This Management's Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Annual Report contain forward-looking statements that involve risks and uncertainties. All forward-looking statements are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements. The Company's actual results may differ materially from the results discussed in such forward-looking statements as a result of a number of factors, which include, but are certainly not limited to, those set forth below in the sections entitled "Future Results," "Year 2000," "Euro Conversion," "Financial Market Risks," and those factors set forth in the Company's Annual Report on Form 10-K in the sections entitled "Competition" and "Additional Factors Affecting Earnings and Stock Price."

INTRODUCTION

Novell is a leading provider of network and Internet directory software and services. Novell Internet solutions make networks more manageable and secure, integrating the complete range of computer platforms, applications, services and devices, and they reduce the total cost of ownership for organizations of every kind and size. Novellís worldwide channel, developer, education, consulting and technical support programs are among the most extensive in the network computing industry.

Changes in the economic and business environment for network software have occurred in the last several years, which have led to strategic and operational changes at Novell. The Company has evolved its business to focus on software applications which leverage network capabilities and capitalize on the growth of the Internet. With products like NetWare 5 and Novell Directory Services (NDS), Novell continues to expand in Internet directory products based on open standards. The Company's education and training, service and support, and consulting areas continued to grow as the Company retained its position of being the leading expert in providing these services.

In fiscal 1999, the Company continued its focus on delivering new products consistent with its strategy and enjoyed the benefits of a lower cost and restructured organization. The results were significant. The Company delivered a number of new applications, utilizing directory technology, which robustly captures the benefits of networking and the Internet. New software delivery technologies have enabled the Company to continue its shift from heavy reliance on physical distribution of product toward lower cost licensing agreements. Indirect distribution channel product shipments, which includes revenue from individually boxed products sold by computer resellers and systems integrators, education materials, and support and consulting services not included in site-license contracts, accounted for approximately only one-third of total revenue in 1999.

Fiscal 1999 also saw continued growth in earnings, incrementally each quarter. Through operational control, rigorous business practices, and improved internal management systems, expense structures were reduced as a percentage of revenue and moved closer to leading software company benchmarks. These expense controls were complemented by sequential revenue growth each quarter of fiscal 1999.


RESULTS OF OPERATIONS

Net Sales 1999     Change     1998     Change     1997    
Net sales (millions)    $1,273     17%  $1,084     8%  $1,007
Novell's products can be categorized into the following four areas, all within the directory-enabled networking software services segment.
  • Directory-enabled server platforms, which includes NetWare 4 and NetWare 5

  • Directory-enabled applications products, or Net Services Software, which include NetWare for SAA host connectivity products, BorderManager, NDS integration and high availability service products, as well as collaboration and management products including GroupWise, ManageWise, and ZENworks

  • Service, education and consulting revenue, which is generated from customer service, educational products and courses, and consulting for network solutions

  • Pre-directory product revenue consisting of NetWare 3, non-directory-enabled infrastructure products and UNIX royalties

The following analysis describes the product lines consistent with the Company's current ongoing business. Prior year amounts have been restated to conform to current year classification of product types. Also, the Company's decision to not ship to the indirect distribution channel in the third quarter of fiscal 1997 makes year-over-year comparisons to fiscal 1997 results difficult.

Directory-enabled server platforms revenue was $659 million in fiscal 1999 compared to $534 million in fiscal 1998 and $475 million in fiscal 1997. The increase from fiscal 1998 to fiscal 1999 was primarily the result of increased sales of NetWare 5, which more than offset the decline in sales of NetWare 4. The increase between fiscal 1997 and 1998 was the result of directory-enabled NetWare sales growth and the introduction of NetWare 5 in the fourth quarter of fiscal 1998. The directory-enabled server platforms product line represented 52% of total revenue in fiscal 1999 compared to 49% of total revenue in fiscal 1998 and 47% of total revenue in fiscal 1997.

Revenue from directory-enabled applications products was $315 million in fiscal 1999 compared to $227 million in fiscal 1998 and $160 million in fiscal 1997. The increase in fiscal 1999 revenue compared to fiscal 1998 was primarily the result of strong sales growth in management and collaboration products, NDS for NT, and BorderManager. The increase between fiscal 1997 and 1998 was the result of revenue from newly introduced products such as BorderManager and ZENworks and growth in sales of GroupWise. Directory-enabled applications revenues represented 25% of total revenue in fiscal 1999 compared to 21% of total revenue in fiscal 1998 and 16% of total revenue in fiscal 1997.

