Opportunity Emerges From Legato's Fall

Analysts see Legato playing a game of catch-up with rival software company Veritas.
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SAN FRANCISCO -- If price charts can tell the future, then a comparison of Legato Systems (LGTO) and Veritas Software (VRTS) - Get Report suggests Legato could be due for a ramp-up.

Historically, the two companies have tracked each other because they are in the same booming market of providing software to store data. On the odd occasion when they've diverged, they've never strayed too far away from each other and have always fallen back in lockstep pretty quickly. In 1999, the stocks have diverged again but in bigger moves. Both were trading in the low 60s in early January, but Veritas has risen to 82 1/4 Thursday, while Legato has dropped to 47.

"The valuation gap over time has waxed and waned, but this is the highest it's been in the recent past," says David Breiner, an analyst at

Volpe Brown Whelan

, which has underwritten for Veritas but not for Legato. He rates Palo Alto, Calif.-based Legato a strong buy and its neighbor Veritas in Mountain View, Calif., a buy.

"There could be a significant trading opportunity here," says one individual investor who has been watching the movements closely and mulling a position in Legato. He says the huge need for storage continues, with companies now storing reams of data ranging from customer preferences to Web sites, so both companies should benefit similarly.

And most analysts agree. Fred Ziegel, an analyst at

Lowenbaum & Co.

who rates Legato a strong buy and has no rating on Veritas, believes Legato will start rising at a faster pace to catch up with Veritas. His firm has not underwritten for either company.

"For companies that are not that dissimilar in revenues in a very large market that can allow both of them to grow at very high rates, there should be a much narrower market-cap gap than we have now," Ziegel says.

Legato's stock price has lagged Veritas' because of concerns that have circulated in the past few months, analysts say. First, worries emerged that Legato's planned purchase of

FullTime Software


in a deal worth $69.4 million would end up being dilutive instead of accretive because of a decline in FullTime's revenue late last year. In the December quarter, FullTime reported a sequential decline in revenue to $5.2 million from $7.0 million in September, says a FullTime spokeswoman.

"Some people said, 'Uh-oh, maybe with that, the deal will be a dilutive acquisition rather than accretive," Ziegel says. Unlike an accretive deal, a dilutive one would depress the EPS figure. But a Legato spokesman says the company still believes the deal will be accretive in the June quarter.

Then, in February, rumors surfaced that Legato was losing much of its sales staff. Although these rumors were denied by the company and have proven to be unfounded, they weighed down the stock price.

In the meantime, Veritas has picked up its pace, rising more than 30% since the start of the year. "Right now, there's a growing sentiment forming that this is a winner-take-all market, and increasingly, people are thinking that the winner will be Veritas," says Breiner at Volpe Brown. Breiner says he doesn't believe the market for storage software is a zero-sum game. But he says those views are being fueled by a few things, including Veritas' slightly larger revenue base and slightly faster growth rate last year, especially in license revenue, which has given rise to the perception that Veritas is gaining market share. In 1998, Veritas total revenue grew 74% from a year earlier to $211 million, with license revenue rising 75%, while Legato's total revenue rose 71% to $143 million and license revenue grew 66%, he says.

Given those figures, analysts agree that Veritas should have a higher market cap, but they question whether Veritas shares are worth about 75% more.

Factoring out planned acquisitions, Veritas and Legato "are similar companies with similar growth rates and operating margins, so they should be trading closer together," Ziegel says. On a price-to-earnings basis, Ziegel notes that Veritas is trading roughly at 77 times this year's earnings and Legato at 45 times earnings. "That means Legato is trading at a 42% discount," he says, noting that the companies' earnings-per-share projections for 1999 are within pennies of each other.

First Call

pegs Veritas' 1999 earnings per share at $1.10 and Legato at $1.08.

Breiner agrees, noting that his forecasts for both companies also look very similar. He predicts Veritas will grow license revenue this year 56% from 1998 and Legato 52%. He also has 12-month price targets that are roughly about 15% apart. His 12-month price target is 85 for Legato and 98 for Veritas.

So if history does repeat itself, then that gap between Legato and Veritas should narrow, making this aberration a time to buy Legato and pick up a big percentage gainer for the portfolio, analysts say. "We are pounding the tables telling people to buy Legato," says Mark Kelleher, analyst at

Tucker Anthony

, which has no underwriting relationship with either company.