Squinting Through the HDS BlueArc Deal

The announcement today that Hitachi Data Systems was acquiring Big Honking NAS player BlueArc got some good play but there’s some diverging information about the numbers. Steve Duplessie asked and answered the following question on his blog: “Didn’t HDS effectively already own them? No. A while ago that was true–HDS represented a huge portion of BA’s revenue–but last year it was sub 25% or so.”

But a glance at BlueArc’s S1 registration suggests that HDS still represents a huge portion of BlueArc’s business. On page 15 of the S1 it states:

“We sell our SiliconFS file system and license additional software applications to HDS, which resells them in combination with its storage arrays. HDS accounted for 22%, 30%, 41% and 45% of our revenue in fiscal 2009, fiscal 2010, fiscal 2011 and the three months ended April 30, 2011, respectively.”

Despite indications that IBM was interested in BlueArc, the high concentration of revenue within the HDS channel is significant to this deal and really made HDS the logical acquiring company as I’ll explain in a moment.

Why Sell to HDS?

BlueArc didn’t want to go public in a lousy IPO climate. In addition, unlike Fusion-io which crushed its first public quarter, the BlueArc story wasn’t nearly as compelling, especially with 45% of its revenues coming from one customer. As we’ve seen with Facebook, Zynga and virtually every flash storage player, private valuations are smoking hot right now but the public market is much more fickle– especially in this post- Data Domain, 3PAR, Compellent, Isilon exit climate (i.e. many would look at BlueArc as too little too late).

Why was HDS the Logical Buyer?

HDS was the only logical exit for this company because no other firm would pay a lofty multiple for an asset where nearly half of the revenue goes poof into the wind on day 1.  HDS was the only firm that would pay the premium and the only company where a decent valuation made sense.

The bottom line: Getting acquired was the best way to avoid an IPO, and HDS was the sensible buyer.

The Valuation Math

The market would price an IPO on FY12 revenue estimates of let’s say $120m (assumes a bit more than 20% growth over FY11). Take a 5X valuation (nearly as rich as the Dell/Compellent deal but with a bit of a haircut because BlueArc wasn’t growing as fast on comparable gross margins). BlueArc was losing money and had huge concentration on a single customer – so it would be hard to justify a multiple higher than Compellent. One might be tempted to use Isilon as a comp because it’s business is closer to that of BlueArc but Isilon was acquired using EMC math and EMC uses a whole different set of metrics when buying companies. Compellent was a fairly clean, non-competitive deal on the heels of Dell’s failed 3PAR bid and represents more balanced negotiations.

So on balance a 5X revenue multiple looks reasonable but you would think that HDS got a discount for its own revenue. Assuming roughly $70M for non-HDS business next year that’s $350M in value. Let’s peg next year’s HDS revenue at $50M. The question is how much was HDS willing to pay for its own revenue stream? A 1X valuation for the HDS portion would put BlueArc’s value at $400M. A 4x value on the HDS revenue would get you to $550M; and a straight 5X multiple gets you to nearly $600M. I don’t believe HDS paid $600M for BlueArc but it was probably close to that – maybe $575M justified on the basis that HDS couldn’t ever get traction with parent Hitachi Limited’s NAS product.

One interesting note is the timing of the deal coincides with the termination of HDS’ purchase commitments which expire at the end of this month. From page 52 of the S1:

“We have a Master Distribution Agreement, or MDA, with HDS. The MDA commits HDS to purchase specified dollar amounts of our product offerings through September 2011. Under the MDA, during fiscal 2010 and fiscal 2011, HDS prepaid $10.0 million and $5.0 million, respectively, for future purchases of our products. As partial consideration for these prepayments, during fiscal 2011 we issued to HDS vested warrants to purchase 206,184 shares of our common stock with a per share exercise price of $1.94 and expiration in 2017.”

HDS, like many companies, has a habit of investing in/negotiating rights to purchase shares of strategic suppliers. When HP bought AppIQ in 2005 (a strategic partner to HDS), HDS told the world that it was actually a good deal for the company because it owned shares. I don’t think that marketing angle would fly for a second time if HDS lost out on BlueArc with such a large portion of its business derived from the BlueArc technology. While evidently IBM was interested, there is no way IBM would have paid nearly as much for BlueArc as did HDS. So the deal was a win for BlueArc and a good one for HDS.

Why is this a Good Deal for HDS?

As I mentioned earlier, HDS has always struggled with homegrown NAS from its parent. The Hitachi Limited NAS products never could get traction outside of Japan and BlueArc has always been the future of HDS’ file strategy– so the time was right for this move. If HDS lost out on BlueArc it would have an empty NAS strategy (which is why it probably paid closer to $600M than $400M). HDS has customers that want one-stop shopping and will keep buying NAS from the company. As well, owning the NAS IP gives HDS very solid technology in File (BlueArc), block (HDS’ VSP home court) and object (with the Archivas acquisition). On balance, HDS has as complete a platform lineup as any player in the business and while the Archivas stuff is complicated to implement, most object storage is initially.

As I’ve stated in the past, for large companies with lots of cash, acquisitions are often less risky than R&D– especially with an established player like BlueArc that is generating $100M in revenue. Owning the BlueArc technology gives HDS the charter to ramp the product through its channels and wrap the HDS rock solid availability banner around the platform. The HDS sales force knows how to sell BlueArc and the combined companies can get some operating leverage out of the HDS infrastructure.

Good move for HDS. Good out for BlueArc.