At the bazaar of high-tech companies, Cisco Systems Inc. is a compulsive shopper. Twice on the same day in early April, $12 billion Cisco bought companies involved with technologies that facilitate voice traffic over data networks. The price: $445 million for the pair. Five days later, Cisco paid $2 billion in stock for GeoTel Communications Corp., in Lowell, Massachusetts, which makes voice call- center software. In less than a year, Cisco has now made eight deals for cutting-edge telecom technology shops.
Rampaging through the same marketplace is Lucent Technologies Inc. In June, the $30 billion provider of communications gear completed its $24 billion acquisition of Alameda, California-based Ascend Communications, a leading supplier of data- networking equipment to the telecom industry and to Internet service firms. It was the 23rd purchase that Lucent has made since being spun off from AT&T in 1996. The next day came announcement of yet another: Nexabit Networks, a maker of high-speed data-routing technology, in Marlborough, Massachusetts. Then, this August, Lucent agreed to pay $3.7 billion in stock for International Network Services Inc. (INS), a Sunnyvale, California, network designer that Cisco had long had in its own sights.
Cisco and Lucent have their origins in decidedly different worlds. San Jose, California-based Cisco is the leading data- networking-equipment provider. Lucent, in Murray Hill, New Jersey, dominates the telecom- equipment arena. But through their acquisitions, the companies are rapidly converging – in a battle to become the leading provider in the crucial new “data-convergence” market. In some ways, their acquisition strategies are strangely similar. Along with Nortel Networks, Siemens AG, and others farther back in the race, Lucent and Cisco aim to provide high-capacity data networking gear to both incumbent and upstart telephone and Internet service providers.
Silicon Valley’s Currency
For its shopping spree, Cisco has moved quickly to scoop up and integrate young firms, choosing that path to “outsource” much of its critical research and development. But so, surprisingly, has Lucent – despite a rich ancestry of research innovation in its former AT&T incarnation.
In part, this is because buying the technology is simply faster. The approach is to “buy the product, buy the engineers, and get a faster time to market” – and let someone else foot the bill to take the initial development risk in the start-up phase, says Christin Flynn, a data-communications analyst with The Yankee Group, a Boston-based consulting firm. Another factor behind the buying frenzy, of course, is the accounting rules that allow generous upfront write-offs for acquired R&D. The anticipated demise of pooling-of-interest accounting will doubtless change the way companies do acquisitions.
A look at the aggressive acquisition strategies of Cisco and Lucent, each with market capitalization around $200 billion, offers insight into one of the major wars for primacy in the 21st-century communications market. In both cases, finance is part of an interdepartmental team. Cisco’s centralized Business Development Group reports to the chief technology officer, and thus straight up to CEO John Chambers. And at Lucent, where acquisition teams grow within each business unit, finance supplies assistance in an effort that works its way through a corporate strategy and development office that reports directly to CEO Richard McGinn.
Both companies shun investment bankers for their acquisitions (although Lucent did retain Goldman, Sachs in its mammoth deal with Ascend) and let their own finance departments take on much of the role that would otherwise go to Wall Street advisers.
The Cisco Kids
Cisco has tended to buy smaller. Despite the big-ticket GeoTel acquisition, most of Cisco’s purchases in the past 18 months have been in the $50 million to $200 million range. That is by design, says Ammar Hanafi, Cisco’s mergers- and-acquisitions director. “Large acquisitions are very hard to make work,” he says. “There are lots of issues to focus on in terms of integration and capturing value.” Smaller is better from the cultural standpoint, too. “We like to think of ourselves as the biggest start-up on the planet,” he explains.
Retention of acquired employees is at the heart of Cisco’s acquisition strategy. “If we’re going to lose the people who are important to the success of the target company,” says Cisco controller Dennis Powell, “we’re probably not going to have an interest” in the company in the first place. “We’re not interested in just bringing in a product by itself. If we don’t continue development of that product, we will not leverage the success of the acquisition as much as we could.”
While the catalyst for an acquisition is often found in the Cisco business units, the dedicated staff in business development and finance provides focus and speed. The company puts together a “virtual acquisition team” for a given purchase, Powell says. The team often includes members of the unit interested in the target company, and a group of dedicated M&A personnel. “Because we are dealing somewhat with the same group of people, the acquisition- team members work well together,” he says. An acquisition can involve as many as eight finance people in combing the target’s balance sheet and the income statement, he says. “We know exactly what our roles are; we’ve done it so many times before. We don’t have a lot of start-up time.”
After the deal, too, Cisco keeps a centralized team of 15 to 25 people ready to take on the integration function, says Hanafi.