Service, education and consulting revenue was $181 million in fiscal 1999 compared to $129 million in fiscal 1998 and $102 million in fiscal 1997. The increase in fiscal 1999 revenue from fiscal 1998 was primarily the result of growth in each of the related areas as the Company continued to focus on expanding the service, education and consulting business. The increase from fiscal 1997 to 1998 was due to the growth of service and education revenue. Service, education and consulting revenues were 14% of total revenue compared to 12% of total revenue in fiscal 1998 and 10% of total revenue in fiscal 1997.

Revenue from pre-directory products was $118 million in fiscal 1999 compared to $194 million in 1998 and $270 million in fiscal 1997. The decrease in fiscal 1999 revenue compared to fiscal 1998 was primarily due to the one-time benefit of $36 million in Tuxedo royalty income in fiscal 1998 and the expected decline in sales of older, pre-directory products. The decrease in fiscal 1998 revenue compared to fiscal 1997 was primarily the result of declines in UNIX royalties and declining sales of non-directory enabled products including NetWare 3.

Sales outside the U.S., comprised of sales to international customers in Europe, the Middle East, Canada, South America, and Asia Pacific, represented 45% of total revenue in fiscal 1999 compared to 42% of total revenue in fiscal 1998 and 44% of total revenue in fiscal 1997. Sales outside the U.S. increased as a percentage of total revenue in 1999 due to strong sales in Europe. International sales as a percentage of revenue decreased in 1998 compared to 1997 due to weak sales in the Company's Japanese subsidiary.

Gross profit 1999     Change     1998     Change     1997    
Gross profit (millions)    $987     18%  $835     16%  $719    
Percentage of net sales 78%  77%  71% 
The increase in gross profit percentage in fiscal 1999 compared to 1998 and 1997 was primarily attributable to lower inventory management costs as the Company continued to tighten its management of product flowing into its indirect distribution channel. In addition, overhead as a percentage of revenue was lower in fiscal 1999 compared to 1998 and 1997. Material costs in 1999 and 1998 were also reduced as a greater percentage of the Company's revenues were derived from multi-product licenses rather than from the inventory intensive distribution channel. The Company's reliance on the indirect delivery channel decreased significantly each successive fiscal year to approximately 39% of revenue in fiscal 1999, compared to 57% in 1997.
Operating expenses 1999     Change     1998     Change     1997    
Sales and marketing (millions)    $434     9%  $399     –13%  $460    
Percentage of net sales 34%  37%  46% 
Product development (millions)    $228     –3%  $236     –22%  $301    
Percentage of net sales 18%  22%  30% 
General and administrative (millions)    $102     –1%  $103     —     $103    
Percentage of net sales 8%  9%  10% 
Restructuring charges (millions)    —     —     —     –100%  $   55    
Percentage of net sales —     —     5% 
Total operating expenses (millions)    $764     4%  $737     –20%  $919    
Percentage of net sales 60%  68%  91% 
Operating expenses increased slightly in absolute dollars in fiscal 1999 compared to fiscal 1998 due to additional spending in the sales and marketing areas for new product introductions and sales force expansion. Operating expenses in fiscal 1998 declined from fiscal 1997 through tighter operational control, continuous expense management and new internal management systems installed in fiscal 1998. In addition, the Company realized the benefits from corrective measures taken in fiscal 1997 to restructure and realign its remaining resources to better manage and control its business. Operating expenses decreased as a percentage of net sales in fiscal 1999 compared to fiscal 1998 and fiscal 1997 due to a larger increase in revenue, proportionately, in each respective year, and the Company's continued efforts to bring these expenses in line with industry leading benchmarks.

Sales and marketing expenses increased by 9% in fiscal 1999 compared to fiscal 1998 primarily due to increased sales commissions on higher revenues, sales force expansion, and increased corporate marketing expenses related to the launch of new products. Sales and marketing expenses decreased by 13% from fiscal 1997 to 1998 primarily due to corrective actions the Company took in fiscal 1997, including decreased sales promotion and advertising expenses resulting from the Company integrating its marketing teams to focus on key initiatives across the Company, while reducing redundant expenses. Sales and marketing expenses can fluctuate as a percentage of net sales in any given period due to product promotions, advertising, and other discretionary expenses.

Product development expenses decreased by 3% in fiscal 1999 compared to fiscal 1998 due to continued focus on operational control. Product development expenses decreased by 22% from fiscal 1997 to 1998 primarily due to workforce reductions in the latter half of fiscal 1997 and operational control efforts in fiscal 1998.

