Cisco: Now Equipped With A Thousand Eyes

Summary

• Cisco has confirmed its intent for the ThousandEyes acquisition.
• The company should benefit immensely as the acquisition is fully aligned to strategic objectives.
• Moreover, there are revenue, cost, and financial synergies.
• Equally important, Cisco should also have a better view of the competition through ThousandEyes.
• There should be a considerable upside in the stock price.

Cisco (NASDAQ:CSCO) has confirmed its intention to acquire ThousandEyes (a private company) which specializes in network monitoring and performance solutions. Taking into consideration Cisco's long list of acquisitions, investors have questions as to whether this is just one more acquisition or that it will make a real difference for the networking giant growth prospects.

According to a video published on Cisco's website, the management through Todd Nightingale, Senior Vice President and General Manager of Cisco's Enterprise Networking and Cloud business, was upbeat about the acquisition and among all the talks, this is the one phrase which caught my attention:

It will enhance our network performance and monitoring capabilities right across the enterprise and into the cloud"

Figure 1: Cisco acquisition of ThousandEyes.

Source: Built using images from Cisco.com and Thousandeyes.com

This appears to be a strong acquisition for Cisco at a time when due to COVID-19 employees are increasingly working from home and managers are thinking twice before sending technical staff to remote offices because of infection risks.

The ability of the ThousandEyes solution to provide visibility across the network and measure performance are undoubtedly key enablers for remote work and the ability to streamline human interventions only when necessary, thereby reducing infection risks.

However, besides all of this praise, it is important for investors to have a clear idea of the real possibilities and impact on both the top and bottom lines.

Some may remember that costly Webex (Cisco web conferencing tool) acquisition back in 2007 for $3.2 billion. However, others will also remember that some employees exited Cisco after the acquisition in 2011 to form Zoom (ZM), which is now a strong competitor for Webex.

Therefore, I first identify opportunities for Cisco by deep-diving into the solution proposed by ThousandEyes and second, bring forward the synergies this acquisition can produce for the combined entity as well as elaborate on how the competitive positioning will be enhanced. I also analyze the other side of the coin and provide a valuation for Cisco taking into consideration this new development.

ThousandEyes acquisition: much more than visibility

ThousandEyes has basically done what cloud providers like Amazon (AMZN) have done for the server. Instead of painstakingly purchasing a server and installing the operating system and applications, subscribers can easily provision servers using the easy-to-use AWS (Amazon web interface).

In the same way, ThousandEyes has enabled thousands of subscribers throughout the world to have a view of how their devices and applications are connected to others in the public cloud. This element of visibility the company has brought is vital to quickly identify pain points at various parts of the huge internet network. After fault identification using a graphical interface, administrators or even some tech-savvy employees just have to escalate issues to private cloud network administrators. These private cloud infrastructures would normally include a switch or router (could be of Cisco made) to be attended to for issue to be resolved.

Thus, engineers can now be deployed to the more productive tasks of solving problems instead of just sitting down in the NOC (Network Operating Center) and waiting for problems to occur.

Figure 2: ThousandEyes user interface

Source: ThousandEyes

ThousandEyes has continually developed its product so that it currently occupies one of the top spots in Gartner's Network performance monitoring and diagnostics ratings. More importantly, it is better than Cisco's own network monitoring tool, but it gets less reviews (7 versus 72 for Cisco).

The reason for getting less reviews is that it is far less popular. Therefore, investors can imagine the significant potential to increase in popularity and revenues with the marketing clout of Cisco behind it.

Figure 3: Reviews for ThousandEyes solutions on Gartner.

Source: Gartner

Moreover, as a trial user last year, I had some difficulty to make a diagnostic of some network equipment in the EMEA (Europe Middle East and Africa) region as agents that are so important for the ThousandEyes application to function were simply not there. These agents normally have to be installed in data centers by partner organizations so that ThousandEyes can function optimally. Therefore, with Cisco's channel partner program, I see significant expansion of the use of ThousandEyes throughout the world.

However, just leaving it to Cisco's considerable finances would amount to pure shortsightedness from my part and it is for this reason that it is important to analyze this purchase from the merger and acquisition (M&A) viewpoint to get a better feel of the opportunities.

