The Next Network Acquisition Target

by: Ron Sommer

Cisco Systems (NASDAQ:CSCO) recently announced acquisition of Sourcefire (NASDAQ:FIRE) has prompted speculation among the pundits about the next target.

Cisco is the 800 pound gorilla in the networking space with fiscal 2012 sales of $46,061 million and a market capitalization of about $152.116 billion. The company is burdened with a legacy hardware-centric product line when the industry has moved to software-based systems and a greater emphasis on cyber-security. The Sourcefire acquisition is meant to fill this void in security products. Cisco is also moving to expand its offerings for programmable virtual networks called Software Defined Networking or SDN.

With $47,388 million in cash and short-term investments and just $12,956 million in long term debt on the books, Cisco can well afford to buy any company operating today.

Cisco paid $2.7 billion for Sourcefire or 12 times revenue. It is hard for me the logic at work here. Sourcefire had just $223 million in sales in 2012 and reported net income of $4.9 million. This is a rounding error for Cisco.

Will this acquisition start a run on other companies? According to an article in Bloomberg, Daniel Ives, an analyst at FBR Capital Markets thinks that Fortinet (NASDAQ:FTNT) could fetch as much as $39 per share. Ives went on to say that other potential targets include the Israel-based company Check Point Software Technologies (NASDAQ:CHKP) and Palo Alto Networks (NYSE:PANW).

The seven companies listed below, including Sourcefire, are in the news and may be in play because of the Sourcefire acquisition.

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These companies offer a mixed bag in terms of performance. CHKP performed in-line with the market; FTNT and PANW performed substantially worse and tiny Proofpoint (NASDAQ:PFPT) has had a terrific year.

Looking at each company's financial performance and valuation is revealing.

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Checkpoint is the low value winner with an EV/EBITDA multiple of 13.63. Sourcefire has an astronomical ratio of 141.24. Palo Alto and Proofpoint are both losing money at the operating level and have no EBITDA.

In each of my articles I always write that my analyses are based on a combination of earnings-based and cash-based measures. I am a firm believer that over the long run, a company's success or failure can be traced to its ability to generate adequate free cash flow. When I measure value based on free cash flow, I use FCF to price. For the companies I examine today, I find that only CHKP to be generating the kind of return that I look for from an investment.

I need to be sure that reported operating earnings are real and are backed-up by free cash. By this measure, Checkpoint, Fortinet, Sourcefire and Qualys (NASDAQ:QLYS) are strong. Though Palo Alto generates free cash, the operating earnings loss is troubling.

I use two metrics to determine if a company is providing an adequate return on investment. The first measure is earnings-based: EBITDA less capital expenditures to invested capital. The second metric is free cash to invested capital. On an earnings basis, Checkpoint provides a return in excess of my minimum as it does based on free cash. Fortinet comes close on an earnings basis and satisfies my requirement with free cash.

Most of these companies have no long term debt and the two that do have debt free cash is adequate to cover.

The irony here is that in 2005, Check Point offered to buy Sourcefire for $225 million but the purchase was blocked by the U.S. government. Check Point is one of the oldest if not the largest in the network security space.

Fortinet and Palo Alto may be the next targets but Check Point should not be ruled out. It is larger than the others but it has the advantage of being a better investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.