Monday, March 29, 2010

Merger Arbitrage Update: Novell (NOVL)

To successfully follow risk arbitrage, one must have a solid understanding of the legal process. We do not have a JDs (it is in no way required, though it makes the learning curve less daunting), but both of us spend many hours a week analyzing legal documents. I also attend any court hearings or trials relevant to the deals I’m following. Long ago I stopped trusting live webcasts of proceedings, as my luck would have the feed cut out right before an important announcement. We will discuss at length the legal aspects of investing in the event-driven space over the life of this blog.

A trial I am currently following involves Novell Inc (NOVL), a target we reviewed earlier. The case involves the ownership of the copyrights to Unix, and is set to conclude a three week jury trial this week in Utah District Court. NOVL bought Unix in 1993 for $300 million, and then sold Unix to the Santa Cruz Operation of California in 1995. Since Santa Cruz could not pay cash for Unix, NOVL retained royalties from the pre-1995 versions, and also shares of Santa Cruz stock. To hedge against a substantial decline in Santa Cruz stock, NOVL also kept the copyrights to Unix. In 1996, the sale agreement was amended to include the transfer of the copyrights. Caldera International (later named The SCO Group) bought Unix from Santa Cruz a few years later. SCO filed suit against IBM Corp in 2003, accusing IBM of using Unix to make significant changes to the Linux operating systems, which made Linux a SCO competitor and forced SCO’s revenues to decline. After SCO sued IBM, NOVL claimed that it owned the copyrights to Unix, and that SCO’s suit against IBM was invalid.

The trial appears to be favoring SCO. Testimony from the Robert Frankenberg, the CEO of NOVL during the sale of Unix, reveals that it was his intention to sell the copyrights in 1995. Even the two top NOVL negotiators of the Unix sale said that the transaction included the copyrights, while one added that it “would not make any sense” to exclude them.

What does the agreement say? The amendment is obviously the relevant document, and it does not support SCO as heavily as the executives do. The wording is amazingly convoluted, but the amendment is essentially a promise to assign the copyrights to Santa Cruz, and therefore it is not evidence of a valid transfer of ownership. To throw more of a twist, the Utah Appeals Court has ruled that intentions matter in contracts, so the jury could rule in favor of SCO.

If SCO wins this case, then it will pursue its lawsuit against IBM. SCO is on the ropes, and it would be unwise for NOVL to look beyond this case. SCO was sent into bankruptcy court in 2007, and it remains under control of a trustee. SCO is in dire need of a financial settlement. NOVL could be on the hook for about $25mn, which would help SCO more than it would hurt NOVL (NOVL has $607 million in cash).

As for an update on the unsolicited offer from Elliott Associates, the board rejected the $5.75/share proposal on March 20, arguing that it undervalues the company’s franchise and growth prospects. Additionally, the board authorized a review of strategic alternatives, including, a share repurchase program, a cash dividend, joint ventures, a recapitalization, and a sale of the company. The last one is crucial, as it shows the company is a willing seller, at the right price. Some management teams are unwilling to let go of their company for any monetary figure. With management on board for a potential sale, a financial sponsor’s lurking, and assets ripe for revitalization by a strategic acquirer, NOVL is likely to be sold.

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About the Authors

Hunter is the founder of the Distressed Debt Investing Blog and the Distressed Debt Investors Club. He has worked on the buy side for the past 7 years in high yield and distressed debt investing.

Edward has been a professional investor for four years, focusing mainly on the event-driven space. His investment philosophy is value-based, and he spends the majority of his time identifying near-term catalyst based opportunities.

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hunter [at] distressed-debt-investing [dot] com