Acquisition Synergies, Cisco's strategy to prioritize on software and subscription and the SD-WAN

First, I strongly believe that there is considerable potential for cross-selling. Here, I have in mind Cisco's App Dynamics, which is more of an IT operations analytics solution being bundled with ThousandEyes' network monitoring tool resulting in an overall availability map for the customer. In fact, there has already been demand in this direction in some NOCs.

Figure 4: The Cisco - ThousandEyes synergy

Source: Keylogin M&A Synergies

There are other opportunities in terms of enhancing Cisco's SD-WAN offering where it is facing tough competition from the likes of Fortinet (FTNT) and VMware (VMW).

Figure 5: Joint solution between ThousandEyes and Cisco SD-WAN since 2017.

Source: Cisco

In this respect, as many work-from-homers reconsider going back to the office and their managers put on hold purchase decisions for SD-WAN routers for branch locations, Cisco now has an opportunity to sell ThousandEyes' network intelligence solutions as companies move applications to the hybrid cloud and thus rely more and more on third-party infrastructures for performance.

Also, there are some cost synergies as Cisco will have access to ThousandEyes' cutting edge technology which it can apply across its whole spectrum of products including Meraki (Cisco's wireless and device management solution) and Webex.

Finally, on the financial side, one aspect of ThousandEyes' pricing strategy is that subscription model which I strongly believe will beef up Cisco's software revenue segment significantly.

The reason for this is that ThousandEyes operates on a subscription model and as per Bloomberg: "ThousandEyes' total customer contractual commitments surpassed $100M in FY20, growing almost 80% YoY". Also, the company includes top US companies across all industries.

Figure 6: Cisco revenues from different segments in millions of dollars and percentage of revenue from subscription derived out of software.

Source: Q3-2020 Earnings Call presentation

Now, in terms of figures, the Applications category should show a significant increase helped from sales coming from ThousandEyes' products in the immediate term. Also, "Applications", while still representing 11% of Cisco's revenues tend to carry better gross margins compared to hardware as after being developed, the cost of duplication falls to near-zero.

I also expect increases in the services category because of bundling opportunities explained earlier.

Figure 7: An estimate of ThousandEyes customers

Source: BusinessWire

Also, "software deployed in conjunction with subscription" is at the heart of Cisco's strategy to transition its business model from hardware and infrastructure platforms to software and subscriptions.

In the words of Kelly Kramer, CFO in Cisco's 2019 annual report:

We executed well in fiscal 2019, delivering strong top-line growth and profitability. The returns on our investments in key strategic areas and driving the shift to more software and subscriptions position Cisco for long-term growth and shareholder value."

Therefore, while there should be longer term gains across the whole of Cisco's product range, the immediate beneficiary will be the software segment as Cisco's transforms SaaS (Software as a Service) using ThousandEyes' visibility to a degree which even the big cloud providers like Amazon have not yet been able to do.

I now analyze the hurdles which may be there along the way.

Integration challenges

The main challenges I have seen for these sorts of M&A activities are cultural, stemming from the fact that these are completely different organizations structures. On the one hand, you have the giant Cisco used to more of an "orderly efficiency" organization culture and on the other, you have the "wild dynamism" of a recent start-up.

However, I am comforted that both of the companies have known each other since 2014 and have been working together on several projects for three years now.

Also, what adds to my comfort is the fact that ThousandEyes, contrary to that Webex acquisition which was left to operate as a stand-alone unit, will have an advanced degree of interaction with other departments in the Cisco ecosystem. The networking giant wants to apply the acquired company's knowledge right across its main products and the current CEO of ThousandEyes will be the new entity's general manager in Cisco's future organizational structure after the acquisition.

Secondly, investors may have questions as to integration costs. However, as per Todd Nightingale, during the video call, Cisco will be embedding ThousandEyes technology in its products. The word "embedding" has all its importance in this case as there is a difference between embedding and integrating. Embedding is the process of firmly lodging into while integrating goes a step further in that it has to be a basic constituent of Cisco's solution. Hence, by definition, the duration and costs for embedding are less than a full-fledged integration.

Finally, some investors may have questions as to the support for non-Cisco products by ThousandEyes after the acquisition. However, with Cisco holding more than half of the global market share for switches and routers, the potential application of the network monitoring company's solutions to Cisco's products itself located at different customer premises represents a considerable source of revenue. Also, during the video call, I have noted the intent of Mohit Lad, CEO & Co-Founder of ThousandEyes to be "technology agnostic" or unbiased towards the use of any particular technology.

