Cisco Gambles $3.7 Billion on Software

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Cisco Systems (NASDAQ: CSCO) , the dominant provider of enterprise switches and routers, is still predominantly a hardware company. Just 29% of total revenue during the latest quarter was recurring, coming from either software subscriptions or services.

The software business, which is spread across all of Cisco's reportable segments, is growing fast: deferred revenue from recurring software and subscription businesses grew by 48% year over year to $3.8 billion during the latest quarter. But hardware is still the core of Cisco's business.

Cisco has managed to maintain its dominance and its margins in the switching and routing businesses despite major shifts in the world of IT, like the emergence of cloud computing and software-defined networking. But neither business is growing consistently. Software will be one of the key growth drivers for Cisco going forward, and the company hasn't been shy about making acquisitions to push software revenue higher.

A $3.7 billion bet on software

On Jan. 24, Cisco announced that it had agreed to pay $3.7 billion in cash and assumed equity awards for privately held AppDynamics, a provider of a cloud applications and business-monitoring platform. AppDynamics was just one day away from going public, and Cisco paid a hefty premium to scoop up the company at the last second. AppDynamics' last private fundraising round yielded a valuation of $1.9 billion, and the high-end of its IPO price range represented a market capitalization of just $1.7 billion.

"Applications have become the lifeblood of a company's success," said Cisco SVP Rowan Trollope. Cisco believes that the acquisition will allow it to provide "end to end visibility and intelligence from the network through the application." AppDynamics will become a new software business unit within Cisco's Internet of Things and applications business, with the deal expected to close during Cisco's fiscal third quarter.

Because AppDynamics was so close to going public, this is a rare case where the financials of an acquired private company have been publicly disclosed. Cisco isn't getting much revenue for its $3.7 billion investment. AppDynamics has produced $158 million of revenue through the nine months ended Oct. 31, up about 55% year over year. Full-year revenue would be somewhere around $230 million if that rate of growth holds. Cisco is paying roughly 16 times sales.

AppDynamics is also unprofitable, producing a net loss of $134 million during the last fiscal year and $95 million through the nine months ended Oct. 31. Big spending on sales and marketing, a common feature of fast-growing subscription software companies, is the main culprit. Operating expenses are growing slower than revenue, a sign that things are moving in the right direction, but this deal won't provide any boost to Cisco's bottom line.

Not a fan of this deal

As a Cisco shareholder, it's hard for me to get behind this acquisition. Cisco's timing, racing against the clock to close the deal, led to a price that was more than twice the expected IPO price. Granted, the stock may have surged following its now-cancelled IPO. But this doesn't seem like a company that Cisco needed to own, price be damned.

Cisco has always been acquisitive, but many of its deals have been smaller, measured in the hundreds of millions of dollars. Bigger recent deals include the $1.4 billion purchase of Jasper Technologies in early 2016 and the $2.7 billion purchase of Sourcefire in 2013. The deal for AppDynamics is bigger than both of those, and one of the largest Cisco has made in years.

To be fair, putting Cisco's resources behind AppDynamics could turbocharge growth. But it will take an awful lot of growth to justify the $3.7 billion price tag. I'm not convinced that this deal is a good idea. If Cisco starts making a habit of overpaying for start-ups valued in the billions of dollars, shelling out more than a dozen times sales, I may have to reconsider my investment in the company.

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Timothy Green owns shares of Cisco Systems. The Motley Fool recommends Cisco Systems. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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