Last week, Cisco Systems (NASDAQ:CSCO) announced that it had entered into an agreement to acquire Splunk (NASDAQ:SPLK) for a whopping $28 billion. The networking and telecommunications behemoth, known for its industry-leading hardware and software, saw its stock slip post-announcement, prompting a mixed response from Wall Street. I share reservations about this move, too, as it appears more driven by desperation than seizing a strategic opportunity. Accordingly, I am neutral on CSCO stock.
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What’s the Rationale Behind Cisco Acquiring Splunk?
Before delving into the criticisms surrounding Cisco’s decision to acquire Splunk, it’s essential to explore the driving force behind the company’s pursuit of this acquisition.
Cisco has articulated its motivation as an alignment with Splunk’s established track record of fortifying digital resilience for organizations. Cisco’s management envisions that this strategic move will serve as a catalyst in realizing its vision of “securely connecting everything to enable limitless possibilities.” The acquisition is also expected to help accelerate Cisco’s business transformation to generate more recurring revenue.
Mr. Gary Steele, the esteemed President and CEO of Splunk, has further emphasized the synergy between the two entities. Together, they aspire to create a global security and observability powerhouse, leveraging the transformative capabilities of data and artificial intelligence to deliver exceptional value to customers while redefining industry standards. As part of this collaboration, Mr. Steele is set to join Cisco’s executive leadership team and will report directly to Chairman and CEO Chuck Robbins.
However, recognizing that ambiguous statements alone may not suffice to garner investor support for such a substantial investment, Cisco has proactively provided a promising financial outlook. The company anticipates that the acquisition will yield positive cash flow and enhance its gross margin within the first fiscal year after the deal’s completion. Non-GAAP EPS growth from the acquisition is also anticipated in the second fiscal year after the closing.
In addition to these financial targets, the acquisition is generally expected to invigorate Cisco’s revenue growth and bolster its gross margin expansion efforts. However, it’s important to note that not everything appears as positive as it may seem, in my view.
While there is some merit in Cisco’s justifications for the Splunk acquisition, there is reason to scrutinize the underlying motives more critically. Specifically, it appears that Cisco is grappling with intensified competition in its core business sectors. Therefore, the acquisition of Splunk appears to be a desperate move to shift the market’s attention from this core issue.
Splunk Brings Benefits but Doesn’t Solve the Problems
As I mentioned, the acquisition of Splunk is indeed likely to have merit and benefit some of Cisco’s prospects in achieving increasing security prospects. However, it falls short of addressing the pressing challenge that Cisco faces — losing ground to an increasingly competitive market. Let’s delve deeper into these two crucial aspects.
Splunk’s Contribution to Cisco’s Financials
On the positive side, Splunk is indeed likely to help Cisco transform toward recurring revenue streams. At the end of Splunk’s Fiscal Q2-2024 trading period, the company’s annual recurring revenue (ARR) stood at $3.86 billion. This figure grew by 16% year-over-year, with Splunk’s customers generating more than $1 million in ARR, growing by 111 to 834. Splunk’s business overall is quite sticky, with high conversion costs. Thus, Cisco is likely to benefit from improved cash-flow visibility and other synergies.
Regarding management’s aspiration for Splunk to contribute to profitability within the second year post-acquisition, this is indeed a viable scenario. Despite Splunk’s current financial losses, its cloud services boast an impressive adjusted gross margin of 73.8%. If the two companies successfully capitalize on synergies by sharing R&D resources and trimming general administrative expenses, Splunk could begin contributing positively to Cisco’s bottom line sooner rather than later.
Splunk’s Inability to Solve the Real Problem
However, while Splunk holds promise for Cisco’s financial landscape, it falls short where it truly matters — stemming Cisco’s market share erosion in the face of fierce competition. Perhaps this should be the central focus for Cisco’s management before embarking on costly acquisitions.
One particular entity poses a significant threat to Cisco’s core connectivity product line — Arista Networks (NYSE:ANET). Arista competes head-to-head with Cisco in the market for network switches and other networking equipment. Founded in 2004 by a former Cisco executive, Andy Bechtolsheim, Arista initially targeted high-performance switches for high-frequency trading environments. Over time, it expanded its product portfolio to encompass a broader array of network switches and related offerings.
Arista’s innovation and product excellence have been consistently recognized with multiple industry awards, with its high-speed networking solutions and competitive pricing steadily eroding Cisco’s market position over recent years.
To illustrate the compelling data supporting this argument, Arista reported a remarkable 38.7% growth rate in revenues, reaching $1.46 billion in Q2. Of critical significance, Arista’s market share in the high-speed data center switching market has consistently expanded, going from 3.5% in 2012 to an impressive 25.3% at the end of last year. Simultaneously, Cisco’s market share during the same period declined from 78.1% to 36.3%.
Undoubtedly, this represents a substantial threat to Cisco’s core business, and the acquisition of Splunk does little to address this pivotal issue. While Splunk may provide a short-term boost to Cisco’s revenue figures, the fundamental long-term challenge remains unaddressed. Hence, it’s not far-fetched to argue that the acquisition, at least partially, serves to mask Cisco’s current challenges.
Is CSCO Stock a Buy, According to Analysts?
According to analysts, CSCO stock comes in as a Hold based on six Buys, 14 Holds, and one Sell rating assigned by analysts in the past three months. The average CSCO stock price target of C$58.74 implies 10.4% upside potential.
If you’re wondering which analyst you should follow if you want to buy and sell CSCO stock, the most accurate analyst covering the stock (on a one-year timeframe) is Ittai Kidron of Oppenheimer, with an average return of 19.57% per rating and a 77% success rate. Click on the image below to learn more.
The Takeaway
In conclusion, Cisco’s recent acquisition of Splunk, while motivated by the goal of fortifying digital resilience and increasing recurring revenue, raises concerns about the company’s broader strategic challenges. While Splunk’s contribution to profitability and cash flow could be promising, it doesn’t adequately address the pressing issue of Cisco’s market share erosion.
Moreover, with the all-cash acquisition carrying a substantial price tag of $28 billion, it is poised to exhaust Cisco’s entire cash and equivalents reserve, which stood at $26.1 billion at the conclusion of its most recent quarter filings.
This scenario may exert significant strain on Cisco’s balance sheet. When compounded with the ongoing challenges in its core business, this confluence of factors could potentially lead to adverse outcomes for the company. Therefore, given the overall uncertainties concerning the value of the Splunk acquisition, it may be prudent for investors to stay on the sidelines.