Finally, according to my own experience with some IT projects, there can be an element of deception that can crop up as the acquirers, after some hiccups tend to get disillusioned in view of the acquisition price having been on the high side. I make sure to cover this aspect in the valuation part.

Valuation

As a prelude to the valuation and offering a glimpse as to the way Cisco's stock can benefit from an upside, investors can have a look at SolarWinds (SWI), which includes network performance management tools as part of its product offerings. Its share price has appreciated by 25% since it announced its subscription model back on April 22 of this year.

Figure 8: Comparison of the share price of Cisco and SolarWinds

Data by YCharts

Moreover, getting back into the valuation, SolarWinds has a market cap nearing $6 billion and nearly $1 billion of yearly revenues. More importantly, it has a gross profit margin of 73%. Now, according to a publication on Crunchbase, "ThousandEyes has a valuation (including capital injections) in the range of $500M to $1B as of Feb 20, 2019."

This would mean that the $1 billion price tag Cisco has paid for the acquisition (according to an unconfirmed report by Bloomberg) is more than reasonable when taking into consideration potential revenues and this, on a purely comparative basis with a company offering similar products.

Exploring this further and adding the revenues and financial synergies going forward (figure 4), there are growth opportunities for Cisco which outweigh an acquisition cost even if higher than the $1 billion mark.

Also, the integration costs should not be significant as this is not a full-scale integration but more of an embedding as I explained earlier. Therefore, there should be improvement in the bottom-line as well.

Figure 9: ThousandEyes subscription model

Source: ThousandEyes

My bullish instance is reinforced by the fact that the acquisition is 100% according to the networking giant's strategy to generate more revenue from software and this through the subscription model.

With a P/E of 14.91, Cisco's stock is undervalued taking into consideration that it is aiming to be more of a software play and has taken concrete steps in this direction. The share price should be at least in the $53-55 range just considering a 10% upside.

Key takeaways

In terms of M&A, this acquisition should be viewed more than just acquiring a new digital capability by Cisco.

That new perspective of the internet Cisco will gain should transcend right through the private cloud, where the company is currently restricted, to the broader multi-cloud paradigm. This will also provide the networking giant with an overview of the very equipment of its competitors.

In terms of figures, it will depend on the execution but Cisco seems to have found a formula for rapidly integrating its acquisitions (number 30 in the last 4 years). The company's operating margins (28%) demonstrate integration of fast-growing companies while, at the same time, increasing efficiency of the company's production and sales processes.

Moreover, with a free cash flow of more than $14 billion on its balance sheet as of April 25, debt to equity ratio of only 48 and considering the low-return environment for unused capital, this acquisition should be beneficial for Cisco's top line and bottom line.

Finally, those who are still doubting that this acquisition may not work are now informed.

Analyst’s Disclosure: I am/we are long CSCO; SWI. 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.

This is an investment thesis and is intended for informational purposes only. Investors are kindly requested to do additional research before investing or divesting.

Comments

[NervousNeville]

CSCO continues to not behave like a quality stock and lag everything else in my portfolio. It was the worst today. It's on thin ice!

[European investor 99]

Oversold for no reason. I just bought a big chunk today

[Lotsdawg]

Cisco Systems is a great play on the suddenly weak to worthless US Dollar.

Who hasn't been buying gold for the last 10,000 years?

[Lotsdawg]

Been 20 years since I've looked at the name but given the weak to worthless US Dollar I would rate Cisco Systems a strong buy on today's total liquidation of all of equities "news."

[Gordonr]

I owned Cisco back in the 90’s when they were growing like crazy. Haven’t owned since.
Until now! The new stay at home trend is what brought me back.
Good article!

[Chetan Woodun]

Thanks - hope you benefit from the dip

[Terry Eger]

More Coolaid! No doubt Cisco is very healthy and it's legacy products ( routers and switches) provide tremendous revenue. Also going to a lease basis has created steady revenue. Cisco first purchase was a company called Cressendo. Cressendo created the switches which account for much of Cisco's revenue. Other than that most of Cisco's purchases have had short term success and long term poor performance. I can list off a bunch. Cisco overpays, then doesn't integrate the software ( they imbed it). Software ends up not keep up, the people they bought vest their stock and leave, and create another better product. The lastest is Zoom which is killing Webex. So expect short term this is a great deal. Long term it will be another company Cisco vastly overpaid for. The good news is Cisco is making so much money that it will never come to light. I remember when Cisco paid almost 5 B for software to manage Phone Company centers, I remember when Cisco bought a company called Ironport for email security. Today the 5 B software is gone and they resell software from Agari rather than Ironport. So stop drinking the Cisco Coolaid. Great cash cow. The remind me of IBM 30 years ago, looking for where to go next.

