This Strategic Network Security Deal Is Worth Watching

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Recently, Sourcefire (NASDAQ: FIRE) shot up almost 28% in a single day after the announcement that the company will be acquired. Cisco Systems (NASDAQ: CSCO) has offered around $76 per share to acquire Sourcefire, with the total transaction value coming to $2.7 billion. Is a $76 per share a fair price for Sourcefire? Is Cisco right in acquiring Sourcefire? Let’s find out.

One of the leaders in intelligent cyber-security technology

Sourcefire is the intelligent cyber-security technology company, offering solutions to a diverse customer base, including global enterprises, the U.S., and international government agencies. In 2012, Sourcefire derived around $135 million, or 61% of the total revenue, from product sales, while technical support and professional services contributed around $87.6 million, accounting for 39% of total 2012 sales. Its largest customer was EC America, the subsidiary of immixGroup, representing as much as 19% of total sales. The company has more than 2,500 customers in more than 180 countries.

Sourcefire has consistently grown its revenue, from $76 million in 2008 to $223 million in 2012. However, net income has fluctuated in the range of $(6) million to $20 million during the same period. What I like about Sourcefire is its cash generating ability. In 2012, its operating cash flow was $43 million while free cash flow came in at $34 million. Moreover, the company has quite a strong balance sheet. As of March 2013, it had $267 million in equity, $206 million in cash and short-term investments, and no debt. Sourcefire is different from other IT companies I’ve come across as it has grown itself organically. The goodwill and intangible assets were only $20 million.

The strategic deal in network security business

By acquiring Sourcefire, Cisco could expand its footprint in the network security field. Cisco is famous for its switching products, generating around $14.53 billion in 2012 sales. The security business is quite small, with only $1.35 billion, accounting for only 3.7% of the total revenue. The combination of Sourcefire and Cisco will strengthen Cisco’s coverage and the expertise in security, helping to accelerate business growth and market penetration.

The combined business will offer world-class threat research and security intelligence, with security services platform, cloud delivery, and network integration. Cisco mentioned that Sourcefire CTO Martin Roesch and other Sourcefire’s executives would work for Cisco’s security group. Hilton Romanski, the VP of Cisco Corporate Development, was bullish about this acquisition, he said: “Sourcefire aligns well with Cisco's future vision for security and supports the key pillars of our security strategy. Through our shared view of the critical role the network must play in cybersecurity and threat defense, we have a unique opportunity to deliver the most comprehensive approach to security in the market.”

At $76 per share, Sourcefire is worth nearly $2.37 billion on the market. The market values Sourcefire quite expensively, at more than 7.9 times its sales. Cisco, a much bigger company, has a much lower valuation. Cisco is trading at $25.70 per share with a total market cap of $137 billion. The market values Cisco at only 2.87 times its sales and 8.08 times its trailing EBITDA (earnings before interest, taxes, depreciation, and amortization). Income investors might like Cisco better with its decent dividend yield of 2.6%. The payout ratio is also conservative at only 29%.

Checkpoint is more innovative and more flexible

Indeed, many investors might think Cisco has paid a high price for this acquisition. However, it seems to be rational for Cisco as the company has been losing market share in the network security field to several small companies such as Checkpoint Systems (NYSE: CKP) and Juniper Networks. According to Infonetics Research, Cisco was still the leader in the network security industry, while Checkpoint and Juniper have been fighting for the second position in this market.

Checkpoint has a much lower price-to-sales valuation than both Cisco and Sourcefire. It is trading at around $16.80 per share with a total market cap of around $689 million. The market values Checkpoint at only one time its sales and 13.85 times its trailing EBITDA.

Being a smaller company, Checkpoint might have more room to grow. In order to sustain its market leadership, the company has been developing the next generation of hardware and consumable products. Looking forward, Checkpoint has eyed China, India, and Latin America as potential fast growing markets for international expansion. By expanding its reach into emerging markets, Checkpoint can deliver greater revenue in the future.

With a lot more resources and cash on hand, the acquisition seems more sensible for Cisco than building the product itself. Despite a premium valuation, Cisco will gain access to Sourcefire's product portfolio and customer base right away. I personally think that with Sourcefire acquisition, Cisco’s leadership position in the network security market will be strengthened substantially.

My Foolish take

Cisco has made the right choice by acquiring Sourcefire to strengthen the company’s network security business. The acquisition will help Cisco gain Sourcefire’s talents, products, and customer base. Although the deal is expected to slightly dilute Cisco’s earnings in fiscal 2014, the potential synergy between Sourcefire and Cisco’s network security business should help improve Cisco’s sales and bottom line in the long run. 

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Anh HOANG has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems and Sourcefire. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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