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EMC 'Paying Too Much' for Smarts

Light Reading
News Analysis
Light Reading
12/24/2004

Acquisitive storage system vendor EMC Corp. (NYSE: EMC) is paying too much for OSS vendor System Management Arts Inc. (Smarts). (See EMC Gets Smarts).

At $260 million, EMC is paying 4.5 times annual revenues for the fault management company, as Smarts says it will hit about $60 million in sales in 2004. That price is way higher than could have been expected, says Patrick Kelly, a partner at consultancy OSS Observer.

"Assuming Smarts's current revenue growth rate is sustainable for the next three years, it should have been valued at between $140 million and $170 million," reckons Kelly.

"Obviously EMC thinks it can help Smarts lift the pace, but I have my doubts," adds the analyst.

The OSS Observer man points to the recent revenues experience of fault management market leader Micromuse Inc. (Nasdaq: MUSE), which managed annual sales growth of 16 percent in fiscal 2004 (see Micromuse Posts Q4 Profit).

Kelly says EMC's offer suggests the storage vendor believes Smarts can build its revenues by between 40 percent and 50 percent over the next four years. That would be a very optimistic target, says Kelly.

Naturally, EMC thinks the price is "in the right ballpark. We're paying for a company, its technology, and its future potential," says an EMC spokesman. "This is an acquisition of technology that will be strategic to EMC in the coming years," he adds.

At least Kelly agrees that the deal makes strategic sense for EMC, as he believes the Smarts' root-cause analysis software is well suited to storage networks.

But the analyst also believes the deal will see Smarts direct more resources into enterprise product developments, and away from the increasingly important carrier market. "I think the EMC acquisition will definitely distract Smarts's focus on the service provider market," says Kelly.

And that's certainly an area Smarts has been developing strongly of late. The OSS firm's president, Shaula Alexander Yemini, says a greater focus on carriers' needs is reaping rewards, and means "Smarts isn't viewed so much as just an enterprise shop. We're hoping to announce our biggest carrier customer ever very soon," she says, adding that Smarts is already one of AT&T Corp.'s (NYSE: T) suppliers for its Concept of One project and has growing traction with Verizon Communications Inc. (NYSE: VZ). (See AT&T Needs New 'Underware,' Says CEO).

But Kelly believes the EMC acquisition spells good news for Smarts's main competitors in the carrier market, namely Micromuse, Aprisma Management Technologies Inc., and Hewlett-Packard Co. (NYSE: HPQ).

Conversely, the deal gives Smarts more muscle, increases its potential customer base, and solidifies its growing relationship with Cisco Systems Inc. (Nasdaq: CSCO), already a key partner of EMC (see EMC, Cisco Do the Deed).

Yemini says a wide-ranging OEM agreement was signed with Cisco in August that covers almost all of Smarts's products, though it's still too early for that agreement to be having any noticeable impact on revenues.

Yemini says this is a critical deal for Smarts, as Cisco has, indirectly, been more of a competitor in the past, as it has long been a major reseller of Micromuse's Netcool software.

Cisco is less gung-ho about the arrangement, however, saying its ties with Micromuse are as strong as ever. Philippe Roggeband, the equipment firm's OSS solutions manager, says Cisco now offers both products to its enterprise and carrier customers, but "there is no way that one is preferred over the other."

He says both have their strengths. The Smarts software is more "out of the box," and requires less customization, but this makes it less flexible than the Micromuse software, says the Cisco man.

And what of Smarts's senior management? Can EMC hang on to the team that has built up the OSS firm? Yemini says she's staying, and will be "reporting to the CTO, focusing on EMC's management software strategy."

Kelly believes EMC will be pulling out the stops to hang on to the top people. "I'm sure the golden handcuffs have been applied," he says, adding that stock option incentives vesting over a three-to-five year period would be a standard offer.

EMC says it won't comment on whether any such deals have been offered.

There's one group of people, though, that will be very happy with their resulting deals should the acquisition close as expected in the first quarter of 2005. Bessemer Venture Partners and Soros Private Equity Partners are Smarts's sole external investors, having pumped in just $25 million, less than 10 percent of the $260 million in cash offered by EMC.

— Ray Le Maistre, International News Editor, Light Reading

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spelurker
spelurker
12/5/2012 | 12:58:06 AM
re: EMC 'Paying Too Much' for Smarts
> What do the employess get for their options when
> it's an all cash deal? Is the money still divided
> proportional to the number of shares/options?

Should be. I think there is a certain amount of leeway available to the original board on this stuff, and there is often a clause in the options grant concerning what happens in the case of buyouts. If you have stock options, look for the agreement you signed along with it, which will have the vesting term, etc.

But a cash deal is applying a fixed market cap to the bought-out company. Therefore each share of stock has a fixed value. If no other agreements apply, this would normally be converted to an equivalent number of EMC shares based on the value of EMC at the time of closing. (rounding errors converted to cash). The EMC BOD would need to agree to a new EMC stock options offering to deal with this as part of the buyout.

I know of now reason that the BOD couldn't convert options into cash, but that would not be in EMC's best interest.
cyber_techy
cyber_techy
12/5/2012 | 12:58:06 AM
re: EMC 'Paying Too Much' for Smarts
What do the employess get for their options when it's an all cash deal? Is the money still divided proportional to the number of shares/options?

Thanks,

ct
douggreen
douggreen
12/5/2012 | 12:57:38 AM
re: EMC 'Paying Too Much' for Smarts
THese types of deals can be structured in many ways. Typically, all vested shares are paid out in cash. Unvested shares can be handled by putting cash into an escrow account, to be paid out as additional shares vest. This would be the case in a true "all cash" deal, although the term is sometimes used loosely.

More typically, vested shares convert to cash and unvested shares convert to options of the aquiring company stock at a ratio determined by valuations at the time of the deal.

In some cases, different classes of unvested stock may be handled differently. Unvested common shares may be converted to options while unvested preferred shares are converted to cash placed in escrow. Preferred shares may be subject to accellerated vesting upon aquisition as well.

Regarding the $260M being divided by the number of shares, this is partly true. The preferred shareholders usually get a minimum return first, with the common shareholders dividing what is left over. If the purchase prices reaches a certain clip level, everyone is paid out the same.



optiplayer
optiplayer
12/5/2012 | 12:57:38 AM
re: EMC 'Paying Too Much' for Smarts
I believe that the $260M would be divided by the number of shares outstanding at the time of the deal - including vested options. The option owner would then exercise and get the cash/share.

I suspect that unvested options disappear and that the acquirer (EMC in this case) would issue new options to its new employees.
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