[Chetan Woodun]

If Cisco executes well on that WebEx part integration & given those security issues on Zoom, Zoom is dead !

[Golfer1130]

Terry- most of your statements above are incorrect. For example, the Ironport acquisition you mention is in fact the core of Cisco Email Security platform. (CES). Agari is an optional add on to CES and ESA (premise Ironport Email Appliance. ) 
Sourcefire IPS acquired in 2013 I think , is now the core software for Cisco NGFW firewalls.
OpenDNS acquired a few years ago is now Cisco Umbrella , Cisco Secure Internet Gateway that is taking share from ZScaler. Cisco bought Meraki and left Meraki brand intact and enhanced Meraki significantly Duo recently acquired as Cloud MFA is already integrated to Cisco ISE and Cisco Firewalls. Cisco is better at integrating acquisitions and creating value of the acquired technology , than almost any other Tech company in the world. Partly because Cisco has more experience integrating Acquisitons. Over 200 acquisitions over last 12-15 years. When w Elon back 3-4 years from now and 1000 eyes agents are embedded in all Cisco networking SDWAN and UCS GEAR you will see the brilliance of this acquisition as well. Please check your facts. Open to any comments or corrections. Thx all.

[European investor 99]

@LBlakeH perfect answer. Was about to write the same actually....

[snosaint]

At least once a year i perseverate over selling cisco and while i am doing that dance usually something just like this crops up and makes me want to stay a while longer...

[Ramy Taraboulsi, CFA]

Thanks @Chetan Woodun for the report.

You said: "Also, there are some cost synergies as Cisco will have access to ThousandEyes' cutting edge technology which it can apply across its whole spectrum of products including Meraki (Cisco's wireless and device management solution) and Webex."

Other than standard common head office cost savings, do you see any other possibilities of integration/synergies of Webex and ThousandEyes?

[Chetan Woodun]

Thanks for your feedback Ramy. I saw two benefits but have too few material to publish it. Will come to you later on this one

[Golfer1130]

@Ramy Taraboulsi, CFA - a few additional benefits Cisco will see w 1000 Eyes integrated into Cisco core Enterprise Networking (EN), Collab line, including Webex ad Webex Teams, Data Center and Multi Cloud portfolios;
There will be Hard dollar savings for Cisco Support (TAC) to help customers trouble shoot difficult IT problems. Cisco TAC is one of the largest, most respected Support Organizations in the world. If Cisco ONLY bought 1K Eyes for their internal TAC teams to support Cisco's largest most complex customers, the acquisition will pay for itself very quickly in TAC man hours saved spent troubleshooting issues.
Cisco will have competitive differentiation vs VMWare, Arista, Zoom, HPE, Huawei and Nutanix by having 1k Eyes agents embedded across entire EN and DC portfolio. Along with App Dynamics, Cisco will give customers visibility across, Networking, Wireless , Routers, SDWAN, Application performance Metrics and Public Cloud Performance metrics in a single integrated Console. 1000 Eyes integrated in to DNA Center and Cisco Intersight. All the other competitors will have to cobble together visibility tools from 2-4 or more different tool vendors to provide the same visibility into performance and bottlenecks in traffic, that Cisco will able to see across Cisco native management tools.
Large Cisco Customers, think; DoD, Apple, Amazon, Microsoft, Oracle, Boeing, JP Morgan, Goldman, SpaceX etc are trying to reduce the number of IT vendors to 3-4 Strategic vendors, and try to eliminate the dozens of smaller niche IT vendors in their environments. This trend will make the Big bigger like Cisco/Microsoft/ VmWare / Amazon/ Service Now/SFDC , and make it harder for small specialized niche players pick up contracts from the largest F500 companies and Governments. the 1k eyes acquisition will help Cisco fill a visibility gap in their portfolio, and keep customers that much more entrenched in Cisco Solutions. I welcome any feedback or disagreements