Cisco (CSCO -0.60%) recently agreed to buy cybersecurity start-up Duo Security, which provides a two-factor authentication service, for $2.35 billion in cash. Two-factor authentication systems require a user to not only provide a password, but also a confirmation from a second device (usually a phone) as an added layer of security.
Duo was founded in 2009 and raised $118 million in funding. Its major investors include Alphabet's Google Ventures, Workday, and True Ventures. Duo was valued at $1.1 billion after its last funding round, so Cisco is paying a hefty premium for the company.
Duo’s annual recurring revenue (ARR) rose 135% to $73 million in 2016, and, according to the company, "surpassed" $100 million in 2017. Duo serves over 12,000 customers across 100 countries, including Facebook, Toyota, and Etsy.
It's unclear if Duo is actually profitable, but its integration into Cisco's cybersecurity portfolio should significantly reduce its operating costs. Let's discuss the three main reasons Cisco acquired the company.
1. Expanding its cybersecurity unit
Cisco generates most of its revenues from network routers and switches. Both markets are slow-growth ones, and Cisco has been losing market share on both fronts to rivals like Huawei, Hewlett-Packard Enterprise, and Arista Networks.
To pivot away from routers and switches, Cisco expanded its ecosystem of software services, which include wireless, collaboration, and cybersecurity solutions. It also cross-sells these services with its routers and switches to lock in enterprise customers with competitively priced bundles.
Cisco's software applications and security businesses are its fastest growing units. During the first nine months of 2018, its applications revenue rose 10% annually to $3.7 billion, while its security revenues grew 8% to $1.7 billion. For comparison, revenue from Cisco's infrastructure platforms -- which include its routers and switches -- stayed flat.
Cisco aggressively expanded its security business by buying companies like Sourcefire, ThreatGRID, and Lancope, but the unit only generated 5% of its revenues during the first nine months of 2018. Therefore, acquiring Duo would slightly boost the unit's weight on Cisco's top line.
2. Tapping into a growing cybersecurity niche
The multi-factor authentication market could grow at a compound annual growth rate of 15% between 2018 and 2025 according to Grand View Research, blossoming into a $17.8 billion market by the final year. The firm expects two-factor authentication solutions to account for 75% of the market's revenues through 2025.
Buying a major two-factor authentication player like Duo ensures Cisco rides that market's growth and widens its moat against other major tech companies -- like SAP, which has its own two-factor authentication system, along with newer stand-alone players like Okta (OKTA -3.04%), which went public last year and saw its stock more than triple from its IPO price. Analysts expect Okta's revenue and earnings to rise 37% and 27%, respectively, this year, as more enterprise customers use its multi-factor authentication solutions. Investors are also willing to pay a premium for Okta's growth potential. That's why its stock trades at a whopping 16 times this year's sales.
3. Spending its repatriated cash
Cisco recently repatriated $67 billion in overseas cash after the U.S. cut its corporate tax rates. Cisco plans to spend $44 billion of that total on buybacks and dividends, but the rest will likely be spent on domestic acquisitions.
Cisco only made a few multi-billion dollar domestic acquisitions in recent years, as most of its cash was locked up overseas. Cisco's biggest purchases over the past two years include Broadsoft ($1.9 billion), AppDynamics ($3.7 billion), and Jasper Technologies ($1.4 billion).
Those purchases all expanded Cisco's higher-growth collaboration, mobile, cloud, and IoT businesses and helped Cisco pivot away from routers and switches. With most of its cash now back home, Cisco can continue expanding its cybersecurity portfolio with big purchases like Duo.
What's next for Cisco?
Cisco's willingness to pay such a high premium for Duo to expand its security portfolio isn't surprising. It has plenty of cash to spend, and it desperately needs to grow its software and security businesses. Looking ahead, investors should expect Cisco to buy more companies to accomplish that goal.