Cisco May Not Be Bouncing Back Soon

The stock-fueled acquisition binge that had Cisco doing nearly two deals a month--and that fed its sales growth--is at a sudden halt

The Nasdaq had topped out weeks earlier. But as Monday, Mar. 27, 2000, dawned, faith in Cisco Systems (CSCO ) still ran high. Just two trading days before, the Internet titan's stock split for the fourth time in 27 months. Then, at 10:25 that morning, in a final hysterical spasm, a single, 100-share lot traded up at $82--the peak from which Cisco has since plunged 80%. Below $16, Cisco must be hysterically cheap. Right?

It's nice to imagine that. Yet beyond the gloomy sales forecasts that are fast becoming CEO John Chambers' regular gig, there's another, less appreciated reason why Cisco stock may have more room to fall. Cisco used its stock freely to pay for an acquisition binge that fed its revenues. In its relentless rise, the stock helped to seduce merger targets. Now, it's acting as a cold shower on Cisco's acquisitions--and growth.

After announcing 18 deals valued at $14.5 billion in 1999, and 23, or $11.4 billion, more in 2000, Cisco this year through March announced none (chart). In last year's March quarter, it unveiled seven. Cisco acknowledges the pause but cautions against making too much of it. "Our acquisition strategy remains unchanged," a spokeswoman told me. "Acquisitions are less difficult in a market like this." Startups, she added, now would be happy to be bought out rather than take their chance on an initial public offering. There's truth in that. It's also true that companies aiming to be bought will have to slash their asking prices.

Yet at the same time, these companies probably will demand more cash, less stock. Steve Workman is chief financial officer of Finisar, an optical networking company that, like Cisco, has grown in part through stock deals. He told me that while some sellers will see an upside potential in today's lower market values and accept stock as payment, "cash will play a greater role" overall. Bob Mohalley recently retired as chief strategist at Lucent Technologies' (LU ) fiber-optic unit. "Cash is king," he says. "I can hear the [sellers'] conversations going on--`I don't want stock, because what if it goes down more?"'

So far, Cisco has had to use remarkably little cash in deals. Stock and options made up payment for all but $154 million of the nearly $21 billion in acquisitions that Cisco closed in its fiscal 2000, which ended last July. Lately, however, the share of cash in acquisitions has been growing. In fiscal 2001's first half, Cisco closed nine deals, valued at $2.3 billion, $205 million of it in cash. It also spent $806 million in cash for minority stakes in other businesses, vs. $125 million in cash during fiscal 2000's first half.

GRIM MATH. Cash is always precious. But also chilling Cisco's dealmaking is that with its lower stock price, acquisitions financed by stock would dilute shareholders' stake far more than before. Last May, for example, Cisco bought Qeyton Systems in a deal valued at $800 million. In payment, the Swedish developer of optical multiplexing took 13.7 million Cisco shares, then trading near $59. Imagine if the deal were done today. With its stock at $16, Cisco would need 50 million shares to get to $800 million. Even if Qeyton halved its asking price--given the market, a reasonable guess--the grim math means Cisco would need to issue 25 million shares in payment.

By all accounts a masterful marketer, Cisco boasts myriad ways to spur growth once the clouds over the economy and telecom lift. Its spending on internal research also has been surging faster than revenue. Yet there's no escaping that 71 acquisitions since 1993 to fill out or extend its product line have proved integral to Cisco's great fortune. Whenever it has spotted the next optical-transport-dense-wave-VPN-connector shop it needed for growth, Cisco could snap it up with currency more alluring even than Federal Reserve notes--a stock that in each year over the past decade returned an average of 73%.

Today, Cisco's 7.3 billion shares look like so many notes on the Bear Republic. That reality won't help Chambers whenever he strides in to clinch a deal with Cisco's next takeover target.

By Robert Barker

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