It all happens fast, as it must in the world of the Web. Cisco aims for about a two-week spread between when a Cisco line manager sponsors a purchase to the time it is announced, says Morgan Stanley Dean Witter analyst George J. Kelly. “The Internet doubles in traffic every 100 days. There’s nothing in the world except bacteria that grows that fast,” he says. “That has an effect on these companies. To play, you’ve got to think at Internet speed.”
Kelly claims that the investment community has learned to trust Cisco’s judgment as a technology shopper, rarely punishing the stock on news of an acquisition–at least since its purchase of Crescendo Communications Inc., in 1993. That deal, arguably Cisco’s most successful, became a driver of Cisco’s business, according to Kelly. Investors also believe the details Cisco tells them about a deal. “If the company says it’s dilutive this year and accretive next year, [investors] trust them,” he says.
Lucent: Building and Buying
After arriving late to data convergence and the Internet, Lucent has rapidly made up for lost time, announcing 12 acquisitions already this year. Lucent celebrates the strategic value of purchasing outside R&D, but notes that it still finds an advantage over rivals by having access to its 25,000-employee Bell Labs idea factory. Data networking is the area farthest from Lucent’s expertise – so it is the technology Lucent is most likely to purchase, as the company rounds out its telecom capabilities in becoming an end-to-end networker. (For Cisco, voice-trafficking technology is farthest afield from its expertise.)
But Lucent continually weighs the comparative advantages of developing capabilities through its own technology when it considers an acquisition, says Lucent executive vice president and CFO Donald Peterson. “In every space in which we have acquired, we have had simultaneous research projects inside,” he says. “It makes us knowledgeable, and lets us have the build-versus-buy option.”
Halving the Time to Market
Observers see Lucent’s acquisition of Ascend as not only a victory in adding superior technology, but also in growing market share. Ascend, with $1 billion in sales, was squeezing out Lucent’s old product line of massive circuit switches. Ascend offers more- compact, powerful, digitally driven switches for asynchronous transfer mode (ATM) data lines. “It would have taken them probably another year, maybe more, to finish the development on the ATM core switch,” says The Yankee Group’s Christin Flynn. “In this marketplace, you just don’t have that kind of time anymore. The market is changing so quickly, and Ascend products have been successful. So why don’t you just cut your time to market in half?”
Ascend also was a success in employee retention, Lucent claims, with 90 percent of Ascend’s employees staying on after the purchase.
Lucent’s recent large investments in data- routing technology overshadow a score of smaller-company purchases, including the pending $99 million acquisition of SpecTran Corp., a Sturbridge, Massachusetts-based maker of fiber-optic products, and the $145 million buy of Mosaix Inc., a Redmond, Washington, customer-service software maker. Industry observers note that few large targets are left, as Lucent and Cisco round out their product portfolios.
Unlike Cisco, with its dedicated acquisition staff, Lucent devotes no personnel to scouting the horizon for potential purchases, Peterson says. “We view acquisitions as one tool among many that our business units can use to advance their business plans,” he says. “We evaluate acquisitions one by one, in the context of the business strategy of the unit. We’re looking for the unit as a whole to do well. If [an acquisition] helps that happen, we would look at adding it into its business plan.”
The Tactics of Intuition
Both Cisco and Lucent also have been aggressive in taking minority stakes in businesses, a practice that provides additional intelligence about new technologies. In February 1998, Lucent established Lucent Venture Partners, a $100 million fund investing in high-growth, early- stage companies, including those working with wireless and data-networking technology.
While Lucent generally doesn’t disclose specific investments there, Cisco often does. Six Cisco minority investments, it says, have evolved into acquisitions, including Palo Alto, California-based Precept Software Inc., which Cisco agreed to acquire for $84 million in March 1998, after taking a minority equity stake two years earlier. Precept made software enabling video to travel over Internet Protocol (IP), the digital standard of Internet communications. “We saw that as an application that was emerging,” says M&A chief Hanafi. “And when the market started to crystallize a little, we thought an acquisition made sense.”
Yet the traditional return-on-investment models for acquisitions sometimes don’t make sense in the data-networking-telecom arena, some observers say. “So much of what you’re doing when you’re running these businesses is intuitive,” notes Morgan Stanley’s Kelly. “Everything is so strategic and the market opportunities are so great, [immediate returns] are not relevant,” he says “The normal rate of return doesn’t apply, because of the leverage you get from filling in the entire hand [of product offerings]. Especially when you’re using your valuable stock as currency, the risk is minimal.” Some believe companies like Cisco and Lucent take a “portfolio approach” in making acquisitions, aiming mainly to round out their offerings so that they can offer customers a full suite of communications solutions.
Any such suggestion stirs up a hornet’s nest at Cisco and Lucent, of course. “We acquire companies because we believe they will be successful,” asserts Powell. “If we didn’t believe in their success, we would not acquire them.” He maintains that the vast majority of Cisco’s acquisitions were accretive to earnings, but adds that the impact of an individual company is often difficult to separate. Some newly acquired technology often is integrated into preexisting Cisco products, obscuring the return.