General and administrative expenses remained relatively flat in total, but decreased as a percentage of sales, in fiscal 1999 compared to fiscal 1998 and fiscal 1997 reflecting the Company's continued efforts to manage these costs and continue the benefits from the workforce reductions in 1997 and the consolidation of certain functions in 1998.

During the third quarter of fiscal 1997, the Company incurred $55 million of tax deductible restructuring charges for excess personnel and redundant facilities as the Company restructured and realigned its remaining resources to better manage and control its business. Of this charge, accruals of $5 million remain as of October 31, 1999, primarily related to redundant facility charges.

     1999     Change     1998     Change     1997    
Employees 5,430     19%  4,557     –4%  4,770    
Revenue per average employee (thousands)    $254     $232     $189    
In fiscal 1999, headcount increased reflecting the growth in the Company's sales, with the largest increases coming from worldwide sales, product development and network and directory consulting areas. The Company will continue to monitor headcount to ensure the Company is in line with industry leading benchmarks.

In fiscal 1998, headcount decreased as the Company continued to align employment within the framework of the competitive environment in which the Company operates. In the third quarter of fiscal 1997, the Company reduced its headcount by approximately 1,000 employees as the Company restructured its resources to better align with expected business levels.

Other income, net 1999     Change     1998     Change     1997    
Other income, net (millions)    $21     –52%  $43     –12%  $49    
Percentage of net sales 2%  4%  5% 
The primary component of other income, net, is net investment income, which was $41 million, $45 million, and $61 million in fiscal 1999, 1998, and 1997, respectively. The decrease in other income, net, in fiscal 1999 compared to fiscal 1998 was primarily due to the write-off of certain long-term investments, net realized losses on the disposal of certain equity securities, partially offset by the negative minority interest impact of profit improvements in the Company's Japanese subsidiary. Lower average cash balances due to the repurchase of common stock during the year kept investment income flat to fiscal 1998. The decrease in fiscal 1998 compared to fiscal 1997 was the result of net realized losses as the Company disposed of certain equity securities.
Income tax expense (benefit)    1999     Change     1998     Change     1997    
Income tax expense (benefit)    (millions)    $53     34%  $40    156%  $(72)    
Percentage of net sales 4%  4%  –7% 
Effective tax (benefit)    rate 22%  28% (48%) 
During October 1999, the Company reached a settlement with the Internal Revenue Service (IRS) for years 1994 through 1997. This settlement resulted in a $15.2 million reduction in the provision for income taxes during the fourth quarter of 1999. The reduction is a result of the favorable settlement of items related to corporate acquisitions, research and development tax credits, and various foreign items including foreign sales corporation benefits, foreign tax credits, and other immaterial items.

At October 31, 1999, the Company had deferred tax assets of $110 million. A portion of these assets is realizable based on the Company's ability to offset existing deferred tax liabilities. Realization of the remaining portion of these assets is dependent on the Company's ability to generate approximately $154 million of taxable income. Of this, approximately $42 million must be earned in certain jurisdictions outside the United States. Management believes that sufficient income will be earned in the future to realize these assets. Management will evaluate the realizability of the deferred tax assets quarterly and assess the need for valuation allowances.

The effective tax rate for fiscal 1999 was lower than the effective tax rate for fiscal 1998 due to the settlement the Company reached with the Internal Revenue Service. The effective tax rate for fiscal 1998 was lower than the effective tax benefit rate for fiscal 1997 due to the Company's return to profitability and the resulting impact of tax benefits in fiscal 1998. The effective tax rate of 22% for fiscal 1999 is not indicative of the expected effective tax rate in future fiscal years.

Net income (loss) and
net income (loss) per share
1999     Change     1998     Change     1997    
Net income (loss)    (millions)    $191     87%  $102    231%  $(78)    
Percentage of net sales 15%  9%  –8% 
Net income (loss)    per share
Basic $.57     97%  $.29    232%  $(.22)    
Diluted $.55     90%  $.29    232%  $(.22)    
Net income per share increased in fiscal 1999 compared to fiscal 1998 and fiscal 1997 due to the increased revenue and profitability discussed above, along with the decrease in the number shares outstanding due to the Company's stock repurchase program.

FUTURE RESULTS

The Company's future results of operations involve a number of risks and uncertainties. Among the factors that could cause actual results to differ materially from historical results are the following: business conditions and the general economy; competitive factors, such as rival operating systems, directory and applications; acceptance of new products and price pressures; availability of third-party compatible products at below market prices; risk of nonpayment of accounts or notes receivable; risks associated with foreign operations; risk of product line or inventory obsolescence due to shifts in technologies or market demand; timing of software product introductions; market fluctuations of investment securities; and litigation.

