EMC's Soft Spot?

EMC Corp. (NYSE: EMC) finally put Legato Systems Inc. (Nasdaq: LGTO) out of its misery with its plans to acquire the stumbling storage software player in a deal worth roughly $1.3 billion (see EMC Gobbles Legato and Behind EMC's New Software Splash).

And many on Wall Street have concluded that the deal is a clear win/win. EMC gets access to a massive installed base (31,000 customers) and a mature family of backup and email archiving software, fertile areas of growth. For its part, Legato, which has lost share to IBM Tivoli and Veritas Software Corp. (Nasdaq: VRTS), gets the backing of one of the most powerful companies in the industry.

But there are risks in any acquisition of this size and some observers have already suggested that EMC/Legato may not be quite as fruitful as the companies expect.

To be sure, these are concerns EMC CEO Joe Tucci is keenly aware of. Part of his stated rationale for waiting as long as he did (the deal has supposedly been kicking around for several months) was to make sure EMC was in a solid position first, in terms of both its financial and managerial stability. Incidentally, whispers on Wall Street are that Erez Ofer, previously executive VP of EMC's Open Software group, was moved aside in favor of CTO Mark Lewis because Ofer opposed the Legato deal (see EMC Sics Lewis on Software).

At heart, however, EMC is still a hardware company. Its quarterly earnings hinge on sales of Symmetrix. Meanwhile, one of Legato's attractive qualities is that it was hardware-agnostic. Will EMC really keep it that way, as it has pledged? Does it have the self control?Some are skeptical the pairing will turn out to be the dynamic duo Tucci has promised. "In the end, EMC had no choice but to do the deal – their hardware sales are falling too fast, and there aren't that many affordable storage software companies with any kind of scale," says one independent storage industry consultant, who wished to remain anonymous. "But they bought a second-tier player held together by baling wire, where all the top talent left in the last several years. It will be interesting to see how much is left after a year or so."

Another concern, voiced by several financial analysts, is that the terms of the acquisition are a bit rich. The purchase price already assumes a lot of upside in the coming quarters, according to analysts – in other words, EMC has placed a bet it can increase sales of Legato's software through its own sales force.

The valuation of 50 times 2004 expected earnings "seems high for Legato, in our view, considering its high expense structure and fragile balance sheet," writes Thomas Weisel Partners analyst Kevin Hunt. He also notes that "the timing of the acquisition seems a bit out of character for EMC, which traditionally has been one of the most frugal acquirers in the industry." (See Tucci on Acquisitions: 'I'm Cheap'.)

And to justify the purchase price, EMC will have to offset the possible drop in revenue from Legato's OEM partners, which include Hewlett-Packard Co. (NYSE: HPQ), IBM Corp. (NYSE: IBM), and Sun Microsystems Inc. (Nasdaq: SUNW). Each of those three companies deeply detests EMC. It's hard to imagine them happily writing sizeable checks to Hopkinton on a regular basis. Currently, Legato's OEM license revenue is about 10 percent of total sales.

Throw into the mix the fact that EMC happily acknowledges that it's eyeing another major software acquisition -- an event that would potentially cause even more turmoil in the Hopkinton machine. Though Tucci didn't tip his hand on which software areas it's looking into ("I've never said where we're going to hunt"), analysts believe EMC would consider storage-centric application, database, or server management software companies. BMC Software Inc. (NYSE: BMC) is clearly a player EMC may still have on its short list. Note that EMC last week picked up BMC's abandoned storage unit (see EMC Chews & Swallows BMC Unit and EMC Eyes BMC).But let's look at the other EMC acquisition of similar size: Data General, which it bought for about $1.1 billion in stock in 1999. How has the DG deal turned out? Well, after a rocky start (arguably because EMC didn't give it enough attention), Data General's Clariion family of midrange storage has become one of the stars of the show at EMC, showing solid quarterly growth and forming the backbone of EMC's successful reseller deal with Dell Computer Corp. (Nasdaq: DELL). Note, however, that it's now four years later – and much of the technology for the Clariion CX family was developed post-acquisition by EMC.

Can EMC find a way to make Legato pay back sooner? It may find itself forced to.

— Todd Spangler, US Editor, Byte and Switch