Cisco (NASDAQ:CSCO) recently agreed to buy California-based chipmaker Luxtera for $660 million in cash and assumed equity awards. Luxtera uses silicon photonics to develop integrated optics capabilities for data centers and other enterprise customers.

Cisco will integrate Luxtera's technologies into its networking portfolio. David Goeckeler, executive VP and general manager of Cisco's Networking and Security Business, stated that merging the two companies' silicon and optics innovations would enable Cisco's customers to "build the biggest, fastest and most efficient networks in the world."

Network connections across a city.

Image source: Getty Images.

Goeckeler noted that with global internet traffic increasing "threefold over the next five years," improved optics will help customers meet "an exponential demand for Internet bandwidth." Cisco expects the deal to close by the third quarter of fiscal 2019.

Here are three likely reasons Cisco wanted to acquire this privately held company.

1. Widening its moat against Arista Networks

Cisco's most disruptive challenger is arguably Arista Networks (NYSE:ANET), which sells cheaper network switches tethered to EOS, its open-source cloud-based operating system. Arista believes that it will render traditional routers obsolete with a combination of switches and cloud-based routing software.

Cisco generally sells big bundles of proprietary switches, routers, and software services -- which leaves it vulnerable to Arista's cheaper switches and cloud-based networking solutions. Arista's market share in switches remains much lower than Cisco's, but its share has been growing as Cisco's has declined:

 

Q3 2017

Q3 2018

Cisco

56.7%

54.4%

Arista

5.6%

6.6%

Global market share of ethernet switches. Source: IDC.

IDC reported that about two-thirds of Arista's revenue now comes from higher-end 100-gig ethernet switches thanks to its focus on cloud providers and big enterprise customers. Arista plans to deploy its next-gen 400-gig ethernet switches in the second half of 2019.

However, Arista expects some optics supply shortages next year -- which explains why Cisco acquired an optics company. Cisco claims that buying Luxtera will expand its 100-gig and 400-gig portfolios, and that optics will play "an increasingly important role in addressing network infrastructure constraints, particularly density and power requirements" in those higher-end markets. It also believes that integration will help customers build "future-proof networks optimized for performance, reliability, and cost."

2. Offsetting a potential deceleration in sales and earnings growth

Cisco's stock remains up about 15% this year thanks to an impressive streak of accelerating sales and earnings growth:

 

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Q1 2019

Revenue

(2%)

3%

4%

6%

8%

EPS*

0%

11%

10%

15%

23%

YOY growth. *Non-GAAP. Source: Cisco quarterly reports.

That growth was attributed to stronger demand for its hardware products from enterprise campus and data center customers, the expansion of its higher-growth applications and security businesses with new products and acquisitions, and the growth of its higher-margin subscription-based software revenues. Analysts expect that momentum to continue with 5% sales growth and 17% earnings growth this year.

However, Nomura Instinet analyst Jeffrey Kvaal recently downgraded Cisco from "Buy" to "Neutral", warning that "some tailwinds, notably IT spending strength, may reverse in 2019 to reveal imperfections in Cisco's story."

A close-up photo of an optical cable.

Image source: Getty Images.

Acquiring Luxtera might help Cisco ramp up its 400-gig portfolio faster, which might offset softer spending in lower-end markets. Cisco's VP of Corporate Business Development, Rob Salvagno, also noted that the acquisition "significantly improves performance and scale while lowering costs" for Cisco, which could protect its long-term earnings growth.

3. It has plenty of cash for domestic acquisitions

Earlier this year, lower corporate tax rates enabled Cisco to repatriate $67 billion in overseas cash. Cisco earmarked most of that cash for buybacks, dividends, and domestic acquisitions.

Many of Cisco's previous acquisitions, like Broadsoft and Duo Security, were aimed at expanding the company's applications and security businesses. Buying Luxtera will strengthen Cisco's core Infrastructure Platforms unit, which accounted for 58% of its revenues last quarter.

The key takeaways

Luxtera reportedly generates less than $50 million in annual revenue, which is a drop in the bucket compared to Cisco's estimated revenue of $51.6 billion this year. However, integrating Luxtera's technologies could give Cisco an edge in the 100-gig and 400-gig markets, boost the growth of its Infrastructure unit, and reinforce its "best in breed" reputation in the networking hardware market.

Leo Sun owns shares of Cisco Systems. The Motley Fool owns shares of and recommends Arista Networks. The Motley Fool has a disclosure policy.