decrease in sales in the most recent quarter. NetWare is a somewhat outdated operating system that continues to lose customers to better options (mainly Microsoft alternatives).
Other major products showed flat to slightly negative growth rates, most notably the company's Open Enterprise Server software, which represents almost 20% of total revenue, and its global services segment, which accounted for more than 30% of revenue last year.
A 'Show Me' Story
Even though Novell's traditional NetWare business is likely to continue to decline, there is significant room for sales growth in its Linux-related products. Analysts estimate the Linux segment of the enterprise software space will experience annual growth of nearly 30% through 2009. Indeed, Novell's first-quarter 2007 results showed a 46% increase in Linux platform revenue vs. a year ago.
However, this segment still makes up a small portion of Novell's overall sales. First-quarter net revenue totaled $230 million, of which only $15 million came from Linux platform products.
Those challenges make Novell a "show me" story, which is one of the reasons we like the stock. The analyst community remains skeptical with regard to how quickly management can right the ship and to what degree customer uptake of Novell's Linux-related products will improve the company's financial results.
We often prefer companies that have something to prove, rather than those that analysts are already expecting good things from. Uncertainty is one of the factors that create opportunities for investors. (Besides getting detailed investment ideas, subscribers to
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receive frequent Alerts focusing on the latest news and numbers for names in the model portfolio.)
For 2007, there are a number of key metrics for Novell investors to keep an eye on. No. 1 on everyone's list should be the company's revenue growth, which is an indicator of how successful management is in combating the decline in the company's legacy NetWare business with new deals, popular Linux-based solutions and attractive alternatives to the products of competitors like Red Hat. In late March, Novell's management reiterated its guidance range of $945 million to $997 million in 2007 revenue, and the midpoint of that range would represent a 6.5% decline in year-over-year revenue.
More important, however, are Novell's third- and fourth-quarter results, which should mark the first positive growth for the company in almost two years, based on analyst estimates and company guidance.
Another major data point to watch is Novell's operating margin, which currently remains in free fall but has become a key component of management's strategy going forward. Full-year 2006 operating margins were 4%, and first-quarter 2007 margins came in at negative 1%. Management's goal is to turn these recent results around sharply and post operating margins in the 5% to 7% range for the fourth quarter of this year.
Analysts remain skeptical about whether this is likely, and their estimates for fourth-quarter operating margins range from around 2% to more than 7%.
Last, Novell has a number of ways to drive earnings growth over the next two years. The company is focused on reducing expenses on a number of fronts -- sales, general and administrative costs and R&D -- which could benefit bottom-line results. In addition, Novell has more than $1 billion in cash and equivalents on its balance sheet, which it can use to buy back shares.
As long-term investors, we look for potential catalysts that could boost the share price six to 12 months down the road. For Novell, the Linux desktop market presents a major future catalyst, while the skeptical view of most Wall Street analysts provides upside opportunity if management can follow through on its financial targets.
We believe that expectations for Novell are relatively low and shares could see 10% to 20% in gains if management can push operating margins above 5% during the fourth quarter of this year.
However, at the stock's current price, there is also potential downside if sales growth in Novell's latest products can't outpace its revenue losses in NetWare. Shares currently trade at around 38 times 2008 consensus earnings estimates, which is not unreasonable for a company in the process of turning its business around, but still well above the valuation of competitor Red Hat, whose shares trade at less than 27 times 2008 earnings expectations.
It's a big plus that Microsoft is in Novell's corner, but Red Hat -- which has been in the Linux game a lot longer than Novell -- remains a formidable opponent with possibly a better grasp on the opportunities.
So while we are bullish about the potential for the stock, the risk/reward profile doesn't quite meet our standards for the
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model portfolio. We have a number of other One-rated names that we believe offer as good or better upside with less risk.
In addition, we are already sporting a 20% gain in what has been our favorite name in the software industry. But Novell certainly merits watching.
In keeping with TSC's editorial policy, Larsen Kusick doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Kusick is a research associate at TheStreet.com, where he works closely with Jim Cramer and works on TheStreet.com Stocks Under $10. Prior to joining TheStreet.com, he worked in options trading and management consulting. He appreciates your feedback;
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