I've owned shares of networking hardware giant Cisco Systems (CSCO -0.33%) since 2012. A lot has happened since then. Cisco has gone through multiple cycles during which its sales temporarily slumped, its longtime CEO was replaced, it shifted toward software and services, and it made some pretty big acquisitions.
I haven't liked all of Cisco's acquisitions. The company paid $3.7 billion in 2017 for AppDynamics, an application performance management software provider, adding to its portfolio of software solutions. The price tag on that deal was about 16 times AppDynamics' annual sales, and it was signed right before the company was set to go public at a lower $2 billion valuation. It was strange, and it didn't sit well with me.
All things considered, I think Cisco is still a great stock to own. The company has a dominant share of the networking hardware market, and that hasn't really been threatened by lower-cost competition and the rise of cloud computing. It would take a really bad acquisition for me to consider dumping my shares.
Please don't do it
Rumors emerged from Street Insider last week that Cisco might be considering an acquisition of content delivery network provider Fastly. Shares of Fastly have had quite a run this year, although the stock has slumped hard from its all-time high. Fastly stock is up over 330% year-to-date, but down about a third from its peak.
Fastly is an expensive stock. The company is valued at about $10 billion, or about 34 times the high end of its revenue guidance for 2020. And growth is slowing: Backing out some extra revenue Fastly expects from an acquisition, sales are expected to grow by just about 25% in the fourth quarter. The loss of revenue from TikTok is part of the problem, but the company also warned in October that it was seeing lower-than-expected platform usage from some of its other customers.
If Cisco were to buy Fastly, it would likely have to pay a premium on top of an already exorbitant price. It would be getting a relatively slow-growing company, at least in the world of high-flying cloud stocks. The bigger problem, though, is the gross margin situation.
Cisco managed a GAAP gross margin of 63.6% in its latest quarter. Cisco is still primarily a hardware company, and hardware typically isn't as profitable as software. Each additional unit of hardware sold carries substantial costs, while each additional unit of software sold costs little.
It would make sense for Cisco to aim to acquire software and cloud companies that could help boost its gross margin in the long run. One of the upsides of Cisco's ongoing shift toward software is the potential for margin expansion, after all.
But Fastly does not have the same economics as your typical software company because it must pay for bandwidth, peering, and colocation for its services. The company warned in its S-1 filing that its cost of revenue as a percentage of total revenue might increase in the future, which would push down its gross margin.
Fastly's gross margin, by the way, was just 58.5% in its latest quarter. That's right: This high-flying cloud company has a lower gross margin than stodgy hardware company Cisco.
At the right price, Fastly could be a reasonable acquisition for Cisco to make, profitability issues aside. But for $10 billion or higher, it makes no sense at all. I've weathered some questionable acquisitions as a Cisco shareholder, but a Fastly acquisition may be a bridge too far.