Why I'm Not Immediately Sold On The Cisco Acacia Deal

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About: Acacia Communications, Inc. (ACIA), CSCO, Includes: MLNX, NVDA
by: Bram de Haas
Summary

Cisco is acquiring Acacia Communications at $70 per share.

I listened to the earnings call to form an opinion on the day of the announcement.

It looks like an ~8% expected annualized return to me, but given the political environment, I think there are better deals.

Cisco (CSCO) and Acacia Communications (ACIA) announced a definitive agreement for Cisco to acquire Acacia yesterday. Acacia is an existing Cisco supplier and designs and manufactures high-speed, optical connection technologies to connect data centers. Cisco will pay $70.00 per share in cash. The deal is supposed to close in the second half of 2020. At the time of writing, the spread is about 7.34%.

The annualized expected return should be around 8.61%* if I put the closing date on 6/1/2020 and award an above-average closing probability.

The closing probability is likely to be above average because Cisco is buying a small existing supplier and intends to continue to supply its competitors with its products on the same terms.

It is a tuck-in acquisition for the $244 billion market cap Cisco. In fact, it can just walk over to the bank, fill up a suitcase and hand it over:

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Data by YCharts

Cisco has a history of closing these and a reputation for allocating capital well. They may have savvily capitalized on trade fears to get this deal done:

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Data by YCharts

On the other hand, a quick review of valuation metrics do not immediately bear this out:

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Data by YCharts

The acquisition appears to be spearheaded not by the CEO but at a more technical level by the senior VP of optical systems. Maybe I'm reading too much into it but that probably makes it an acquisition Cisco really wants to do from a technical viewpoint, but it isn't a transformational deal or that requires the CEO to explain to shareholders.

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Data by YCharts

Risks

My initial assessment is that the deal risk is on the Acacia side. They could be interested in backing out if trade (which doesn't mean they can but it does not help odds of closure) fears disappear completely and they feel they got the short end of the stick.

Acacia actually generates a lot of revenue in China. This industry is currently very sensitive to political interference. Most of you will be aware of the issues around Huawei if not the general trade negotiations between the U.S. and China. The PRC can make this acquisition a lot harder or cause delays if there is the political motivation to do so. If you want good returns from M&A situations, it is fairly important not to get hit with too many surprise delays. They really cut into your ultimate rate of return.

The closing date could be over a year from now which is a long time for stuff to get derailed.

Conclusion

On first review, I don't like this deal as it's currently priced. There are lots of reasons why it's a high probability deal that most likely closes. I've awarded it an above-average closing probability. But even with that probability, it is only generating an 8% annualized return. That falls pretty short of typical deals in the tech industry that require Chinese regulatory approval. The market seems to assess the risk of PRC delays in this deal at very low while it is a major issue with a deal like Nvidia (NVDA) and Mellanox (MLNX) among other deals we track on the M&A dashboard. Maybe, that's because the closing date is so far out. Odds are trade issues will have been resolved by mid-2020 and, therefore, delays don't need to be priced in... The bottom line is that I'm not immediately interested in the ~8% given the risks involved. To like this, it would need to be even safer for me.

Disclosure: I am/we are long MLNX. 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.