Legato Up for Sale?

Shares of Legato Systems Inc. (Nasdaq: LGTO) jumped almost 8 percent to $5.99 per share in midday trading Friday, following rumors that the storage software company is shopping for a buyer.

The two-year-old rumor, reported again by Reuters today, has had the industry guessing at the most likely suitor for a while -- and the odds-on favorite, observers say, is EMC Corp. (NYSE: EMC).

The storage giant has made no secret in the past 18 months of its intention to get into the software market. In an interview last year with Byte and Switch, Chris Gahagan, EMC's SVP of storage infrastructure software, said EMC covets the backup and recovery market, a sector dominated by two companies: Veritas Software Corp. (Nasdaq: VRTS) and Legato (see the interview with Chris Gahagan, SVP Storage Infrastructure Software, EMC).

"We believe that there's a huge opportunity for us in that space, given that we believe we can use new technology to shift how customers do backup," Gahagan said at the time. "Clearly, in the infrastructure space... they [Veritas] are one of the leading providers... But I think if you talk to customers, they are wanting some choice."

While Legato has put up a decent fight against Veritas in the backup market, analysts say the company has struggled to keep up and is a weak second. With EMC behind it, however, this picture could change swiftly.If EMC pulls this one off, it would give Veritas plenty of cause for concern, observers say. "With a large direct sales force behind it, Legato becomes a much more credible threat to Veritas," argues John S. Webster, senior analyst and founder of Data Mobility Group.

Wall Street analysts speculate that EMC has the cash to make such a deal, which could fetch between $800 million and $1 billion. Legato has a market capitalization of only $695 million, but looking at other recent software acquisitions, a bid for Legato is likely to carry a 25 percent to 50 percent premium. Veritas just paid $537 million, including a 37 percent premium, for Precise Software; and IBM Corp. (NYSE: IBM) recently forked out $2.1 billion for Rational Software, paying a premium of about 28 percent.

"Legato has great gross margins but spends a ton to sell its product, giving them razor-thin net margins," says Mark Kelleher, analyst with First Albany Corp. "That could easily be fixed using EMC's sales force... I don't think it would be hard to put an accretive purchase together."

With regard to intellectual property, Webster says there's no question that Legato's acquisition of OTG Software, with its Xtender application-oriented management products, would add significant value to EMC (see Legato Ropes In OTG).

In an interview with Byte and Switch earlier this week, EMC president and CEO Joe Tucci said an important consideration for EMC in acquiring a software company is its distribution channel (see the interview with Joseph Tucci, President and CEO, EMC).Legato's channel, with three quarters of its sales through value-added resellers (VARs) and the remaining third from OEM deals, looks good for EMC, according to Steve Berg, analyst with Punk Ziegel & Co.

It's entirely possible EMC won't pull the trigger, as the company allegedly missed the on boat on Precise. But all in all, EMC appears to be the most likely suitor at this point. Other companies thought to be interested include BMC Software Inc. (NYSE: BMC), Hewlett-Packard Co. (NYSE: HPQ), IBM, and Storage Technology Corp. (StorageTek) (NYSE: STK).

Legato's financial advisor, Morgan Stanley