Cisco Systems: More Bolt-On Deals With Acacia

About: Acacia Communications, Inc. (ACIA), CSCO
by: The Value Investor

Cisco Communications is making another deal, this time acquiring Acacia.

I like dealmaking and while this bolt-on deal is relatively small, multiples are quite high.

Following significant valuation multiple inflation, on the back of improved execution, I am no longer particularly attracted to the shares at a market multiple.

Cisco Systems (CSCO) announced its next bolt-on deal, this time acquiring Acacia Communications (ACIA). The $2.6 billion deal is equivalent to about a percent of its market valuation, yet while I have applauded Cisco for making some bolt-on deals in recent years, I find the premium attached to Acacia quite steep. More importantly, I find that Cisco is fairly valued at a market multiple, with growth having recovered to mid-single digits, while the balance sheet remains strong.

For now, I am not willing to chase the shares following a big momentum run higher, but am more than happy to congratulate true long-term patient investors who have held the shares for a long time, and finally got rewarded in the first half of 2019.

Deal Terms And Rationale

Cisco and Acacia have reached a deal in which Cisco will acquire the company for $70 per share in cash, working down to a $2.6 billion enterprise valuation. Acacia is well known to Cisco as it is an existing supplier to the company of high-speed optical interconnect technologies. This allows data center operators and service providers to meet the increased demand for data. The goal of Cisco is to support existing customers and new customers, including its own customer base.

With the deal Cisco will become stronger in switching, routing and optimal networking, amidst ever more demanding requirements imposed by customers. This is not the first deal of Cisco in this area following deals made in the past including Core Optics, Ligthwire and Luxtera, among others.

No financial details have been announced and no synergy target has been communicated. In February of this year, Acacia reported its result for 2018 with revenues down 12% for the year to $340 million, although fourth quarter results were quite encouraging with the company returning to growth. The company reported adjusted EBITDA of $40 million for the year, which implies that a $2.6 billion deal is quite expensive. This works down to 7.5 times sales and over 60 times EBITDA. It should be said that based on the annualised Q4 results, revenues run at $430 million a year while EBITDA comes in at $72 million, reducing valuation multiples quite a bit to about 6 times sales and 36 times EBITDA.

Just A Bolt-On Deal

Do not get me wrong. $2.6 billion is a great deal of money, yet it marks just a bolt-on deal for a company the size of Cisco. The company ended the third quarter with $34.6 billion in cash and $23.7 billion in debt, for a net debt load of $11 billion. This provides plenty of liquidity to fund the deal with pro-forma cash holdings totalling $8.3 billion.

With 4.4 billion shares trading at $57 per share, the equity valuation comes in at $251 billion, or $240 billion accounting for net cash balances, making that the deal comes in at 1% of the valuation of Cisco, just a rounding error. In terms of the revenue contribution, the contribution of Acacia is even less as Cisco is about to generate $52 billion in sales this year, making that the revenue contribution from Acacia is less than a percent and the earnings impact is very limited as well.

Important to consider is that savvy deals have made that Cisco has returned to growth, currently growing sales by about mid-single digits. Based on the outlook for fourth quarter earnings of $0.80-$0.82 per share, adjusted earnings come in just above $3 per share this year, as the gap between reported GAAP and adjusted earnings is very modest.

With net cash holdings equal to about $2 per share, operating assets trade at $55 per share, which now makes that Cisco trades at a market multiple at around 18 times earnings, while the balance sheet remains utterly strong and growth now comes in at mid-single digits.

What Now?

Reality is that this is just a small bolt-on deal for Cisco and investors have liked the strategy in which Cisco has steadily made some acquisitions in recent times which has provided a boost to overall sales growth and the organic growth profile. On the other hand, the purchase of Acacia looks to take place at quite a steep multiple, and with a 46% premium involves quite a large premium, not just in dollar terms but percentage terms as well. This however is insignificant given the small numbers involved based on the relative importance of the deal.

The market's appreciation for bolt-on dealmaking and improved operational results has steadily been reflected in the share price as Cisco has gradually built down its very large net cash position over time while organic growth improvements have resulted in valuation multiple inflation. Currently, the valuation is just about approaching the market multiple at large.

The latest article which I have written on Cisco dated back almost a year ago as it was August of 2018 when I concluded that shares were fairly valued while the transformation was in full swing. With shares trading in the mid-forties at the time, I was looking to buy shares around the $40 mark. With the exception of the huge declines in the markets in December of 2018, shares have not hit those levels, as I missed out on a +40% rally ever since. At current levels, I have no desire to chase the shares as I am not particularly impressed with the premium paid for Acacia and the valuation multiples.

Disclosure: I/we 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.