Behind EMC's New Software Splash

Grab your popcorn, sit back, and get ready to enjoy the action of this summer's blockbuster. In a move today that should realign the storage software industry, EMC Corp. (NYSE: EMC) announced plans to acquire Legato Systems Inc. (Nasdaq: LGTO), driving straight for Veritas Software Corp.'s (Nasdaq: VRTS) jugular (see EMC Gobbles Legato).

The merger, which has been rumored off and on for two years now, holds the potential to seriously reshape not only the companies involved, but also the dynamics of the storage software market itself.

"This is a watershed event," says John Webster, an analyst with the Data Mobility Group. "It's in the software realm, which is obviously EMC's stated future direction... and information lifecycle management looks like it will dominate a lot of their software marketing... That certainly encroaches on Veritas's space."

Steve Berg, a financial analyst with Punk Ziegel & Co., agrees that it will make EMC and Veritas more direct competitors than they've been in the past. "Veritas had a fairly easy job of competing against Legato as a standalone [entity], but as part of EMC, this is a much more serious competitive threat," he says.

And that seems to have been the point of the deal. As EMC has watched the hardware side of its business slow to a crawl over recent quarters, it has openly coveted the prospect of snatching more of the juicy storage software market away from pure software players like Veritas and Computer Associates International Inc. (CA) (NYSE: CA). Once completed, the Legato acquisition should catapult the storage giant closer to its goal of software sales accounting for at least 30 percent of its revenue (up from 22 percent in the most recent quarter).What's more, EMC has already said its software appetite is not yet satisfied. On a conference call this morning, CEO Joe Tucci said he is already on the lookout for the next big software deal. While EMC refused to even hint at what kind of company it might be interested in buying, several industry analysts say that, as with Veritas, it may have set its sites beyond the storage software market (see Veritas Moves up the Stack).

Pursuing a software strategy is perhaps the company's only chance to prosper in the long term, industry observers say. "As storage becomes more of a commodity, what are these guys going to do?" asks Greenwich Technology Partners consultant Ron Lovell. "They're sort of a one-trick pony."

EMC has, of course, been working toward its storage software goal for some time. The Legato deal will be its tenth software buy in less than three years. But so far, sales of open software -- that is, software that doesn't reside on EMC's own hardware arrays -- have hovered around 7 percent of the company's overall revenues (see EMC Chews & Swallows BMC Unit and EMC Sucks Up Astrum).

With its $1.3 billion price tag, representing up a little less than 5 percent of the value of the combined company, this latest acquisition carries the promise of a more serious software commitment. The deal is expected to boost EMC's presence in the backup and recovery space, and especially in the growing area of information lifecycle management. "I think all their competitors are definitely watching this very closely," says Forrester Research Inc. analyst Anders Lofgren. "I'm sure Veritas is definitely taking notice of this."

Veritas refused to comment on the EMC/Legato deal [ed. note: too busy sweating bullets?], but several of EMC's other competitors were more than willing to come out to prove they're not afraid.CA, for one, insists that there is nothing threatening about the move. "The question is: Will the market wait for EMC to conclude their digestion process?" asks Bob Davis, VP of BrightStor Solutions at CA. "The market is moving too fast for customers to wait for this or any vendor to assimilate a complicated set of acquisitions."

Many analysts, too, say EMC will likely face substantial challenges as it attempts to swallow Legato and sustain the Legato image of an independent, open software vendor. "The challenge for EMC is going to be in making this acquisition actually work for them, and I personally think they're going to have to work very hard," Webster says. "They're perceived as a hardware company with a hardware axe to grind. If EMC wants to keep that momentum going, it really has to shed itself of that hardware image."

EMC's hardware legacy could also prove a sticky point with Legato's existing OEM partners. Sun Microsystems Inc. (Nasdaq: SUNW), IBM Corp. (NYSE: IBM), and Hewlett-Packard Co. (NYSE: HPQ), for instance, are surely less likely to cooperate with Legato if it's part of archrival EMC.

Losing these partnerships will, however, probably be more than offset by EMC's market leadership and Legato's installed base, Robert W. Baird & Co. Inc. analyst Daniel J. Renouard wrote in a note today, pointing out that EMC's sales channels could drive market growth for Legato products.

But then, of course, there's the integration of Legato's products and sales force. "This clearly does offer some strengths in terms of the complementary product lines -- there are only a few products that overlap -- and a complementary sales force," says IDC analyst Fred Broussard. "But how much integration has been done at the mid-management level... and how will the overlap between [Legato's] NetWorker product and the EDM [EMC Data Manager] product be handled? That needs to be managed."As EMC's slumping stock price today indicates, a lot of investors are also skeptical about the company's potential to grow into an 800-pound gorilla in this space, analysts say. EMC announced today that it expects to report better than expected second-quarter earnings -- but it saw its shares drop by 4.3 percent to $11.24 a share (see EMC Upbeat on Q2).

Legato, meanwhile, fared far better. That company saw its stock price soar nearly 9 percent today on the news, jumping to $9.91 at the close of the market.

Most observers seemed to agree that the deal is a good one for Legato, which has seen its storage software market share shrink as it has cowered in Veritas's growing shadow. The acquisition will not only give the company's shareholders about 50 times Legato's projected 2004 earnings, but will also ensure much broader sales channels for its products.

One of Legato's largest reseller partners, Cambridge Computer Services, says it's happy with the news. "This is a great opportunity for Legato to get much broader adoption of their products," says Jacob Farmer, CTO and founder of Cambridge Computer Services, a systems integrator that specializes in data storage and backup. "We've seen that growth in the adoption of their products directly translates into growth in our business."

"Longer term, I view EMC as wanting to expand beyond just storage management," says Lofgren. "They probably want to extend into other areas to be more of a data-center management company."Eugénie Larson, Reporter, Byte and Switch