The last couple of years have been relatively quiet when it comes to high-profile mergers and acquisitions in the technology space. In recent months, however, investors have seen the likes of Microsoft, Alphabet, and Amazon invest billions into artificial intelligence start-ups like OpenAI and Anthropic.
While these transactions have garnered lots of attention, they represent only a small slice of the overall appetite of big tech. Cisco Systems (CSCO -0.50%) recently announced its intention to acquire cybersecurity firm Splunk (CSCO -0.50%) for $28 billion.
Let's dig into the specifics of Cisco's proposed deal and see if now is a good opportunity to buy some shares before the deal is finalized.
How can Splunk help Cisco?
As it stands, almost 70% of Cisco's total revenue is concentrated in one category: secure, agile networks. On the other hand, end-to-end security accounts for less than 10% of revenue and grew only 4% during the company's fiscal year, ended July 29. Given the increasing demand for cybersecurity applications, Splunk appears to be an attractive target for Cisco as it looks to augment its own offerings.
The strategic rationale makes sense at a high level, and Cisco's management provided investors with some important details around the transaction. Upon announcing its intent to acquire Splunk, Cisco published a presentation on its investor relations site that was filled with helpful takeaways.
It believes Splunk can add $4 billion in annual recurring revenue to its existing business. This should be attractive for investors because bolstering its recurring subscription revenue should, in theory, lead to margin expansion.
Management also alluded to the fact that the deal will carry meaningful synergies across go-to-market and product teams. This likely means that Cisco will employ head-count reductions and eliminate overlapping vendor costs in an effort to trim the combined expense profile.
The combination of accelerating revenue, expanding margins, and cost savings are forecast to generate accretive cash flow in the first year following the close of the deal. This all looks good, but there are a number of risks that investors should consider before loading up on Cisco stock.
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A look underneath the hood
Cisco does not carry the same allure as other high-flying software growth stocks. Rather, the company is more of a blue-chip name that might attract investors due to its overall healthy financial profile and dividend. For this reason, the prospects of a big acquisition might spook some investors. However, management made it clear that the Splunk deal is not going to affect existing shareholder-value programs such as buybacks and dividend increases.
The proposed transaction also needs to clear regulatory hurdles from the Federal Trade Commission (FTC). To me, this could be the biggest threat. The FTC has ratcheted up its scrutiny over mergers and acquisitions to address heightened antitrust concerns. One of the more notable deals involving the FTC is Microsoft's proposed takeover of gaming company Activision Blizzard. While all signs point to the deal going through, the regulatory process has gone on for almost two years.
Should you invest in Cisco?
To me, Cisco's proposed acquisition is a signal to the competitive landscape. Management understands that it needs to identify more growth catalysts in an effort to diversify the business.
However, should Cisco have decided to invest internally by building new teams and marketing campaigns, the company likely would have faced an uphill battle. Cybersecurity in particular is becoming increasingly dominated by newer entrants such as CrowdStrike, SentinelOne, and Okta, to name a few. Furthermore, Splunk operates in a crowded market that includes the likes of legacy big tech enterprises as well as younger players such as Datadog.
By acquiring Splunk, Cisco is not necessarily adding a rocket ship to its platform. However, it does immediately provide Cisco with a broader total addressable market and presents some obvious cost savings that make the financial dynamics of the deal attractive. In addition, Splunk already possesses the ability to integrate with a tool called AppDynamics, which Cisco acquired back in 2017.
So while this deal might seem like a technology dinosaur looking to inject some new life into the business, the addition of Splunk into Cisco's ecosystem actually looks pretty savvy.
CSCO PE ratio data by YCharts.
The chart above illustrates Cisco's price-to-earnings (P/E) ratio over the past three years. Investors can see that the stock is trading at a heavy discount compared to a couple of years ago.
What's more, I do not think that potential tailwinds from the Splunk deal are priced into the stock. I believe that Wall Street is discounting the overlap between AppDynamics and Splunk, and does not appreciate Cisco's ability to cross-sell more products to new and existing customers.
Given the accretive nature of the deal, I think Cisco could be an attractive stock to own for the long term should the deal be approved.
