SAN FRANCISCO (CNN/Money) -
Last week I became a Cisco product owner. No, I'm not opening a server farm or starting up my own Internet service provider. Rather, the humble Linksys wireless access point and router that sit in my office became honorary Cisco products on Thursday when Cisco announced that it would acquire Linksys for $500 million in stock.
The market's reaction to the announcement was a muted "feh," pushing Cisco's (CSCO: Research, Estimates) stock down slightly at week's end. But I think this is a smart deal. My optimism stems in part from the structure of the agreement and in part from some economic voodoo I've concocted called the "trickle-up" theory.
Take a look at the numbers: Cisco is a famously high-margin company that has historically used cash reserves and stock to fund acquisitions (it authorized a new $5 billion stock buy-back program last week).
According to Cisco, privately-held Linksys has $429 million in annual sales and a 24 percent sales growth rate. Linksys also commands a 39 percent market share for home and small-business networking equipment, a segment that may be worth $7.5 billion a year by 2006.
But Linksys's margins are 35 percent -- half the 70 percent margins Cisco commands for its high-end backbone products. There may be some temptation to bring Linksys into the Cisco fold, rebrand the products, and sprinkle some Cisco magic dust to boost margins. But wisely, Cisco has opted not to do so. Linksys will operate as a separate entity and, for the time being, maintain the Linksys brand. "It's an entirely different operating model for Cisco," says Charles Golvin, an analyst with Forrester Research (FORR: Research, Estimates).
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Golvin argues that the acquisition makes sense for Cisco because Linksys is already the dominant player in home-office networking. If it stayed independent, the next logical move for Linksys would be to capture some of Cisco's territory: medium-size enterprises and higher-end networking products. Purchasing Linksys is a smart defensive play for Cisco. "Rather than be eaten away from below, Cisco gets to protect its business a little longer," Golvin says.
Which brings me to my own hunch about why the Cisco/Linksys announcement makes sense: The growth of the consumer home-networking segment will have a trickle-up effect, generating additional purchases of Cisco's high-end products.
A December 2002 survey conducted by Jupiter Media found that nearly a third of all home broadband users have some sort of networking setup. DSL providers have encouraged their subscribers to set up home networks, but cable broadband providers have been less enthusiastic.
That may be because cable companies are built around a business model under which customers who want additional TVs in their homes must buy more cable boxes. The concept of allowing several computers to run on a single broadband connection is foreign to most cable operators.
But Cisco already sells a lot of back-end broadband equipment to cable operators. As a vendor, the company could potentially strike deals that would encourage the Comcasts (CMCSK: Research, Estimates) of the world to offer customers cable broadband and a Linksys router as part of a premium package. The net result would be additional Linksys router installations for consumers and more sales of Cisco gear to infrastructure providers.
That's a lot of dots to connect, to be sure. But you have to imagine that Cisco is envisioning some version of that scenario. "There aren't a lot of direct synergies here," Jupiter senior analyst Joe Laszlo says of the Cisco/Linksys deal. "But there are a lot of indirect synergies." My theory may be a little squishy, but in relatively new markets like home networking, some squishiness ought to be allowed.
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