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Cisco's M&A machine gears up

by Suzanne Miller  |  Published January 11, 2013 at 2:00 PM
Cisco_227x128.jpgOver the past 12 months, Cisco Systems Inc. has been on an acquisition binge. Last year the traditionally deal-intensive networking equipment maker racked up 13 deals worth $6.8 billion after spending a measly $372 million on ten acquisitions in 2011. Even as most other companies cruised to a quiet close for 2012, the San Jose, Calif.-based telecom picked up the pace in November -- nabbing three companies for $1.5 billion, according to Dealogic.

The pace and mix of acquisitions comes as Cisco is gunning to bolster its competitive presence in software-heavy, cloud-focused businesses. It is also looking more intently at emerging markets for future growth. Last year at least nine of its acquisitions were in the cloud and software space, while its largest deal in years -- the $5 billion purchase of video software provider NDS Group Ltd. -- was in Israel. It has also been investing steadily in China, a country where it continues to build a strong foothold. (story continues below video) 

Although Cisco still commands a dominant role in the enterprise market for routers, switches and networks, it has been facing stiff headwinds from relative newcomers such as Mountain View, Calif.-based Big Switch Networks Inc., which have been whipping out new technologies and products, as well as more established competitors such as Juniper Networks Inc., Hewlett Packard Co., Brocade Communications Systems Inc. and China's Huawei Technologies Co.

Competition has become particularly fierce in Cisco's core businesses, switching, where customers have been buying across broader segments and specific needs as rivals offer a broader range of business models and architectures.

In an interview, corporate development head Hilton Romanski said Cisco's spending spree is far from over as the company keeps its foot on the gas. "Cisco will continue to be active in using M&A, in addition to organic R&D, to drive market leadership as well as expansion into new markets," Romanski said.

He added that the past year has seen "an acceleration" in M&A that's directed at building strength across its core strategic priorities: core routing, switching and services, collaboration, data center virtualization and cloud, and architectures and video. "For some time we've been seeing an acceleration in the challenges and opportunities among service providers and the increase in traffic traversing their networks and, in many cases, their not being able to either properly plan for that traffic or fully take advantage of their own networks, where in many cases they've invested billions of dollars," he noted.

Cisco's deal surge coincides with Romanski's recent ascendency as the company's chief M&A rainmaker. A 12-year veteran of the company -- the bulk of that time spent in corporate development -- Romanski replaced Charles Carmel, who left to join Warburg Pincus in August 2011. When the energetic Romanski speaks about his own approach to M&A, he points to the company's core strategy -- one that CEO John Chambers clarified in a mea-culpa-flavored, back-to-the-roots speech in mid-2011 when the company announced a major restructuring.

The revamp followed several quarters of disappointing earnings and steady declines in businesses such as switching and consumer products. Chambers, conceding that the company had become bureaucratically "too fat," vowed to simplify and speed decision-making around product innovation, exit some 10 businesses and reduce investment in six other areas -- freeing up investment capital. The restructuring sliced about 9% from the workforce and $1 billion off expenses.

For his part, Romanski describes his style as straight up. "I think if you have a really good strategy, you can share it with anyone," he said. "Those who work with us should expect relatively straightforward dealings. High integrity in what I say and do during a negotiation is sacred to me. I'm not going to create a Russian doll set of negotiations." That's probably just as well, considering all the time Romanski has spent doing back-to-back deals the past year.

Analysts have generally welcomed Cisco's newer, leaner focus. "The M&A strategy looks much more cohesive now versus 2003 to 2009," said Grady Burkett, an analyst with Morningstar in Chicago. "During that period they were trying to expand into lower-margin consumer markets and it looked a bit haphazard." That period culminated with Cisco's $590 million acquisition of U.K.-based Pure Digital Technologies in 2009 and its entry into consumer videocam sales -- a move that proved disappointing and resulted in Cisco killing off its line of pocket video cams, the Flip Camera line, in the 2011 revamp.

"The 2003 to 2009 period was more about achieving targets," Burkett said. "Now, Cisco's strategy is more focused around strengthening their competitive advantage in their existing markets and shoring up stable growth and high market share."

Cisco has managed to bolster market share in its growth markets thanks at least in part to big disappointments in high-profile initial public offerings for the likes of Facebook Inc., Groupon Inc., Zynga Inc. and Pandora Media Inc. Declines in all these names prompted a number of startup tech companies to rethink going public. Cisco's $1.2 billion acquisition of San Francisco-based Meraki Networks is an example of a deal that could have slipped through Cisco's fingers had the tech IPO market been more vibrant.

Privately owned Meraki, launched in 2006 by members of MIT's Laboratory for Computer Science, originally planned to go public but changed its mind, it said, because it thought it could better achieve its goal of hitting $1 billion in revenue a year under Cisco. Meraki provides customers with Wi-Fi, switching, security and mobile device management centrally managed from the cloud. The company now forms Cisco's new Cloud Networking group and is led by Meraki CEO Sanjit Biswas.

Looking to 2013, Romanski said he'll be monitoring the health of the IPO market and younger companies eager to seize better value. "How active we are is obviously relative to what happens with sellers and getting to deal values that make sense for us," he said. "With public markets being less accessible, it's a good time to have conversations with folks and to be aggressive. Where there are gaps, we're going to continue to look hard."

Some have worried that Cisco may be tempted to stuff those gaps with more mega-acquisitions, such as the $5 billion purchase of NDS in March. After all, the company, with a market capitalization of more than $100 billion, has about $30 billion in cash. This stack of money is something of a mixed blessing for its U.S. acquisition ambitions, since only about $8 billion is on its U.S. balance sheet. The rest is parked overseas, with little prospect of repatriation unless the U.S. government lowers U.S. corporate tax rates.

