Taking Stock: Legato's Laid-Back Business ModelTaking Stock: Legato's Laid-Back Business Model

Business is about generating a profit, not just introducing neat technologies. Quite a few technology companies have yet to realize this, as if the not-for-profit rules of the Internet's heyday still apply.

Legato Systems Inc. is one of those companies that fall in the not-quite-for-profit category. Legato is a significant player in storage software. Its largest business segment is information protection, which entails protecting data by providing companies with the capabilities to back up, restore, and archive data. This segment accounted for about 80% of Legato's revenue in the third quarter this year. Legato's two other segments are availability, which ensures that applications are available at all times, and content and messaging, which assists with archiving of E-mails and other content. The latter two segments each accounted for 10% of third-quarter revenue. Legato focuses on large enterprises that have complex storage systems. It has a direct sales force handling large companies, while other customers are serviced by partners and resellers.

The storage-software industry is best characterized by a state of co-opetition. Legato cooperates with companies such as EMC, Hewlett-Packard, IBM, Network Appliance, and Sun Microsystems to optimize the performance of its software. However, EMC, Hewlett-Packard, and IBM also are competitors. Other competitors include CommVault, Computer Associates, and Veritas.

In its third quarter ending Sept. 30, Legato reported revenue of $68.1 million, up 19.5% from the same quarter a year ago. Much of this increase was due to the acquisition of OTG Software Inc. Pro-forma loss was $5.1 million, and Legato spent $9.3 million in cash during the quarter. Over the last 12 months, Legato had $247.3 million in revenue. Meanwhile, the company continued to report losses (we are on year three), and has told investors that it will likely be profitable some time next year. It makes you wonder why a company with revenue of $247 million isn't profitable. Gross margin of 79% this last quarter is very respectable. The problems arise further down the income statement, where one can see that sales and marketing expenses amounted to an exorbitant 51% of revenue, and general and administration expenses were 13% of revenue. Add to that R&D expenses that were 29% of revenue, much higher than the typical 15% one would expect from a tech company. Subtracting all these expenses from gross profit gives you a negative operating margin of 14%.

So, Legato will implement substantial layoffs and bring its cost structure more in line with the revenue base, right? No, management has indicated that the current R&D expense is necessary to fend off competition. Likewise, Legato feels it's necessary to retain almost all the employees in sales, marketing, and administration. Marketing and sales seem ripe for some streamlining. Legato is expecting to generate little cash from operations during the next quarter, which is better than the outflow of $9.4 million incurred in the third quarter this year. However, with only $45 million in cash on the balance, one can worry that another downturn in business could produce a substantial outflow of cash, which would strain liquidity.

Legato is clearly a company that needs to adjust its business model to focus on profitability rather than wait for revenue growth to solve the profitability problem.

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