STREET WISE by Sam Jaffe September 1, 1999

Why Corel's Sudden Liftoff Could Quickly Return to Earth
Oddly, its stock got a boost from Sun's announcement of a free software suite that ultimately could hurt Corel badly

It had to happen. The same weird things that sent Internet stocks skyward are now infecting stocks that are associated with Linux -- the upstart open-source operating system that many view as a viable competitor to Microsoft's NT operating system. So far this month we've had an initial public offering for software distributor Red Hat (RHAT) that quadrupled in its first day, frantic rumors of other imminent IPOs from Linux companies like hardware manufacturer VA Research, and a host of also-ran stocks that have gotten a boost thanks to obscure connections with Linux.

The most curious stock-price jump was in Corel (CORL), which makes graphics and spreadsheet applications. Corel, based in Ottawa, announced earlier this year that it would introduce its own version of Linux, and it shipped a stripped-down version of its WordPerfect office productivity suite that runs on Linux. In one week, the stock has risen 28%, to $5.75, as of the close on Tuesday, Aug. 31.

Although numerous factors were involved in Corel's leap, by far the dominant one was an announcement by Sun Microsystems (SUNW) that it would provide a suite of applications, based on its StarOffice productivity package, as a free download over the Internet (or $9.95 on CD). It also announced a Web-based version called StarPortal that will be available later this fall. Rather than users downloading and installing the suite on their own PCs, Sun plans to make StarPortal available on its servers and let consumers connect to them and use the application via the Net. The market responded by selling off Microsoft's (MSFT) stock 5% in the last three days, because it owns 85% of the office productivity applications market and derives almost 40% of its revenue from sales in that area.

CHEAP ISN'T FREE. Surprisingly though, the market also rewarded Corel, which is Microsoft's leading competitor in the applications arena, with an approximate 8% market share. Apparently, investors are assuming that Sun's move somehow validated Corel's business model. They could be sadly mistaken.

While WordPerfect, which accounts for about 50% of Corel's revenue, costs about one-third of what Microsoft Office would if you were to buy it at a computer store, Corel still charges for WordPerfect. But when it comes to operating margins, Corel barely squeaks by. The company reported a loss for fiscal 1998. And the consensus of analysts who cover the stock is that it'll show earnings growth of 2%, hitting about $250 million or $0.09 per share, for fiscal 1999, which ended Aug. 31. That would give it an operating margin of around 2.3%. Microsoft makes a 52% operating profit margin on its software.

"Corel has struggled with margins for a long time," says Nutmeg Securities analyst Jean W. Orr, who rates the stock a buy for speculative investors. But Orr also figures that "in the past year, WordPerfect has been producing more revenue and profit than ever before."

Suddenly, that growth is threatened. A major technology company is putting its full weight behind a suite of free applications. While Microsoft executives should be duly concerned about the move, Corel has even more to fear. Right now, it's the first alternative to Microsoft's applications. With Sun's financial backing behind StarOffice, that won't last for long. If StarOffice is successful, few customers would choose to pay for WordPerfect when they can use Sun's suite for free. This means WordPerfect's revenue production drops steeply or Corel changes its business model also and begins to offer WordPerfect for free as an Internet application and charges for service. While such a model might be viable, it's debatable whether Corel has the ability to pull off such a drastic change in strategy.

NOT DO OR DIE. Of course, Corel isn't necessarily doomed. Sun's StarPortal plan is based on people having broadband access to the Net, because that's what you'll need to run the program. Right now, less than 5% of Internet connections are broadband. In addition, much of Corel's customer base is fanatically loyal to WordPerfect and would have to be given the hard sell to give it up. "This is not a do-or-die proposition for Corel," says Merrill Lynch analyst Alex Baluta, who is neutral on the stock. "The implications of the StarOffice/Sun announcement are yet to be determined. In the near term, Corel has some good products that are showing decent revenue growth, and they are turning a profit."

That brings us back to Corel's big plans for Linux. It expects to start distributing Linux for desktops by yearend and also to come out with a fully functioning version of WordPerfect for Linux early next year. Again though, analysts are skeptical. "I haven't made any revenue forecasts for their Linux product because we haven't even seen it yet," says Orr. "It's difficult to determine what the potential market is."

Investors will need to figure if Linux could a bigger plus for Corel than Sun's StarOffice/StarPortal could be a negative. If the latter scenario prevails, the rocket that was lit under Corel's stock recently could just as quickly burn out.

Jaffe writes about the markets for Business Week Online _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _


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