- 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
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.
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
Figure 5: Joint solution between ThousandEyes and Cisco SD-WAN since 2017.
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
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.
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.
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
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
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.
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.
This article was written by
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.
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