On Tuesday, Cisco announced that it was buying Acacia Communications for $ 70 per share, which was $ 2.6 billion in cash.
For those who praise Cisco for being the dominant computer network player, this deal is a reason to rejoice.
Buy Acacia makes sense at all levels for Cisco. Acacia makes super-fast optical network chips and other components used in equipment purchased by telecom providers.
This service provider market is an area where Cisco has been struggling over the years and where progress is still soft. For example, service provider revenues were down 13% when Cisco reported its quarterly results in May in May. And Cisco holds $ 34.6 billion in cash, so even at that point, a $ 2.6 billion deal is peanuts.
So to buy Acacia to increase Cisco's credit with service providers alone, this $ 2.6 billion deal is smart.
But under the cap, the deal is far more strategic than that.
If you can't beat them, buy them
Acacia does not sell the full paired optical network routers or devices. It sells the parts to the hardware – the brain, so to speak.
Acacia was founded 10 years ago and it zoomed in to popularity with the so-called "white box" time in computer networks. White boxes are network equipment, namely routers and switches, mounted with shelf components such as those sold by companies, including Acacia or Broadcom.
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White boxes emerged specifically to challenge Cisco.
Cisco builds complete systems and manages everything from chip to software. Cisco's networking equipment is very powerful but has a high price tag. And generally, Cisco's customers can't update, modify, or modify their hardware, even if they want to.
By putting bits and pieces together in a tailor-made unit, white boxes are a cheaper option for network operators and large internet businesses.
For comparison sake, it is the difference between buying an entire computer from Dell, as opposed to purchasing motherboards, chassis, display, CPU and graphics cards and mounting it yourself.
Acacia is especially involved in Facebook's Open Compute Project and OCP's cousin project, Telecom Infra Project (TIP). The technology is used in Facebook's home cultural data center optical switches, a direct Cisco challenger.
Customers of OCP products include Facebook, Goldman Sachs, Microsoft and some of the largest internet players in the world.
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Acacia is even more involved in TIP, a project that tries to make large telecommunications companies what OCP did for the data center.
But wait, there's more.
Acacia is an important supplement to Cisco's archrivals
Cisco's archrival Arista is heavily involved in OCP. And as Cowens Paul Silverstein pointed out the conference call with Wall Street analysts about this deal, Arista is also an Acacia customer.
Cisco's CEO of optics business Bill Gartner, who led this agreement, insists that Acacia will continue to sell products to all Cisco competitors, including Arista.
But Silverstein points out that ownership of Acacia still gives Cisco an advantage. Cisco could choose to do Acacia's newest, best technological work on Cisco's products, first and foremost before it was released to competitors, he asked.
Gartner promised not to let that happen.
"I don't think that's true, Paul," Gartner said on Tuesday's call. "If we are to make this a success, we need to make sure that we give the technology to third parties who they want to consume when they want to consume it and to the right price points. I don't think we can do this more successfully if we give Cisco Preference. "
Keep in mind that the deal still needs to pass regulatory approval, so executives are unlikely to say they plan to use it to tear down their competitors.
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Although Cisco keeps that promise forever, its competitors can't be happy. No one wants to write big checks to buy a rival's equipment, or to share product engineering details with them.
Acacia and the pressure on China
It is a little less clear why Acacia wants to sell for this stock price, although the ongoing trade war with China and blacklisting Huawei may have something to do with it.
Acacia is a profitable, fast growing company. It brought in $ 105.2 million of revenue in the quarter, an increase of 44% in the quarter, and dropped $ 7 million in GAAP net revenue to the bottom line. It was completed in 2018 fiscal year with $ 340 million in revenue.
The $ 70 stock price is a 45% premium over Monday's proximity of $ 48. Just a few months ago, the stock price fluctuated around $ 59, which would have put this deal into one relatively modest 18% premium.
Acacia's stock pummeled thanks to the Trump administration's trade war with China. Both Huawei and ZTE, two giant Chinese telecom vendors, are the customers.
Acacia even had to make a press release that depressed the impact of the white house move: Huawei accounted for only 1.5% of Acacia's total revenue, it said. Compliance with the order to stop selling the product to it would be negligible for the bottom line. Also in the note is that Huawei is one of Cisco's biggest competitors.
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But Acacia also admitted that press release that tensions between the United States and China could have other types of fallout.
"The development or regulatory measures against Huawei may have a wider impact on the general conditions in the markets where Acacia operates," it warns.
Asia-Pacific region, especially China, accounted for 67% of sales, Acacia said in May earnings. And Chinese companies, cautious of US politics, were prepping to remove their business from US suppliers.
Acacia seems to have been confronted with a choice: sell to Cisco and cash in now, or risk going alone and striving for the situation in China not to surpass.
Millions for Acacia-execs
Interestingly, execs on Acacia will not receive huge bonuses just to sell the company – even if they have trigger clauses that pay millions if they are fired within the first year.
In other words, there was no gigantic incentive, paid by change of control, which probably played a role in the decision to sell.
Founder and CTO Benny Mikkelsen, 59, owns 2% of the company or 892,661 shares. At $ 70 / share he will get him under $ 63 million. He will receive an additional $ 324,368 in share warrants when changing control. In addition, he gets a maximum of $ 4 million if fired or withdrawn for a valid reason before the first year. This is not his first startup either: he also founded another network company called Mintera back in 2000 and sold it for a reported $ 32 million in 2010.
CEO Raj Shanmugaraj, who joined the company in his first year, owns more than the founder: he owns 2.4% or 958,092 shares. These are worth over $ 67 million in $ 70 share. He gets $ 371,868 for change of control and up to $ 6 million if he has started or has reason to quit before the first year.
Guaranteed payouts are about the same for the rest of the directors, with termination clauses ranging from around $ 3 – $ 4 million each.
The acquisition immediately inspired two law firms to put out sensors in search of shareholders who may want to sue over concerns about the price being too low.
Such suits rarely go anywhere, and Acacia's board not only agreed not to seek new offers, but agreed to pay a termination fee if they were to get this deal going south.
So, all in all, this should be a good deal for Cisco in every way.