The trials and tribulations of Legato

The market for corporate storage systems may be red hot, but this is scant consolation for storage management software vendor Legato Systems, beset as it is by an apparent mountain of troubles.

The latest blow to hit the company was the launch last week of a formal investigation by the US Securities and Exchange Commission (SEC) into a number of alleged accounting irregularities.

This follows a tempestuous year of executive walkouts, a failed merger, rogue sales executives, shareholder litigation and an unexpected profit warning. If it's bad and can happen to an organisation, it seems to have happened to Legato.

Last week's decision by government regulators to exhume the ledgers for fiscal 1999 follows Legato's restatement in June of its financial results for that period.

Sales deals on the side
This, in turn, followed the unfortunate discovery by the firm that members of its sales team had struck unauthorised side deals with resellers, granting them extremely preferential terms. These included obliging the resellers to pay Legato only after receiving payment from their customers. Such revenue is not fixed or determinable, and is therefore not admissible by US law on a profit and loss statement.

But the company blamed the knock-on effect of the restatement for making a loss of $9.99m in its first fiscal quarter of 2000, after analysts had predicted a profit.

About 25 per cent of Legato's sales force have since left, including vice president of sales, David Malmstedt. Chief financial officer Stephen Wise has also fallen on his sword, resigning from the company in July.

In case all this sounds like an over-reaction to an afternoon's work by a couple of high spirited sales mavericks, it should be made clear that the corrected results showed profit of $2.7m on revenue of $228.6m.

This amounted to a shortfall of about $23m on the originally reported sales figures, about $7m of which resulted from the unauthorised deals. The rest was attributed to another earlier restatement of results that followed an even more unsavoury and sinister train of events.

Strange, but true...
In April, Legato's shareholders accused the supplier's executives of concealing a slowdown in business in order to maintain its stock price. This followed the sale in January of $11.5m in stock by chief executive Louis Cole and other officials, shortly before issuing a profits warning that dented the firm's valuation on Nasdaq.

Four days after this warning, a prospective buyout of Ontrack Data International, another storage software vendor, fell through. Ontrack claims it canned the deal following concerns about Legato's financial strength. The subsequent fall in Legato's value by almost 90 per cent would appear to vindicate this point of view.

Up until its collapse, the prospective Ontrack link-up had received the full publicity treatment, being pitched as a great way forward for Legato's customers. Cole had been pushing it as "giving customers a more complete and more comprehensive set of data and application availability solutions".

But the backdrop to the failed deal is a storage market in turmoil, as a number of powerful vendors fight for a share of a profitable yet increasingly competitive market. As a result, providing the "complete and comprehensive set of solutions" that Cole was talking about is becoming more and more de rigueur.

EMC takes the top spot
Of all the tensions in the market, however, none is more potent than the current battle to put the brakes on EMC, the clear market leader.

Thanks in part to rising demand for storage area networks (SANs) among the world's major enterprises, EMC has had a tremendous run of success in the past couple of years. Not only is its hardware in high demand, but it leads the even more crucial storage management software market as well. According to market researcher Dataquest, EMC took an 18.2 per cent share of this space last year, with second in command IBM/Tivoli taking 17.3 per cent.

A number of key acquisitions have consolidated EMC's position even further. Only last week, it added to its storage software line-up by purchasing Avalon Consulting Group for about $50m. Avalon makes media management software for the television industry.

This combination of acquisitions and strong sales is delivering spectacular financial results. EMC has just unveiled second quarter figures that saw its net income rise by 50 per cent over the same period last year to $2bn. Profits from its storage software sales alone grew 96 per cent to $351m.

The response from competitors has been feverish. Hewlett Packard (HP), until last year a partner with EMC in the SAN space, has been playing a desperate game of catch-up since the relationship ended.

As a result, it has just launched a new high-end data storage system called the XP512 that can hold up to 24 terabytes of data and will cost more than $1m per unit. What makes the XP512 different from most HP storage offerings of the past - aside from the prodigious research and development budget that created it - is the fact that it is designed to interoperate with every major server on the market, including systems from arch rival Sun Microsystems.

The world of storage is, according to convention, proprietary, and HP's departure from this stance is a clear indication of its desperation to score points off EMC. EMC's storage products owe much of their success to their ability to interoperate with different servers - not a sacrifice for the company since it hardly ever plays in the server space itself.

Desperate battle draws old enemies together
But IBM has also designed a new system to compete with EMC's Symmetrix. And in an almost unprecedented move, it has agreed to work with arch rival Compaq to take on the market leader. Sun too has got in on the act by appointing a crack new sales team specifically to win accounts from EMC.

Tom Hanrahan, an analyst with Bloor Research, said: "EMC is well ahead of the pack and will almost certainly continue to grow. Everybody is gunning for it."

A casualty of this fierce competition and deal-making has been the stalemate that has beset standards-setting efforts around SAN technology. The situation has become so problematic that the whole SAN apple cart is in danger of overturning unless some order can be restored to the troubled market.

With Legato's own battles being played out against the backdrop of this internecine warfare, it is unclear whether the vendor will be able to continue to go it alone. Unless it can spring itself from the jaws of the SEC in double quick time and with some sort of dignity intact, a takeover would appear almost inevitable.