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Will Cisco Increase Its Exposure to China by Buying Acacia?

By Leo Sun – Jul 10, 2019 at 9:40AM

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The optical equipment maker that Cisco just bought for $2.6 billion was temporarily caught in the trade war crossfire last year.

Cisco (CSCO -1.08%) on Tuesday agreed to acquire optical equipment maker Acacia Communications (ACIA) for $2.6 billion. Cisco will pay $70 per share for Acacia, representing a 46% premium to its closing price on Monday, and the deal should close in the second half of Cisco's fiscal 2020, which ends next July.

Acacia was already one of Cisco's suppliers. Its chips and machines, which translate optical signals into data, are used to upgrade data centers and telecommunication networks. Buying Acacia could reduce Cisco's supply chain costs, enable it to sell upgraded gear to hyperscale data center owners like Amazon, and establish a new revenue stream by selling optical components to other companies.

Two hands (comprised of networking connections) shaking against a dark background.

Image source: Getty Images.

David Goeckeler, Cisco's networking and security business chief, stated that the "acquisition of Acacia will allow us to build on the strength of our switching, routing and optical networking portfolio to address our customers' most demanding requirements."

The acquisition makes strategic sense, but investors might recall that Acacia's heavy exposure to the Chinese market nearly crippled the company last year when the Trump Administration blocked American companies from selling components to Chinese tech giant ZTE (ZTCOY).

That ban was ultimately reversed, but Acacia still generated 29% of its sales from China last year. For comparison, Cisco only generates about 3% of its sales from China. So would buying Acacia significantly increase Cisco's exposure to China, the trade war, and tariffs?

Is Acacia exposed to the trade war?

Acacia's revenue in China plunged 33% to $98.9 million last year amid the ZTE drama and slower network upgrades. That slowdown, along with the company's weakness in the U.S., caused its total revenue to fall 12% to $339.9 million.

However, Acacia's revenue in China nearly doubled annually to $42.9 million in the first quarter and accounted for 41% of its sales. Acacia attributed that growth to robust orders from its two largest network equipment manufacturer (NEM) customers.

Acacia noted those Chinese NEMs were providing more equipment to massive customers like Baidu, Alibaba, and Tencent, which are all expanding their cloud-based ecosystems. Those orders indicate that the ZTE ban, Huawei drama, and escalating tech war didn't discourage Chinese companies from buying Acacia's components.

Acacia also stated that most of its products weren't subject to existing tariffs. Since the Trump Administration recently paused tariff hikes against China in a temporary trade truce, Acacia probably won't face any near-term tariff pressures.

Clashing shipping crates adorned with the American and Chinese flags.

Image source: Getty Images.

In the first quarter of 2019 Acacia generated 31% of its revenue from ZTE, 18% from Cisco, 10% from Infinera, and another 10% from ADVA. Acacia's heavy dependence on ZTE is still a soft spot for the company, especially if the trade war escalates again, but its outlook in China looks stable for now.

Will Acacia significantly increase Cisco's exposure to China?

Wall Street expects Acacia's revenue to rise 34% to $455.5 million this year, while Cisco's revenue is expected to grow 5% to $51.8 billion.

Assuming Acacia generates 40% of its revenue from China this year, that would equal just $182 million, or just 0.3% of the two companies' combined revenues. Those percentages should shift by the time the deal closes, but it's safe to say that buying Acacia won't significantly increase Cisco's low single-digit exposure to China.

Instead, investors should focus on Cisco's ability to develop more in-house optical equipment, the enhancement of its hardware with Acacia's high-speed digital signal processing (DSP) technologies, and the widening of its moat with more competitive bundles of networking hardware, software, and security solutions.

In other words, investors shouldn't fret over China and focus on Cisco's promising long-term growth prospects instead.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon, Baidu, Cisco Systems, and Tencent Holdings. The Motley Fool owns shares of and recommends Amazon, Baidu, and Tencent Holdings. The Motley Fool recommends Infinera. The Motley Fool has a disclosure policy.

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