Aug 26: Upgraded by Thomas Weisel from Buy to Strong Buy
Cisco to buy Cerent, Monterey for $7.36 billion
PALO ALTO, Calif., Aug 25 (Reuters) - Cisco Systems Inc. (Nasdaq:CSCO) , the world's largest maker of computer networking equipment, said on Thursday it agreed to buy Cerent Corp. and Monterey Networks Inc. for a combined $7.36 billion in stock.
The deals represent one of Cisco's most aggressive moves yet into the hot market for optical networking, which uses fiber-optic cables to transmit data, voice and video across both phone and data networks. They also should turn up the heat on competitors like telephone equipment suppliers Lucent Technologies Inc. (Nyse:LU) and Nortel Networks .
Cisco said it will exchange 100 million shares of its common stock for all of closely held Cerent's shares and options, making it Cisco's largest-ever acquisition at $6.86 billion, based on Cisco's closing price Wednesday of $68.625.
The purchase of privately held Texas-based Monterey Networks is valued at $501 million, based on the 7.3 million shares Cisco is paying. Monterey Networks makes so-called cross-connect technology that boosts network capacity at the core of an optical network.
The Cerent deal is believed to be the most ever paid for a privately held technology company, analysts said, and shows the staggering premiums being paid for companies developing technology to help phone companies build faster networks.
Analysts praised the transaction as strategically sound and, although there were initial concerns about the deal hurting Cisco earnings because of the large price. Cisco Chief Financial Officer Larry Carter told analysts that it would be only "neutral to slightly dilutive" to net income.
Cisco will take a charge of 7 to 11 cents a share in the current fiscal first quarter for in-process research and development, and boards of both companies have voted in favor of the deals, the San Jose, Calif.-based company said.
Asked how he could justify the hefty price for Cerent, Cisco Chief Executive John Chambers said at a conference in Austin, Texas, "We who understood our market understood that optical transport was going to explode and so our shareholders as well as industry analysts have been asking us for a while what were going to do."
The market for telephone equipment is worth more than $300 billion, and as the Internet continues its geometric growth, phone and cable companies need to upgrade their networks to accommodate demand. Traditional phone networks will be replacing their circuit-switch technology with networks that carry packets of digital data the way the Internet does.
Because of the vast opportunity, Cisco is aggressively targeting far larger rivals with long and close relationships with phone companies.
"This does hit in the heart of what Lucent and Nortel are doing and where much of their growth is coming from," said Martin Pyykkonen, an analyst at CIBC World Markets.
Pyykkonen said this was exactly what Cisco needs to do to keep sales, profits and its stock price rising.
Cisco's sales to phone companies, Internet service providers and cable companies are growing at 70 percent a year, and accounted for 30 percent of fiscal 1999 revenue of $12 billion. Traditional data networking gear accounts for 70 percent of sales and is growing at about 30 percent annually.
"One of the things I've harped on a lot with Cisco in the past year and a half is that service provider growth is very important to them," Pyykkonen said.
Cerent's only product, the Cerent 54, is a box the size of a microwave oven that sits between the fiber-optic cable and routers or cable systems or other devices. Using sophisticated software, it organizes and compresses the data -- whether voice, data or video -- and vastly increases the size of the pipe through which that information is sent.
It also lets Internet service providers change the effective size of the data pipe, known as bandwidth, almost on the fly. Service providers such as PSINet, a Cerent customer, could then allocate bandwidth in a matter of minutes rather than the several days now required, Cisco said.
"Cisco will be able to roll out some pretty sophisticated bandwidth management tools," which service providers need, said analyst John Armstrong at market research firm Dataquest.
Cerent, based in Petaluma, California, did not come cheap. Coupled with the $6.86 billion Cisco is paying and including the 6 million-share, or 8.2 percent, stake, Cisco already held, the deal values each Cerent employee at more than $20 million.
While Cerent is losing money -- it lost $29.3 million, or 54 cents a share, on sales of $9.92 million for the six months that ended June 30 -- its annual sales are now at a run rate of $100 million, Cisco executives said on a conference call.
Cerent, which was founded in 1997 and now has 287 employees, said in July it planned to raise $100 million through an initial public offering, but analysts said it was obvious Cisco had made Cerent an offer it could not refuse.
Cerent's "current order rate is way over $100 million (annually)," Chambers said. "Now that ramp-up in this market would have fetched a much higher number in an IPO."