Setting a precedent: Cisco’s $3.7 bln purchase of AppDynamics
“We are buying AppDynamics because we fundamentally believe that they are redefining the application development space. We want to turbo charge that.” — Robert Salvagno, Head of Cisco’s M&A and venture investment team
How much did Cisco pay?
- 17x EV/TTM Revenue
- 15x EV/Estimated 2017 Revenue (assuming 2016 growth rate)
- $3.2 million per employee
- $1.8 million per customer
On January 24th, 2017, Cisco announced its intent to purchase AppDynamics, a San Francisco-based application intelligence software platform, for $3.7 billion in “cash and assumed equity awards.” Forbes estimates AppDynamics investors chose primarily cash as the acquisition currency. The deal is expected to close in Cisco’s Q3 this year.
This M&A transaction occurred at a presumed local maximum for AppDynamics. The company planned to be the first IPO of 2017. They were priced between $12–$14 a share initially, to be valued at $1.7 billion. Early this week though, the company raised the subscription price by ~15%. AppDynamics allocated 12 million shares to be sold to the public, another 2.5 million in a concurrent private placement, and set aside another 1.8 million shares for its underwriters. According to an unnamed source in Erin Griffith’s term sheet, the AppDynamics deal was “crazily oversubscribed” as a result of pent up institutional demand for IPOs. Cisco’s purchase occured when AppDynamics had a particularly strong BATNA.
- Morgan Stanley & Co. LLC
- Goldman, Sachs & Co.
- J.P. Morgan Securities LLC
- Barclays Capital Inc.
- UBS Securities LLC
- Wells Fargo Securities, LLC
- William Blair & Company, L.L.C.
- JMP Securities LLC
These firms were the underwriters listed in the S-1. Their efforts certainly helped the incredible demand for AppDynamics seen on its road show. Dan Primack’s Axios reported this the IPO was already oversubscribed after day one of the road show.
The obvious winners of the acquisition are the investors and early employees. Valued at $1.9B as of November 2015, the company was at risk of a down round, having raised $158M on a $1.74B Pre-Money valuation. Assuming an all cash purchase, below are the expected returns for beneficial owners above 1%.
The Acquisition from Cisco’s Perspective
While I was not present in any of the road show presentations, the SEC mandated S-1 gives us incredible insight the AppDynamics business. Even more preferable than attending a road show presentation, I can assess the business without a narrative spun around it. AppDynamics had an implied ARR of $170 million as of their most recently reported quarter. They estimate their total addressable market as $12 billion.
We believe that our solution replaces legacy products across various well-established categories of IT spending. According to Gartner, the IT operations market in 2016 is expected to be $23.0 billion, and the business intelligence and analytics market is expected to be $17.1 billion, resulting in a total addressable market (TAM) of $40.1 billion in 2016, and is expected to grow at 7.6% annually to $53.8 billion in 2020. We believe we currently address a significant portion of those markets. We internally estimate that the TAM for our solution is approximately $12 billion. We calculated this figure using the total number of global companies with greater than $50 million in annual revenue in 2015, which we determined by referencing certain independent industry data from S&P Global Market Intelligence, for each industry in which we currently serve customers. We then multiplied the total number of companies for each such industry by our industry-specific average recurring contract value for customers as of October 31, 2016.
AppDynamics has three forms of revenue: subscription revenue, license revenue, and professional services. Subscription revenue has three components:
- “Time-based on-premises license agreements bundled with maintenance and support,
- SaaS subscriptions where the license agreement is bundled with maintenance and support and hosting services, and
- Software maintenance and support agreements associated with perpetual licenses.”
License revenue occurs through on-premises perpetual software license agreements. Here, revenue is recognized upon delivery. Finally, professional services revenue is an assortment of “fees from consulting services related to the implementation and configuration of our applications which do not involve significant production, modification or customization of software.” AppDynamics is the archetypal SaaS revenue model. The company expects subscription revenue to increase while license revenue to decrease as a percentage of total revenue. Hats off to Tomasz Tunguz of Redpoint for the visual reproduce below of its evolving revenue mix.
Certain key business metrics explain why the AppDynamics IPO was oversubscribed:
- Dollar-Based Net Retention Rate: This metric represents recurring dollars expected in the current trailing 12-month period from the cohort of customers from the previous trailing 12-month period without any expansion or contraction. Their growing net retention rate explains why their subscription revenue continues to increase as a percentage of revenue.
- Billings: SaaS businesses “generally bill our customers at the time of sale, but typically recognize a majority of the related revenue ratably over time, we use billings to measure and monitor our ability to provide our business with the working capital generated by upfront payments from our customers. Billings consists of our total revenues plus the change in our deferred revenue in a given period. Billings reflects sales to new customers plus subscription renewals and additional sales to existing customers.” Billings has grown at a CAGR of 104% measured from 2014 to 2016.
- Cohort analysis: AppDynamics uses a “land and expand” model of sales to new organizations. The CIO is no longer the only individual who can bring new technical solutions into businesses. Instead, companies like AppDynamics offer their services in a bottoms-up fashion (landing) and introducing their service to more business segments over time (expanding). Below is the cohort analysis as presented in the S-1. It “illustrates the total subscription contract value of each cohort amortized over the relevant respective contract terms.” For example, the FY 2012 cohort has increased its aggregate recurring contract value from $1.2 million in FY 2012 to a total of $9 million in FY 2016. The compounded annual growth rate for this cohort is 65%.
AppDynamics is a best of breed SaaS business. It is unwise to apply the multiple Cisco paid to other business without intimate knowledge of their financials. Valuation multiples are only a shorthand to roughly approximate a DCF. In an article I highly recommend, Alex Clayton, investor at Spark Capital summarizes some of AppDynamics’ relevant financials for coming to a valuation. His metrics accompany those I highlighted earlier in this article:
- Revenue growth: “AppDynamics did $158M in total revenue in the first 9 months of the year, up 54% YoY. In FY’16 (ending January 31st) they did $150.6M, up almost 85% YoY. The year before they grew revenue almost 250%.”
- Average contract value: “AppDynamics charges customers on a per-agent basis and for certain applications on a volume basis. The company has 630+ customers paying more than $50K in ACV, and 165+ paying more than $1M in TCV (total contract value), up from only 20 in January 2014.” “They sell SaaS (and time-based licenses) contracts that are typically 1 or 3 years in duration and their implied average subscription ACV (annual contract value) across all customers is $86K, which is total implied ARR over customers.”
- Implied ending ARR: “In the last 7 quarters they have added $9M, $10M, $16M, $17M, $23M, and $24M, respectively.”
As far as I can estimate, Cisco’s purchase of AppDynamics marks the largest EV/Revenue multiple ever paid for a software business. Typically, rapidly growing software companies trade for 6x revenue. Only time will tell if the 17x EV/Revenue paid will pay off for Cisco. Sporting a market capitalization of $154B, Cisco can afford to obfuscate AppDynamics in its financials until it is ready. One thing is for certain: Cisco’s goodwill account has increased.