Still, $8 billion is a lot of money and some analysts reckon Cisco could easily borrow another $8 billion if it wanted to gun for more big deals. That is a question that until fairly recently had been troubling many investors. Was Cisco planning another NDS-sized deal, or something even larger? Those fears spilled over on Dec. 7 at the company's annual analyst event, where some investors thought John Chambers had suggested he might consider deals as big as $10 billion. The worry was serious enough to cause a brief hiccup in Cisco's share price until analysts had a chance to clarify.

In a follow-up note to the meeting, Barclays analysts said Chambers clarified that another big deal like NDS was unlikely, and that Chambers thought the November $1.2 billion purchase of Meraki was much closer to his idea of an archetypal deal. That took the heat off the share price, which resumed its upward climb and as of Jan. 10 was trading around $20.40 a share, near the top of its 52-week range.

In his own comments, Romanski emphasized that major transactions will remain the exception, although Cisco will continue to look at all opportunities. "The large platform acquisitions either represent entry into a new marketplace or taking leadership in a marketplace where we're looking to double down our leadership position," he said. NDS fit that prescription as Cisco sought to amp up its reach in video. "We were trying to address what was becoming a major transition in the video space, where service providers are looking for a way to deliver content and users on any screen, any time, leveraging a software model. So the ability to deliver that at scale was the driver for the acquisition of NDS," he added.

On the other hand, midsized transactions such as the $1.2 billion purchase of Meraki hit Cisco's "sweet spot," as he put it. "When you look at a deal like Meraki, it is definitely the kind of company where the business model itself is proving a significant portion of revenues that are recurring -- and that is growing. So when you think about disruptions, it's not just in technology innovations, but in business models. That's going to be increasingly important for us as well," he said.

Smaller, younger companies can, of course, take longer to turn into accretive acquisitions -- an issue Romanski said Cisco seeks to balance. "I think from a materiality perspective, we're very much focused on the measure of financial accretion across the overall portfolio, and I think most of the large platform transactions can get you there. We also recognize that we have to lean forward a bit on some of the smaller deals that bring us great capabilities but don't have the scale yet to be at the profitability profile that we want for the full company."

Romanski pointed to the $2.9 billion acquisition of Tewksbury, Mass.-based Starent Networks in 2009, which today is nearing a multibillion run rate and NDS, which is a $1 billion business, as well as Meraki, which has $100 million in bookings and a growth rate in bookings greater than 100%.

"Those businesses add scale, are growing rapidly and are accretive both at the gross margin line all the way down to the bottom line, with the exception of Meraki, which will grow into that as they scale out the business," he said.

As for other growth opportunities, Cisco has said it plans to keep mining opportunities in emerging markets, including Eastern Europe and Israel, where it already has a foothold, as well as China. In each of these regions, Cisco has used its $2 billion investment fund to help finance venture capital and private equity opportunities, with the goal of "really understanding major disruptions and talent in those markets to eventually do more M&A or R&D," he said. "Those are principally the markets we think are going to be important for us outside the U.S., but obviously there are many others where there may be an opportunity for us to access talent if we're able to make long-term commitments [in those places]."

China remains one of the more interesting and challenging regions for Cisco. For one thing, it's home to a serious rival, Huawei, which has become the world's second-largest provider of telecommunications equipment and has proved to be an aggressive low-cost competitor in enterprise networking. Last year it established an enterprise networking division in the U.S.

Over the past 12 years, Cisco has invested over $1 billion in China through private equity and venture capital financings -- more than it has invested in any other country -- and where Romanski said the company has made "significant returns." He said Cisco has also done "a handful of acquisitions, in part informed by our experience on the investment side, including our entry into the service provider video market. So we're very serious about China."

As for pursuing a joint venture, he said, "In the context of China, the JV model is just coming to the table." One of the key challenges, he said, is protecting intellectual property and "making sure that whatever we do is in keeping with our ability to keep value in what we create." Not surprisingly, the U.S. government shares that concern. In October, the U.S. House Intelligence Committee issued a report after a yearlong investigation that Huawei and another Chinese telecom, ZTE Inc., posed a national security threat because they had attempted to gain sensitive information from U.S. companies and because of their close ties to the Chinese government. The government findings could end up preventing Huawei from encroaching on Cisco's home turf in any significant way, at least for now, though the Chinese company has already made big inroads elsewhere by winning large telecom contracts in Europe and emerging markets.

The bottom line is that China is a market Cisco cannot afford to leave or to alienate. And while the U.S. findings may help Cisco protect some of its U.S. share, it probably won't help it advance in China right now. Analysts noted that there have been hundreds of negative reports about the U.S. ruling on Huawei in the Chinese press and that Cisco could be in China's penalty box for the next four to six quarters.

For his part, Romanski said Cisco is well aware "that there are strong and important partners that we have to work with on the ground [in China]," but added that progress will be spiced with patience. "When you look at China more generally, being patient is going to have to be the mode you're in no matter what you do."

Tags: Big Switch Networks Inc. | Brocade Communications Systems Inc. | Charles Carmel | Cisco Systems Inc. | Cloud Networking | Hewlett Packard Co. | Hilton Romanski | Huawei Technologies Co. | initial public offering | IPO | John Chambers | Juniper Networks Inc. | Meraki Networks | NDS Group Ltd. | Sanjit Biswas | Warburg Pincus | ZTE Inc.

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