In Veritas, a Good Price

The buyers of Seagate's disk-drive business drove a hard bargain. Is it too hard on Seagate holders?
S.L. MintzJune 1, 2000

Managers at Seagate Technology Inc., teamed with a group of well-heeled investors, have added a new page to the dog-eared annals of leveraged buyouts. They are paying a very friendly price for the core business–in this case, Seagate’s disk-drive manufacturing–while still seeking applause from the sellers.

“Personally, I think the price of the disk-drive business is cheap,” says securities analyst Wendy Abramowitz, of Argus Research Corp., in New York. “But when you add in everything, it’s a good deal.”

“Everything,” in this case, means the tax-free distribution of Seagate’s lucrative stake in Veritas Software Corp., through a complicated maneuver that experts call a “reverse triangular merger.” First, Seagate will sell its disk-drive business to investors in an LBO led by technology buyout group Silver Lake Partners and including Seagate managers. Then, Veritas will acquire Seagate– along with its 128 million shares of Veritas stock–and distribute shares of Veritas to Seagate shareholders in a tax-free exchange.

The LBO angle supplies a fresh twist on a tax strategy employed in two earlier acquisitions: AT&T Corp.’s purchase of Associated Group last year, and the purchase of Petrie Stores by Toys ‘R’ Us in 1996.

Events leading to the Veritas- Seagate transaction began in October 1998, when Seagate announced plans to swap its Network Storage Management Group for 40 percent of Veritas, a stake then worth $1.6 billion. On the strength of Veritas’s rapid growth, and the raging popularity of software stocks at the time, Veritas’s share price soon took off, tripling by the time the deal closed a few months later. And it kept rising. The run-up bestowed some benefits on Seagate, of course, but not without cost. By last March, Seagate, with less than $16 billion of market capital, owned shares of Veritas worth nearly $22 billion.

The embarrassment of riches was, nonetheless, an embarrassment. And the market-cap imbalance that resulted from the meteoric success of Veritas became an irritant to Seagate shareholders, Seagate managers, and even Veritas managers. “I can’t tell you how many conferences there were where investors or analysts asked, ‘What’s going on with that stock Seagate owns?’” says Veritas CFO Kenneth Lonchar. Such a large overhang in the hands of a disk-drive maker–amounting to a third of Veritas’s entire market cap–hampered a company trying to remain focused on its core software business, says Lonchar.

An Expensive Haircut

While something had to be done, it wasn’t clear just what that might be. Distribution of the pent-up value in Veritas to Seagate shareholders, either through a special dividend or some type of share buyback, would have been taxable. Seagate’s board, seeking alternatives, mulled selling the company.

Veritas, the likeliest merger partner, had no appetite for disk drives. Far from nurturing an interest in Seagate’s manufacturing operation, “we were interested in staying away from it,” says Lonchar. “We are building a nice software business, and we don’t want to be distracted.” It’s easy to see why. Disk-drive makers in recent years have “faced the perils of Pauline,” having to slash prices in suicidal pursuit of market share, according to Jim Porter, an industry analyst and president of Mountain View, California-based Disk/Trend Inc. The upshot: scant profit margins in good years and steep losses in bad ones.

Beyond Veritas, though, no other candidate made any sense at all–because only Veritas could distribute its own shares to shareholders without triggering a taxable gain. “No other merger partner in the world could have enabled [Seagate] to unleash the value tax free,” says tax expert Robert Willens, of Lehman Brothers Inc., in New York. “Veritas knew it, and exacted a fee.”

The fee takes the form of an expensive haircut. If the deal is consummated this summer, Seagate will temporarily surrender its 128 million shares of Veritas, the entire Seagate stake remaining after earlier redemptions. (Seagate will also hand Veritas its much-smaller investments in a handful of companies, including Gadzoox Networks, a storage-area network company, and Dragon Systems Inc., a voice- recognition concern.)

Veritas will then reissue approximately 109 million shares of its stock to Seagate shareholders–with the 15 percent discount in share ownership substituting for the 39.2 percent tax bite Uncle Sam would have taken. On May 10, the 15 percent of shares that Veritas plans to retire had a market value of about $1.6 billion.

Without new owners for the volatile disk-drive business, any deal with Veritas would have faltered. Enter Silver Lake Partners, whose legendary venture- capital successes include such investments as Cabletron Systems and Submit- Order.com. Silver Lake’s role in the Seagate-Veritas transaction included the organization of a blue- chip investor group that includes Chase Capital Partners, an arm of Chase Manhattan Bank, and Goldman, Sachs & Co. A management group including Seagate CFO Charles Pope will also participate in the buyout, and Chase and Goldman will supply any cash needed to close the deal.

Understanding The Price

By enabling Seagate to monetize its Veritas stake, the investor group clearly has rendered a valuable service to Seagate shareholders. But is $2 billion–the price tag generally quoted for the deal, and an amount equal to about a third of Seagate’s annual revenues–a fair price for the world’s leading disk-drive maker?

“If sold in an IPO, [the disk-drive business] would probably get more than $2 billion,” maintains Dane Lewis, who follows the disk-drive industry for Robertson Stephens. Lewis compares Seagate with a rival disk-drive supplier, Maxtor, noting that in early May, its market value equaled roughly half of its 1999 revenues. Western Digital Corp., a company considerably more strapped than Seagate, is valued in the stock market at about one-third of revenues. Moreover, Willens notes, the investor group will get an added tax benefit in the deal, thanks to Section 338(h)10 of the Internal Revenue Code. This bit of law allows buyers to step up the basis of certain assets so that when amortized and depreciated, Willens estimates, the assets have a present value in excess of $350 million.

If the effective price of Seagate is lowered to $1.65 billion, that represents a price equal to about one-fourth of revenues for Seagate’s June 30 fiscal year–giving an even greater bargain to the buyers, without any of that benefit being passed on to the Seagate shareholders.

But there’s more. Besides disk drives, the operating company will retain two other high-tech outfits–IMG Software and XIOtech–which, valued conservatively, together are worth $750 million. Even after subtracting $200 million of net debt on Seagate’s books, which will carry $1 billion in total debt after the transaction, some experts suggest that Seagate’s true market value could exceed $3.5 billion.

Still, others dismiss such an appraisal, citing risks inherent in the volatile disk-drive sector. Holding out for an extra $1 billion would not serve shareholders’ interests if it caused the larger deal to crater, taking the tax benefits of the Veritas share-distribution with it. Absent a competing bidder, say defenders of the price Seagate holders are being paid, it is difficult to argue for a price higher than $2 billion.

Asked for their comments, Seagate’s Pope and Silver Lake partner Roger McNamee would not discuss the deal. In published statements, however, insiders tout the merits of the transaction. “This transaction epitomizes the mission of Silver Lake,” McNamee said. “As a private company, Seagate will be free to make the investments and take the strategic steps necessary to extend its leadership position in the storage industry.”

Freedom from having to report quarterly results could provide a competitive advantage when it comes to disk-drive pricing, giving Seagate’s new owners an even better deal.