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Bloated technology mainstay X buys sexy, high-growth, no-profit upstart Y for an outrageous price. Latest example: Cisco Systems Inc. last week shelling out $2.7-billion (U.S.) for security software maker Sourcefire. Cisco paid eight times Sourcefire's forward revenue (no need to even broach profitability multiples). The deal is no different from others that the likes of Oracle, Microsoft and IBM have struck in recent years to buy their way into the latest mobile, cloud, virtualisation trend.
A couple of billion is a trifle for these juggernauts. Yet shareholders are right to wonder: why is it not more valuable if mature market leaders instead just returned more cash to us? The correct response: do both. If the curse of being a tech giant is the constant threat of being disrupted, then the privilege is having the firepower to spend billions on M&A to remain relevant while rewarding shareholders for their patience.
In the case of Sourcefire, Cisco's logic is reasonable. Cisco has a strong network security business and Sourcefire can help it become the sector leader. It will be years before we know but in the meantime the deal's near-term return on capital is dreadful (even if earnings will not drop much). For the rope to go after such value-crushing if necessary deals, Cisco owes its shareholders an olive branch. The good news: Cisco and its peers have, indeed, spent billions more on dividends and buybacks relative to M&A. However, cash balances are excessive and growing. And all have dividend yields below 3 per cent, so it is reasonable to return more cash.
The Dell imbroglio is instructive. Its dissident shareholders smartly point out that the PC maker has spent $8-billion so far to remake itself, but to little avail. Dell's best course may be to turn to software. But the dissidents' recapitalisation idea declares that Dell has enough cash flow and borrowing capacity to both invest and reward shareholders. With a fully-priced takeover offer on the table, the recap is wrong for Dell. But it remains a template for the other ageing tech giants.