Thursday March 23, 11:11 am Eastern Time
worldlyinvestor.com Sector of the Day
Don't Leggo Your Legato
By David H.M. Baker, Columnist
Storage-software company Legato had the rug pulled out from under it. But it's still got legs.
The upward momentum in many of the leading technology stocks has taken this market to levels many did not believe possible. Prescient investors can use negative momentum to own shares in some great growth companies, especially when the market overreacts to news that at the moment is taken as negative, yet poses no threat to a company's long-term business opportunity.
The "shoot first and ask questions later" investment psychology has recently offered up another great opportunity -- Legato Systems (Nasdaq:LGTO - news).
Legato is a global leader in the enterprise storage-management software market and sports a market cap of $3.1 billion with 1999 revenues of $251 million. It is ideally positioned to benefit from the vast surge in data across the corporate enterprise and over the Internet.
Who's Minding the Storage?
Corporations are moving data off of local area networks to storage area networks or to virtual storage networks. The volume and management of the data is proving too great for their internal networks to handle. This is all part of a general outsourcing trend by large corporations as they seek to concentrate on their core competencies and leverage their data assets.
This is a monumental requirement and Legato's product offerings are well suited to meet emerging needs in data security, information management and availability. Legato provides products that ensure business-critical corporate data assets are secure, can be seamlessly manipulated and accessed rapidly across the corporate enterprise.
Most analysts are predicting annualized growth rates north of 50% for the foreseeable future for the storage market, with estimates for the storage area network to grow to over $13 billion by 2003. The demand for storage will directly track the increasing demand for bandwidth, net traffic and the number of documents on the web. The opportunity in this sector has helped ignite the stock of companies like Exodus (Nasdaq:EXDS - news) and Digex (Nasdaq:DIGX - news).
Legato formed the Celestra Consortium -- which has brought together most of the storage equipment and software vendors -- and the company is trying to position its products as the de facto platform. The Celestra architecture is built on the ability of storage devices to copy data between each other. I believe ultimately Legato will become the standard for enterprise storage solutions.
Harsh Judgment
Legato's stock price was crushed when the company's fourth-quarter earnings missed estimates back in January. The stock is now down 60% from its high.
The market also reacted negatively to the fact that Legato made a downward revision in its third-quarter earnings to $65.9 million from $71.7 million, reducing earnings per share to 14 cents from 18 cents. During the audit of the company's 1999 results, Legato was informed by its auditors that $13 million in revenues from two new contracts should be recognized throughout fiscal 2000 instead.
This caused the company to "miss" fourth-quarter estimates. Unfortunately, Legato's chief financial officer several weeks earlier indicated that the company would meet analysts' estimates.
In Good Faith
The bottom line here is I can find little data that supports management impropriety or any fundamental shift for the company's long-term opportunity. However, class-action lawyers have seized on the fact that a few executives sold shares earlier in the year at higher prices prior to the announcement. These lawyers will no doubt be a thorn in the side of the company for some time, although I do not see them as a threat to the company's fundamental business opportunity or ability to execute its plan.
The fact of the matter is that investors are ignoring the great performance and focusing only on the recent downside news. But even with the accounting adjustment, fourth-quarter sales were up 47% and operating income rose 41% from a year ago while year revenues were up 55% and year operating income rose 130%.
People are still stung by the announcement. Analysts feel they were mislead and investors trumpet the fact that the company's forward growth rate will "only" be 50% compared with their previously stated 65%. This sentiment is ridiculous.
Negative Sentimental Journey Will Pass
Legato may not be cheap on a fundamental earnings basis when compared with legacy technology or established industrial companies, but it is a steal based on the tremendous growth opportunity in the enterprise storage market. Further, Legato is much cheaper than its only real comparable, Veritas (Nasdaq:VRTS - news), which trades at 80 times sales. Legato trades at only 13 times sales, and I believe Legato has superior technology and product offerings.
The bottom line here is that rarely do investors get an opportunity to own a great growth company at such reasonable levels. I initially established a position for my clients and in the hedge fund around the $63 to $65 level and aggressively bought shares between $26 and $30.
These shares are a must-own at current prices, and I believe after the current negative sentiment passes, Legato will approach its former price level with the real possibility of piercing its former $82 high over the next 12 to 18 months.
David H.M. Baker CFA is an analyst for worldlyinvestor.com and president of Rivendell Capital Management, a private-client money management firm, and a partner in Vision Investors LP, a Boston-based hedge fund. His column covers stocks that he feels are undervalued relative to their peers. While he has bought shares in Legato for his hedge fund clients, he does not hold a position in his personal portfolio. |