YEAR 2000

In the past, many information technology products were designed with two digit year codes that did not recognize century and millennium fields. As a result, these hardware and software products may not function or may give incorrect results beginning in the Year 2000. The Year 2000 issue is faced by substantially every company in the computer industry, as well as every company which relies on computer systems. To address this issue, such hardware and software products were required to be upgraded or replaced to correctly process dates beginning in the Year 2000.

The Company created a company-wide Year 2000 team which identified and resolved Year 2000 issues associated either with the Company's internal systems or the products and services sold by the Company. As part of this effort, the Company communicated with its main suppliers of technology products and services regarding the Year 2000 status of such products and services. The Company identified and tested its main internal systems and completed the implementation of needed Year 2000 related modifications to its information systems. The Company also completed testing and implementation of needed Year 2000 related modifications on its main internal non-information technology systems, which are also date-sensitive.

The Company has a general contingency plan to address extreme events such as earthquake, flood, or serious equipment failures. The Company's Year 2000 contingency planning is an extension of this effort. Based on the Company's planning efforts, the worst-case Y2K-related scenarios that were identified include:

  • temporary loss of power—to address this risk Novell has its own power generation capability in critical locations;

  • temporary loss of voice and/or data communications or other utility services—to help minimize this risk Novell uses multiple telecommunications providers;

  • temporary inability to access key information systems due to a Y2K related failure—to address this risk Novell has identified manual procedures to at least partly facilitate needed processes until systems are restored;

  • temporary inability to ship products due to a Y2K issue with the systems of a key business partner— to minimize this risk Novell uses multiple partners.

The Company's Year 2000 effort included Year 2000 testing for Novell products currently on, and some that were previously on, the Company's price list. Generally, for products that were identified as needing updates to address Year 2000 issues, the Company has prepared updates or has removed the product from its price list. Some of the Company's customers are using product versions that the Company will not support for Year 2000 issues; the Company is encouraging these customers to migrate to current product versions that are Year 2000 ready.

The Company's total cost relating to these activities was not material to the Company's financial position, results of operations, or cash flows. The modifications were made on a timely basis. The Company did not experience a delay in, or increased costs associated with, the implementation of such modifications, nor did the Company experience problems due to suppliers inadequately preparing for the Year 2000 issue. The Company also did not experience an inability to deliver products or services to its customers.

The Company's Year 2000 Web site at www.novell.com/year2000/ provides information on its products that are Year 2000 ready and general information on the Company's Year 2000 efforts. For third party products which the Company distributes with its products, the Company has sought Year 2000 readiness status from the product manufacturers. Customers who use these third-party products are directed to the product manufacturers for detailed Year 2000 status information.

The Company believes that its current products, with any applicable updates, are prepared for Year 2000 date issues, and the Company plans to provide support for these products' Year 2000 date-related issues, as described in the Company's support policy statements. However, there can be no guarantee that one or more current Company products do not contain Year 2000 date issues that may result in material costs to the Company. Because it is in the business of selling software products, the Company's risk of being subjected to lawsuits relating to Year 2000 issues with its software products is likely to be greater than that of companies in other industries. Because computer systems may involve hardware, firmware and software components from different manufacturers, it may be difficult to determine which component in a computer system may cause a Year 2000 issue. As a result, the Company may be subjected to Year 2000 related lawsuits independent of whether its products and services are Year 2000 ready. The outcomes of any such lawsuits and the impact on the Company cannot be determined at this time.

EURO CONVERSION

On January 1, 1999, 11 of the 15 members of the European Union established fixed conversion rates among their existing sovereign currencies and adopted the euro as their common legal currency. At the end of a three-year transition period during which companies may choose to operate either in the euro or national currencies the legacy currencies will be eliminated. In June 1998, the Company formed a cross-functional team to assess the impact of the conversion on the Company's operations and to address associated issues. The Company is currently conducting transactions in the euro and expects to have all affected information systems fully converted by April 2001. Novell does not expect the euro conversion to have a material effect on its competitive position or financial results.

Novell believes that it has the product offerings, facilities, personnel, and competitive and financial resources for continued business success, but future revenues, costs, margins, product mix, and profits are all influenced by a number of factors, such as those discussed above, as well as risks described in detail in the Company's fiscal 1999 report on Form 10-K.

