Cisco's Appetite for Startups Shifts
During a presentation to Wall Street analysts yesterday, Chambers said Cisco will acquire eight to 12 companies this year, about par for the course it's set over the past few years. But the nature of the acquisitions will change.
"You'll probably see us be more selective, and you'll see us probably use acquisitions to move into new market areas, not just expand our presence in existing markets," he told the audience.
It's a message Chambers has been giving for a couple of months. In another analyst presentation in December, Chambers reportedly said that in 2002 the company will only be acquiring startups with revenue on their balance sheets.
Over 1999 and 2000, Cisco didn't have this luxury, Chambers maintains. Pursuing acquisitions meant paying enormous pricetags or buying products that were still on the drawing board -- a risky business in either case.
Now Chambers wants to turn back the clock, and he says the market's ready to do that too. "The acquisition market's turned back more towards what it was three to nine years ago. [Then], we'd go to a customer and say here's what we'd like to sell you; they'd say, 'Hey that's nice but here's a better product from a small startup. I don't feel comfortable buying from a startup. You buy them, and I'll buy from you.' "
But over the last two years, by the time Cisco's customers had a startup's product in house, the startup was already valued at "a billion dollars plus," Chambers asserted. Buying cheaper startups meant investing in unproven technology.
The risks slowed Cisco's acquisitive appetite but didn't keep it out of the game. In fiscal 2001, the company spent more than $4 billion on acquisitions, compared with $15 billion in 2000 and about $800 million in 1999.
In the past few months, as Cisco has shared the suffering of the economic downturn, including 8,500 layoffs to date (see Grim Reaping: A Downturn Tally), all these purchases have forced the question: Was it worth it?
The easy answer seems to be "no." In the case of some of Cisco's more notorious broadband acquisitions, for instance, the simple exercise of multiplying the shares of common stock Cisco issued for each deal by the share price at closing versus today's share price seems to indicate that Cisco paid too much for the companies it bought, particularly in its year 2000 merger heyday:
But this kind of exercise merely reveals the inflated prices Cisco paid to play in new markets. To gauge the overall value of acquisitions is a lot more complicated and often involves measuring things that can't be nailed down in dollars and cents -- at least in financial reports.
What is the value of keeping a particular technology out of the hands of competitors for a few extra months, for example? What about the value of market share or customers that may have come along with a deal?
"Cisco's made a lot of smart moves for the future," says consultant Frank Dzubeck of Communications Network Architects (no Web site). He notes that with the Cerent purchase, for instance, Cisco gained substantial market share at a critical time, even though the product has subsequently suffered criticism for its lack of advanced functionality (see Was Cerent Worth It?).
Indeed, Dzubeck says Cerent was perhaps Cisco's best purchase in recent memory, simply because it paid off, albeit not in hard cash. "Cerent got an optical product at a good time." That's not to say Cisco's making sufficient money to justify the billions it spent on the deal. "If you read between the lines, they may be seeing revenue but profit is questionable," he notes.
Evaluating other Cisco purchases turns up some soft dollar paybacks, Dzubeck says. With Pirelli Optical Systems came a key customer in Telecom Italia, although the product line itself could only be termed "an investment." And with ArrowPoint came content distribution technology supporting Cisco's IP strategy for the next couple of years.
Bean counting alone tells a darker tale about Cisco's deals, however. Most of the companies Cisco buys require substantial investment just to blend into the product line. Even then, there are no guarantees: According to its latest annual report, the company has spent about $2.6 billion since 1999 on so-called "in process R&D," the amount used to write down the costs of making a purchased technology feasible -- or writing it off because it can't be made so.
In some cases, these costs seem very high: In fiscal 2000, Cisco spent $245 million on Pirelli Optical Systems R&D, $260 million in Qeyton R&D, and $354 million on R&D for Monterey, despite completely ditching the Monterey product (see Cisco Kills Monterey Router).
One trend seems apparent: Cisco has reduced the cost of in-process R&D relative to its acquisitions over time. In 1999, Cisco paid an average of $64 million per acquisition for each of the six companies it recorded as a purchase, and it averaged $78.5 million per company in follow-up R&D. In 2000, it spent $621 million on average for each company purchased and $171.62 million for R&D. In 2001, it averaged $410.42 million per purchase and $122.14 million for R&D.
Cisco's lost out by another measure, though -- that of goodwill lost. Goodwill -- the difference between the actual price paid and book value of an acquired company's assets -- is typically amortized over time.
In all, Cisco's spent $5.3 billion on goodwill on the 21 companies it recorded as acquisitions over the last three years -- about 37 percent of the $8.5 billion it spent on these purchases in total.
Does Cisco's goodwill represent the actual writedown on assets that were overvalued? We will never know for sure, because public documents don't go into sufficient detail -- and Cisco's not willing to divulge anything beyond what it must about the value of its acquisitions.
The general goodwill figures also may be incomplete: Not all of Cisco's acquisitions were recorded as such. The year 2000 purchases of Cerent, StratumOne Communications, TransMedia Communications, WebLine Communications, SightPath, InfoGear Technology, and ArrowPoint, for instance, were recorded as "poolings of interest." In each of these cases, Cisco rewrote its financials to show the blending of another company's assets into its own balance sheet, and no specific goodwill or intangible line items were recorded. The federal government now requires companies to record all acquisitions as purchases, and Cisco did this in 2001.
Still, while goodwill isn't a tangible asset that can be easily tracked, it's got the power to hurt a company's financials.
"[Goodwill] sits on a company's balance sheet until amortized or written off (all the while dragging down reported earnings in the process)," says Chris Bulkey, research analyst for the Optical Oracle, Light Reading's subscription service.
Ultimately, the specifics of Cisco's M&A activity raise many questions that aren't easily answered. Some details will probably remain clouded indefinitely in layers of hearsay, financial complexity, and discarded agendas.
But Chambers' recent comments about Cisco's more cautious approach to M&A is perhaps the surest signal that the company's been burnt in reaching for profits from startups and doesn't want to repeat the exercise any time soon.
— Mary Jander, Senior Editor, Light Reading
Editor's Note: Light Reading is not affiliated with Oracle Corporation.