Investors have to start taking notice when IT stalwarts such as Cisco and Lucent fork out surreal amounts of money for small companies who have never even heard of the word profit.
Earlier this year, Ford paid $US6.4 billion for Volvo's car business. In exchange, Ford got one of the most venerable and respected names in the auto industry. It also obtained factories and assembly lines, offices and relationships with suppliers and dealers that took Volvo decades to build and nurture. Ford also got thousands of new customers worldwide for Volvo's $35,000 cars.
Late last month, Cisco Systems shelled out $US6.9 billion for Cerent Corporation, which posted less than $10 million in sales in the first six months of this year and whose operations, serving about 100 customers during the company's brief history, have had nothing in common with the word "profits".
The deal came a month after Cisco rival Lucent acquired International Network Services, a $300 million integration company, for $3.4 billion. That's roughly 10 times revenue, a benchmark different from the 10-times profit figure that until recently was used to guide technology company acquisitions. Cisco paid roughly 300 times revenue for Cerent.
Has the world gone nuts? Has Cisco, arguably one of the best-managed companies on Earth, taken leave of its senses? Should you be worried about some of your main suppliers?
The answers to these three questions are yes, no and maybe. Investors have given market values to startups, primarily Internet companies, that utterly defy logic. Then the startups go off half-cocked on acquisition binges they are unprepared to manage.
Cisco isn't a startup and historically hasn't gone off doing half-cocked things. So what explains its action? What should you look for in evaluating whether your suppliers are acting rationally?
First, understand that the currency of choice in acquisitions today is paper, not cash. Cisco bought Cerent with stock, and with Cisco's market value of some $225 billion, $6.9 billion isn't a lot at all. If the stock market believes at some point that Cisco is vastly over-valued, its stock price plummets. But it still owns Cerent. It's the shareholders who are out big money.
Second, you have to look closely at just what the company is buying. The biggest buyers of high-end network equipment today are the booming telecom vendors. Cerent makes gear that moves data across fibre-optic lines at phenomenal speeds and volumes, which is what the telecom vendors want. It would have taken Cisco years to develop the technology on its own, by which time rivals like Lucent may have beaten them to market.
Third, look closely at a vendor's track record at assimilating acquired companies and technologies.
Cisco's track record is remarkable. Its 40 acquisitions spanning an eight-year period have each contributed to its amazing record of sales and profit growth, not to mention customer service. Not one clunker.
Although deals like Cisco-Cerent have elements of otherworldliness, you have to examine them from different perspectives before passing judgment, particularly when you do a lot of business with a vendor and might be wondering if it's gone off the deep end.