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An accounting goof of that magnitude has about the same effect as a large meteor hitting the earth: People notice. Legato's shares have fallen 81%, from a November high of $82.50 to $16 as of the market's June 14 close. Investors have fled the stock because analysts have downgraded it, and the Nasdaq has even threatened to delist it because Legato filed its annual report late to fully investigate the accounting snafu. And yet, to write off Legato may be folly, especially with its shares so low -- at a price-sales ratio of 4.6. Although most analysts have a hold recommendation on the stock, some think that it still has life. The heart of such an argument is that the company's mistakes were understandable and that it has been punished far more than necessary. STORAGE OUTSOURCER. "This is a good company, and it's unfortunate that this has happened to it," says analyst Joseph Payne of Hoak, Breedlove Wesneski & Co, who has an accumulate rating on the stock. "The greatest crime it committed was being on the cutting edge of technology." To understand Payne's argument, you have to understand what Legato sells. Its primary product is software that helps enterprises manage their data-storage networks. The booming storage software market -- of which Legato's product is just one cog -- is doubling every six months and should reach $14.7 billion by 2004, predicts Dataquest. Traditionally, such software has been sold to large corporations via licenses. Many of Legato's sales are like that. But it has also been a pioneer in selling to a new type of company, called a storage service provider (SSP), which is essentially a storage outsourcer. Other companies will pay an SSP to manage their data storage. SIDE DEALS. Last year, one of the leading SSPs, a private company called Storage Networks, paid Legato $10 million to use its software. But the software wasn't to have been used until the beginning of this year, and then was to have been rented out to customers of the SSP. When independent auditors looked at the way Legato recognized the Storage Networks revenue on its books, they balked: The company had recorded the entire sale in the fourth quarter, whereas the auditors suggested spreading it out over the four quarters of 2000. Upon investigation of the dispute, Legato's management uncovered other problems. Some salespeople had been making side agreements with vendors without telling management about them. These agreements obligated Legato to provide certain services in the future in exchange for an immediate purchase of its software -- and thus further cut into Legato's revenues and profits. While the overall effect of those side agreements was small, they were nonetheless odious. MISUNDERSTOOD POLICY. Payne argues that investors shouldn't overreact. For one thing, the issue of how to recognize revenue is controversial, and not every software company has done the right thing. Even mighty Microsoft has had run-ins with analysts over how it recognizes revenue (although it has never been the subject of a Securities & Exchange Commission investigation of the matter). Legato made its mistake in December, then quickly corrected the error in January -- and restated its results in the most conservative way possible, analysts say. Payne blames the side deals on a poor job of merging corporate cultures when Legato acquired FullTime Software earlier in 1999. "There was a small group of salespeople who misunderstood the policy," says Payne. "They've all left the company." Besides, argues Payne, side agreements are nothing new in the software business. "They're as old as the invention of coin. If you want to sell your product in a competitive environment, you have to bundle it with something else. The problem with Legato was that it didn't communicate effectively to its salespeople how they should go about negotiating the side agreements." The company didn't respond to requests for comment. Since the initial restatement of revenues, a quarter of the company's 400 salespeople have left. The learning curve for their replacements will be long and steep -- and it will take some time for the company to get back on the selling track. "WAIT AND SEE." Moreover, many customers may hesitate to buy Legato products, knowing that the company is under investigation for accounting irregularities. "Whenever buyers see a company going through that sort of thing, red flags go up, and they say 'I'm going to wait to see where they are going,'" says Illuminata technology analyst John Webster. He also notes that the event's timing couldn't have been worse, since Legato's main competitor, Veritas Software (VRTS), had started stealing market share even before the restatement of earnings. The matter is so serious that most Wall Street analysts won't recommend buying Legato. Says CIBC World Markets analyst Melissa Eisenstat, who has a hold rating on the shares: "When I see a problem with accounting, it tends to be a red flag. This one is a run-for-the-hills red flag." Still, Illuminata's Webster points out that Legato is trying to rebound, with a new product that he considers a breakthrough. The program is called Celestra, and it's the first serverless storage software package. It allows companies to store data that's currently sitting in servers on nonserver storage devices, allowing the customer to significantly reduce hardware costs. Veritas is said to be developing a similar product, but it has yet to be launched. Celestra is "a breakthrough product if I ever saw one," says Webster. "It's a shame that they've been so distracted, because it means everyone can't concentrate on Celestra." So what should an investor do? Payne argues that it's time to get back into Legato Systems. Although the company has declared a loss for the first quarter, it expects to be profitable again by yearend. "I think the problem is behind them," Payne argues. "Now they just have to convince the rest of the world." Jaffe writes about the markets for Business Week Online Is Legato worth buying, even under a cloud? Let us know at our Ask Sam Jaffe Forum |
