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Why Cisco's $2.6 billion acquisition of Acacia Communications is a brilliant strategic move

Jul 10, 2019, 03:04 IST

Cisco CEO Chuck RobbinsBusiness Insider

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  • Cisco's $2.6 billion acquisition of Acacia Communications makes sense for Cisco in every way.
  • Acacia makes super-fast optical networking chips and other components. A good number of Cisco's biggest competitors are Acacia's customers.
  • It's a little less clear why Acacia wanted to sell now for that price.
  • The uncertainty around China trade war and the blacklisting of Huawei may have had something to do with it.
  • Click here for more BI Prime stories.

On Tuesday, Cisco announced that it was buying Acacia Communications for $70 a share, which works out to $2.6 billion in cash.

For those rooting for Cisco to stay the dominant computer networking player, this deal is a reason to rejoice.

Buying Acacia makes sense on every level for Cisco. Acacia makes super-fast optical networking chips and other components that are used in equipment bought by telecom service providers.

This service provider market is the one area where Cisco has struggled over the years, and where its progress remains soft. For instance, service provider revenue was down 13% when Cisco reported its last quarterly financial results in May. And Cisco is sitting on $34.6 billion in cash, so even on that score, a $2.6 billion deal is peanuts.

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So buying Acacia to boost Cisco's cred with service providers alone makes this $2.6 billion deal smart.

But, under the hood, the deal is way more strategic than that.

Cisco's Q3 2019 growth by segment reported May, 2019Cisco

If you can't beat 'em, buy 'em

Acacia doesn't sell the fully put-together optical networking routers or devices. It sells the parts for that hardware - the brains, so to speak.

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Acacia was founded 10 years ago, and it zoomed to popularity with the so-called "white box" era in computer networking. White boxes are networking gear, namely routers and switches, assembled with off-the-shelf components such as the those sold by companies including Acacia or Broadcom.

Read: Microsoft has caused an uproar among its partners by canceling one of their favorite perks: software for their own use

White boxes arose specifically to challenge Cisco.

Cisco builds full systems and controls everything from the chip to the software. Cisco's networking equipment is exceptionally powerful, but comes with a high price tag. And generally speaking, Cisco's customers can't update, change or modify that hardware, even if they wanted.

Facebook's modular switch called the &quot6-Pack"Facebook

By allowing bits and pieces to be assembled into a bespoke device, white boxes are a cheaper alternative for network operators and large internet companies.

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For comparison's sake, it's the difference between buying a whole computer from Dell, versus buying the motherboard, chassis, display, CPU, and graphics cards and assembling it yourself.

Acacia is especially involved in Facebook's Open Compute Project and OCP's cousin project, the Telecom Infra Project (TIP). Its technology is used in Facebook's home-grown 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.

Read: Facebook's plan to eat the $127 billion data center market swallowed $2.5 billion last year, and will soon gobble more than $10 billion a year

Acacia is even more involved in TIP, a project that is trying to do for large telecom companies what OCP did for the data center.

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But wait, there's more.

Acacia is a major suppler to Cisco's archrivals

Cisco's archrival Arista is heavily involved in OCP. And, as Cowen's Paul Silverstein pointed out on the conference call with Wall Street analysts about this deal, Arista is also an Acacia customer.

Cisco's general manager of the optics business, Bill Gartner, who led this deal, insists that Acacia will continue to sell products to all of Cisco's competitors, including Arista.

Arista

But Silverstein points out that owning Acacia still gives Cisco an advantage. Cisco could choose to make Acacia's latest, greatest tech work with Cisco's products first and better before releasing it to competitors, he questioned.

Gartner promised not to let that happen.

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"I don't think that's true, Paul," Gartner said on Tuesday's call. "If we're going to make this successful, we're going to have to make sure that we're providing the technology to third-parties that they want to consume, at the time they want to consume it and at the right price point. I don't think we can make this successful more broadly if we give Cisco preference."

Remember, the deal still has to pass regulatory approval, so executives aren't likely to say that they plan to use it to shake down their competitors.

Read: This Israeli founder sold his first company to Cisco for $475 million when he was 26. Now he's raised $117 million from a who's who of US angel investors to take Cisco on

Even if Cisco keeps that promise forever, its competitors can't be happy. No one wants to write big checks to buy a rival's gear, or to share product engineering details with them.

Acacia and the squeeze on China

It's a little less clear why Acacia would want to sell for this share price, although the ongoing trade war with China and blacklisting Huawei may have something to do with it.

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Acacia is a profitable, fast-growing company. It brought in $105.2 million of revenue in its last quarter, up 44% over its year-ago quarter, and dropped $7 million in GAAP net income to the bottom line. It finished its 2018 fiscal year with $340 million in revenue.

Huawei founder Ren Zhengfei attends a panel discussion at the company headquarters in ShenzhenReuters

The $70 share price is a 45% premium over Monday's close of $48. Just a few months ago, however, its share price was hovering around $59, which would have put this deal at a relatively more modest 18% premium.

Acacia's stock that got pummeled thanks to the Trump administration's trade war with China. Both Huawei and ZTE, two giant Chinese telecom providers, are it's customers.

Acacia even had to issue a press release downplaying the impact of the White House's moves: Huawei accounted only for 1.5% of Acacia's total revenue, it said. Complying with the order to stop selling product to it would be immaterial to its bottom line. Also of note is that Huawei is one of Cisco's biggest competitors.

Read: Sebastian Thrun, the godfather of the self-driving car industry, explains how Larry Page taught him to be a visionary, not just an 'expert'

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But Acacia also admitted in that press release that tensions between the US and China could have other kinds of fallout.

"Developments or regulatory actions against Huawei may have a broader impact on overall conditions in the markets in which Acacia operates," it warned.

The Asia Pacific region, particularly China, accounted for 67% of its revenues, Acacia said during its earnings in May. And Chinese companies, wary of US politics, were prepping to take their business away from US suppliers.

Acacia seems to have been faced with a choice: sell to Cisco and cash in now, or risk going it alone and bet that the situation in China would not devolve.

Millions for Acacia execs

Interestingly, the execs at Acacia will not get enormous bonuses just for selling the company - although they do have trigger clauses that pay millions if they are fired within the first year.

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In other words, there was no giant incentive, paid upon change-of-control, that was likely to have 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, his stake will gain him just under $63 million. He gets another $324,368 in equity awards upon a change of control. Plus, he'll get a maximum of just over $4 million if he's fired or resigns for a valid reason before the first year. This isn't his first startup, either: he also founded another networking company called Mintera back in 2000 and sold it for a reported $32 million in 2010.

CEO Raj Shanmugaraj, who joined the company in its first year, actually owns more than the founder: He holds 2.4% or 958,092 shares. These are worth over $67 million at $70 share. He gets $371,868 for a change of control and up to $6 million if he's booted out, or has reason to quit, before the first year.

Guaranteed payouts are about the same for the rest of the executive officers, with termination clauses that range from around $3 - $4 million each.

The acquisition immediately inspired two law firms to put out feelers looking for shareholders who may want to sue over concerns that the price was too low.

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Such suits rarely go anywhere, and Acacia's board not only agreed not to seek new offers, but agreed to pay a termination fee should they cause this deal to go south.

So, all-in-all, this should be a good deal for Cisco in every way.

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