NEW YORK (Reuters Breakingviews) - Cisco Systems is chasing a fairy tale. The networking giant’s core switch and router businesses face tough times. Buying software firm AppDynamics for $3.7 billion offers some respite from hardware woes. But the company is paying well over the odds to add a bit of excitement to its story.
Cisco’s revenue has stagnated over the past several years. Switches and routing account for more than 45 percent of sales, and demand for these is tepid. Virtual networking software reduces enterprises’ need for high-end hardware. Chinese gear makers compete fiercely on the cheap end.
The company, under Chief Executive Chuck Robbins, has tried to compensate by growing its software operations. AppDynamics fits the bill. The company’s software allows enterprises to monitor and manage the performance of applications. It’s a fast-growing business, and better yet, most revenue comes in the form of sticky subscriptions. That’s the sort of combination investors love.
The problem is the price. Cisco snatched the firm up literally on the eve of its IPO. At the top of the indicated range, the company’s market value would have been a bit above $2 billion, including outstanding equity grants. The stock might have priced above that range and popped once it floated, considering the paucity of tech listings over the past year. But Cisco paid a substantial premium to prevent this possibility – handing a big payday to AppDynamics and advisor Qatalyst.
AppDynamics is losing money - $95 million over the nine months ending Oct. 31 - and burning cash, albeit at a slower rate. So let’s look at the price as a multiple of revenue. The outfit had about $200 million in revenue over the past 12 months and is growing around 50 percent annually. Assuming it can maintain that pace, Cisco is paying some 12 times estimated revenue. Relic, a similar software firm that’s growing about as fast, is valued at roughly five times estimated revenue.
It will take several years of rapid growth and improving margins for Cisco to earn a decent return on its unicorn purchase. Such a happy ending would be magical, but looks improbable.
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