LIQUIDITY AND CAPITAL RESOURCES

Oct. 31    
1999    
Change     Oct. 31    
1998    
Change     Oct. 31    
1997    
Cash and short-term investments (millions)    $895     –11%  $1,007     –3%  $1,033    
Percentage of total assets    46%  52%  54% 
Cash and short-term investments decreased to $895 million at October 31, 1999 from $1,007 million at October 31, 1998. This decrease can be attributed to $69 million of cash used for expenditures on property, plant and equipment, $403 million used to repurchase common stock, and $92 million cash used to increase the cash reserved as collateral for building leases. These expenditures were partially offset by $329 million provided by operating activities and $95 million provided by issuances of common stock, and $28 million provided by other investing activities including short-term investing activities.

The investment portfolio is diversified among security types, industry groups, and individual issuers. To achieve potentially higher returns, a limited portion of the Company's investment portfolio is invested in mutual funds, which incur market risk. The Company believes that the market risk has been limited by diversification and by use of a funds management timing service which transfers funds out of mutual funds and into money market funds when preset signals occur.

The Company's investment portfolio includes securities with net unrealized gains of $61 million, before effects of deferred taxes, as of October 31, 1999. The majority of the Company's unrealized gains are due to the Company's investment in Red Hat, Inc., which completed its initial public offering of common stock in August 1999. Prior to the public offering, this investment was classified as a long-term investment.

The Company's principal source of liquidity continues to be from operations. At October 31, 1999, the Company's principal unused sources of liquidity consisted of cash and short-term investments and available borrowing capacity of approximately $18 million under its credit facilities. The Company's liquidity needs are principally for financing of accounts receivable, capital assets, strategic investments, product development, and flexibility in a dynamic and competitive operating environment.

The Company anticipates being able to fund its current operations and capital expenditures planned for the foreseeable future with existing cash and short-term investments together with internally generated funds. The Company believes that borrowings under the Company's credit facilities, or public offerings of equity or debt securities are available if the need arises. Investments will continue in product development and in new and existing areas of technology. Cash may also be used to acquire technology through purchases and strategic acquisitions. Capital expenditures in fiscal 2000 are anticipated to be approximately $75 million, but could be reduced if the growth of the Company is less than presently anticipated.

In June 1998, the Company announced its intent to repurchase and retire up to 10 percent, or approximately 35 million shares, of Novell common stock over the following twelve months. During fiscal 1998 and fiscal 1999, 21 million and 14 million shares, respectively, were repurchased and retired under this plan at a total cost of approximately $245 million and $204 million, respectively. In July 1999, the Board of Directors authorized up to $500 million for the repurchase of additional outstanding shares of the Company's common stock through October 31, 2000. During the fourth quarter of 1999, the Company repurchased approximately 9 million shares under this plan at a cost of $199 million.

FINANCIAL MARKET RISKS

The Company is exposed to financial market risks, including changes in interest rates, foreign currency exchange rates and marketable equity security prices. To mitigate these risks, the Company utilizes currency forward contracts and currency options. The Company does not use derivative financial instruments for speculative or trading purposes, and no derivative financial instruments were outstanding at October 31, 1999.

The primary objective of the Company's investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is accomplished by investing in widely diversified short-term investments, consisting primarily of investment grade securities, substantially all of which either mature within the next twelve months or have characteristics of short-term investments. A hypothetical 50 basis point increase in interest rates would result in an approximate $5 million decrease (less than 0.6%) in the fair value of the Company's available-for-sale securities.

The Company hedges currency risks of investments denominated in foreign currencies with currency forward contracts. Gains and losses on these foreign currency investments would generally be offset by corresponding losses and gains on the related hedging instruments, resulting in negligible net exposure to the Company. A substantial majority of the Company's revenue, expense and capital purchasing activities are transacted in U.S. dollars. However, the Company does enter into transactions in other currencies, primarily Japanese yen and certain other Asian and European currencies. To protect against reductions in value and the volatility of future cash flows caused by changes in foreign exchange rates, the Company has established balance sheet hedging programs. Currency forward contracts and currency options are utilized in these hedging programs. The Company's hedging programs reduce, but do not always entirely eliminate, the impact of foreign currency exchange rate movements. If the Company did not hedge against foreign currency exchange rate movement, an adverse change of 10% in exchange rates would result in a decline in income before taxes of approximately $10 million.

The Company is exposed to equity price risks on equity securities included in its portfolio of investments entered into for the promotion of business and strategic objectives. These investments are generally in small capitalization stocks in the high-technology industry sector. The Company typically does not attempt to reduce or eliminate its market exposure on these securities. A 10% adverse change in equity prices would result in an approximate $7 million decrease in the fair value of the Company's available-for-sale securities.

All of the potential changes noted above are based on sensitivity analyses performed on the Company's financial position at October 31, 1999. Actual results may differ materially.

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