Battling for the Bells
If the Cisco and Lucent acquisition strategies seem similar, their targets often were different. But today, their buying patterns are “converging to the point where they are going after the same marketplace,” Kelly says.
Cisco is leveraging its legacy as data networker and a primary builder of the Internet. It has a 67 percent market share in routers, the devices that move data from network to network. It is also the leader in local-area-network and wide-area-network switches, which “intelligently” alleviate data congestion in networks and increase bandwidth. As voice travels well over the IP and ATM- based networks that Cisco produces, the company naturally wants to be first to provide the next generation of full-service, data- networking technology that can integrate voice.
“Cisco has been extremely aggressive, all the while having a fairly glaring weakness,” says Tom Valovic, a telecom analyst with International Data Corp., in Framingham, Massachusetts. “It wants to bridge the old world and the new. But it doesn’t have experience in the old world.”
While Lucent, the dominant old-world telecom- equipment provider, looks to data convergence for the future, it is still reaping strong profits from its traditional circuit-switch offerings. “Lucent is really focusing on an evolution of the network,” says The Yankee Group’s Flynn. “Lucent says, Keep your PBX [public branch exchange], and we’ll evolve you into the next generation. Cisco says, You’re going to be throwing away your PBX.” Lucent’s message has a strong appeal to telecom-service providers, which have made significant investments in the past and “don’t want to junk their legacy equipment.” Adds Valovic: “Lucent is going to have a clear advantage with the incumbents, because of the depth of knowledge of existing systems. And they’ll have the ability to play in the new world. With the ‘green-field’ players, Cisco will have the advantage.”
So, who wins? The burgeoning need for high- speed, high-capacity infrastructure suggests both may. “The market is exploding at such a rate, it’s even hard to determine what the market shares are,” according to Kelly. “Neither company is on the defensive. Both companies are on the offensive, because the market opportunities are enormous.”
———————————————– ——————————— Draining the Pool
Will FASB’s accounting-rule change cool the acquisition frenzy?
The current state of accounting rules is clearly a factor in the frenetic acquisition activity at Cisco Systems Inc. and Lucent Technologies Inc. Like many high-tech companies, the two giants can acquire with little drag on their finances, because pooling- of-interest accounting enables them to avoid the onerous goodwill charges that otherwise would ravage earnings. And when the target company and the acquirer’s book-value assets are combined, the new entity’s asset-based growth is minimized.
But because of the death sentence the Financial Accounting Standards Board has levied on pooling, companies must use straight- purchase accounting after January 1, 2001. Then buyers will have to amortize goodwill for no more than 20 years. It’s hard to imagine a bigger goodwill impact than that which Lucent would have felt after acquiring Ascend. Had Lucent accounted for it as a $24 billion straight purchase, the deal might have generated something in the neighborhood of $10 billion in goodwill charges for Lucent to manage.
“We’d be taking at least a billion-dollar-a- year hit,” says Lucent CFO Donald Peterson. Lucent’s fiscal 1999 net income is projected to be about $3.8 billion. Ascend’s equity was slightly over $2 billion at the end of 1998.
Still, “I would like to think our acquisitions are predicated on business strategy and returns rather than accounting,” Peterson says. “My expectation is we will see the investment community go to some kind of cash- equivalent earnings, and the market will look through this kind of thing.”
Chuck Hill, director of research at First Call/ Thomson Financial, agrees. “We’ll be looking at earnings before amortization for some companies,” he says. “Suddenly, they’re going to be valued on a different basis.” Indeed, such a valuation strategy is already being worked into projections at First Call.
Cisco controller Dennis Powell is still peeved, at least on the macroeconomic level, by the FASB rule change. “What’s broken and needs to be fixed?” he asks. “We’re talking about a financial model that’s creating the highest level of confidence in capital markets in the world. This accounting model has served us.”
FASB’s response? “Virtually every business combination is an acquisition of one company by another,” says Kim Petrone, a project manager on the board’s business-combinations project. The purchase method “provides more useful information, and our purpose in life is to try to improve financial reporting. [The purchase method] reflects the investment one entity makes in another, and provides feedback over time about the investment.”
FASB’s plan, allowing companies a separate line for goodwill amortization on the income statement, doesn’t mollify Powell. “We’re just adding confusion to our financial reporting,” he says. “My question is: Will the right earnings-per-share number stand up?” Challenging the concept of goodwill as a wasting asset, he adds: “Why are we taking a charge for goodwill against earnings when the goodwill is actually increasing, not decreasing? It points out the limitations of the old-world model that FASB is using to address the new-world economy. What a company acquires today is intangible assets: 30 years ago, they acquired hard assets.”
The new rule, says Powell, significantly, “could really hurt merger activity.”