Cisco Systems: A Big Deal For Splunk
Contributor since 2011 / 24554 Followers
Summary:
- Cisco Systems’ shares fell after announcing a $28 billion deal to acquire Splunk, as the market questions the premium and Cisco’s M&A track record.
- The deal with Splunk is strategic and will improve Cisco’s competitive positioning, but it comes at a cost and makes some investors cautious.
- Cisco’s valuation has been re-rated to a higher multiple, and the deal adds uncertainty, leading to caution in getting involved at current levels.
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Shares of Cisco Systems (NASDAQ:CSCO) fell amidst the announcement of $28 billion deal for Splunk (NASDAQ:SPLK) as the market is not convinced that the premium or Cisco’s M&A track record justified such a big deal.
To see how the deal impacts the investment case, we go back to the final days of 2022 when I believed that Cisco was surprisingly resilient as it hiked the 2023 guidance following a solid first quarter earnings report. While I believed that Cisco was too large to escape softening market conditions, overall valuations looked reasonable, and I was willing to buy on dips.
The deal for Splunk is strategic and will improve the competitive positioning of Cisco and furthermore add about 6% of faster growing sales to the business. It does come at a cost as Splunk incurs some operating losses here and Cisco will incur interest expenses (and forfeit interest income) as it spent $28 billion in cash to acquire the firm. All this makes me a bit cautious, although greater dips to the forties are seen as an attractive entry opportunity.
The Base
Besides huge volatility around the dotcom crisis, Cisco has been a rather steady value creator as it has combined a bolt-on deal strategy with steady buybacks. A $20 stock in the early 2010s, as the world was coming out of the big recession, it steadily advanced to the $40s in 2017, even traded in the $50s in 2019 and started around the $40 mark when the pandemic arrived.
The gains achieved over the decade have been rather modest as revenues only rose some 10% from $47 billion in 2014 to $51 billion in 2022, as quite frankly organic growth (outside M&A) likely has been negative, or at least not meaningful. In the meantime the company managed to get more profitable with GAAP operating earnings advancing from about $10 billion to $15 billion as the greatest achievement might have been a quarter of a reduction in the share base.
Going to the summer 2022 Cisco posted its fiscal 2022 results, a year in which revenues rose some 3% to $51.6 billion on which GAAP earnings of $2.82 per share and adjusted earnings of $3.36 per share were reported. With most of the discrepancy between both earnings metrics relating to stock-based compensation expenses, the GAAP earnings likely were more representative. Net cash was down to about $10 billion, with these balances being equal to $2.50 per share.
Trading at $40 in the summer of 2020, valuations weren’t demanding at all, as the business traded at just 13 times earnings if we factor in net cash holdings. Moreover, the company guided for fiscal 2023 sales to rise by 4-6%, with adjusted earnings seen up to $3.49-$3.56 per share. Following this outlook and a solid first quarter earnings report, shares rose to $47 by year-end 2022, which pushed up realistic valuation multiples to 14-15 times earnings.
This marked some valuation re-valuation, but these were still undemanding valuations. With a tougher operating environment coming up, I was cautious to chase the shares at those levels, waiting for a pullback before becoming involved.
2023 – Turning Eventful
Since I last looked at Cisco in December 2022, shares have traded in a $45-$50 range in the first half of 2023, as shares recently rose to the $58 mark. Shares traded at $55, ahead of a decisive move.
The peak in the share price coincided with the release of the 2023 results in mid-August. Full year sales actually rose by a solid 11% to $57.0 billion, far exceeding the original guidance for the year. The company managed to grow GAAP earnings from $2.82 per share to $3.07 per share, amidst a modest increase in operating profits, higher interest expenses and a small reduction in the share count. Adjusted earnings rose to $3.89 per share and if we subtract a $0.57 per share stock-based compensation expense, adjusted earnings run closer to $3.30 per share.
Net cash holdings rose to nearly $18 billion as a 4.1 billion share count granted equity a valuation of $225 billion at $55 per share. Adjusted for net cash this values the business at $207 billion. Following the strong year, the company trades around 15 times realistic earnings of around $3.30 per share if we back out the growing net cash holdings.
This comes amidst tougher conditions as the outlook for the fiscal year 2024 is not too convincing, with sales seen between $57.0 and $58.2 billion, seen flat to up 2% on 2023. Non-GAAP earnings are set to rise in a modest fashion to $4.01-$4.08 per share.
A Big Deal – Adding Splunk
In a rather spectacular move, Cisco announced its intention to acquire Splunk in a $157 per share cash deal, granting the business a $28 billion valuation, equal to just over 10% of the existing business.
The deal is that the addition of Splunk will allow Cisco and its customers to help organizations to improve threat detection and response capabilities. Both companies hope that complementary capabilities in AI, security and observability will create value for its customers and the business. With shares down $2 per share, or nearly 4% in response to the news, shares of Cisco lost $8 billion in value, marking healthy skepticism to the deal, more than the roughly $6 billion premium paid for the shares of Splunk which traded around the $120 mark pre-deal.
This is not due to concerns on the position of Cisco, as the dividend and buyback program are kept intact, as pro forma net debt load of $10 billion remains very manageable. Furthermore, there is still a long way until deal closing, which means that we might never see such a net debt load. With the $28 billion deal being equal to 12% of the valuation of Cisco, it is Splunk which commands a higher valuation.
Splunk is generating about $3.5 billion in sales which commands a premium sales multiple at around 8 times. Moreover, the business shows double-digit growth, but the issue is that the business is reporting narrowing losses of around half a billion. Furthermore, Cisco might increase the net debt load by a delta of $28 billion, easily adding over a billion in interest expenses. This and the added operating losses make that the business might hurt pre-tax profits by $1.5 billion. After taxes, this could easily result in about thirty cents dilution, although in an interview management suggests that dilution should be modest, with accretion seen soon thereafter.
What Now?
The deal with Splunk adds about 6% of sales to Cisco’s business, but some growth is needed to further bolster Cisco’s growth profile, although it comes at the expense of the near term dilution. The deal makes strategic sense to improve the strategic position of the business and add growth, AI and cybersecurity to the offerings, but it seems that the burden of proof is with Cisco’s management here.
With realistic GAAP earnings trending lower to $3 per share and net cash holdings being depleted, Cisco has been re-rated to a 17-18 times multiple at $52, which is on the higher end of the range in which shares have historically traded. This makes me naturally cautious as the deal will cause some uncertainty for a while, as all of this and a modest addition to the business makes me a bit cautious.
That said, the market has priced in quite a bit of the disappointment already, which makes me cautious to get involved at these levels, but willing to reconsider if shares drop further to the high forties.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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