Dividend Growth Stock of the Month for June 2016: Cisco Systems (CSCO)

June 11, 2016
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DG Stocks of the Month So Far in 2016

I began this Dividend Growth Stock of the Month series at the beginning of 2015. Thus far in 2016, these are the stocks that have been covered:

Month, 2016 Company Ticker Article Link
January ExxonMobil XOM January 23
February PepsiCo PEP February 18
March Wal-Mart WMT March 16
April Ventas VTR April 8
May Southern SO May 3

This month, we turn our attention to a stock that I purchased for my Dividend Growth Portfolio back in February: Cisco Systems (CSCO).

Cisco’s Dividend Characteristics

CaptureWith the perennial caveat that past performance does not guarantee future results, this is an excellent dividend growth resume. Highlights include:

• Nice yield of 3.6%. This is 71% more than the S&P 500’s yield.
• The payout ratio from earnings (52%) is relatively low. The payout ratio from cash flow (36%) is even lower.
• The dividend growth record is outstanding. This year’s increase was 24%. Obviously, this pace of growth can’t last forever, but for a new (6 years) dividend growth company, it is as good a start as could be hoped for.
• Share count has been declining for years (see chart below).
• Highest dividend safety rating from Safety Net Pro.

Here is a chart of Cisco’s share count over the past 10 years. Cisco has authorized an ongoing share repurchase program.

CaptureAbout 17% of shares have been removed from the market. The decline is good for dividend growth investors, because fewer shares means not only that each share represents a larger piece of the total pie, but also that the dividend pool is spread over fewer shares. That makes dividend maintenance and increases easier for the company.

This is how Cisco recently portrayed its capital allocation. You can see that its allocating cash to both dividends and share repurchases. Those two uses accounted for about 2/3 of operating cash flow in the last quarter.

CaptureYou can also see in the above slide how declining share count helps dividend investors. