Many were surprised when Cisco (NASDAQ:CSCO) announced in late January its decision to buy AppDynamics. Not the acquisition itself -- Cisco's major strategy, after all, involves buying tech start-ups and rebranding them under the Cisco parent name. What was surprising was the price and timing of the purchase.
Cisco announced the deal the evening before AppDynamics was set to go public. Public investors interested in the company may have been disappointed, but Cisco did shell out a big number, buying the company for $3.7 billion in cash and equity options. This was more than double what the IPO price would have been, as shares at the top end of the company's range would have priced the company at $1.7 billion.
The $3.7 billion seems steep. AppDynamics only generated $158 million in first the nine months of 2016, for an annual run rate revenue of roughly $210 million, which means Cisco paid roughly 17 times revenue for the company. While AppDynamics did sport an impressive growth rate of 54% in the first nine months of 2016, that's still a hefty price. Moreover, a previous round of financing for AppDynamics had come in at a valuation of $1.9 billion, so the IPO could have even been considered a "down round."
So, why did Cisco pay up? Let's go through some of the possible rationales.
What is AppDynamics?
AppDynamics is an enterprise software company that is essentially a diagnostic tool for large IT departments. Many businesses now have a complex assortment of applications, databases, on-premise servers, and cloud infrastructure, plus other networking components that form the backbone of their businesses. The interplay between all of these tools can cause bottlenecks, slow performance, or even crashes. Traditionally, IT professionals would have to do extensive detective work to find trouble spots and get everything performing at an optimum level.
AppDynamics makes software that will detect what is wrong and can vastly cut down the amount of troubleshooting IT teams have to do. It also allows real-time monitoring of all of the elements in a company's network. That type of insight is very valuable. For instance, if a company's webpage is not loading correctly, that can result in lost sales.
AppDynamics boasts a laundry list of high-profile companies that rely on its services, from Charter Communications (NASDAQ: CHTR) to Kraft-Heinz (NASDAQ: KHC) . The Motley Fool is also a customer.
It appears Cisco didn't want to let this product and management team slip through its grasp, so out came the checkbook.
AppDynamics has been compared to New Relic (NYSE: NEWR) and Solarwinds.
New Relic has a market cap around $1.93 billion and the stock trades around eight times revenue. That being said, New Relic's year-over-year revenue growth of 43% in the third quarter is slightly slower than AppDynamics at 54%.
Solarwinds used to be a public company, but was bought out by private equity firms in early 2016 for $4.5 billion. The buyout represented a 44% premium over the stock's price before news of the deal surfaced. Solarwinds had a somewhat larger suite of products, though, beyond merely application management.
Don't forget attach rates
While some people may scoff at the premium Cisco is paying, one must always remember the concept of attach rates in these types of acquisitions. An attach rate is when a large company is able to cross-sell a secondary product into its existing customer base, thereby giving the secondary product a much larger market than it would have had on its own.
While AppDynamics has an impressive list of public and private clients, it is nowhere near the level of penetration that Cisco has among enterprise, commercial, and service provider businesses.
Taking this into account, investors should assess the attach rate Cisco can produce for AppDynamics. Surely Cisco is looking to add software and services capabilities to its suite of enterprise products. The company is struggling with its legacy hardware businesses, which are becoming more and more commoditized. In response, Cisco is attempting to boost its software and services portfolio via venues including cybersecurity, performance-enhancing solutions such as AppDynamics, or 2016's IOTservices acquisition, Jasper Technologies.
Thus, if Cisco can immediately "attach" AppDynamics to its existing product bundle and spread it quickly, it's possible Cisco can make a good return. Moreover, AppDynamics had been losing money because of its high sales and marketing efforts, so perhaps Cisco, in folding the company into its own sales force, can boost profitability as well as growth. We just don't know yet how successful Cisco will be in this regard.
To be sure, Cisco investors may have been wary about the price it's paying for AppDynamics. Still, the company does appear to have a best-in-class offering, and it's possible Cisco can accelerate the company's growth and margins.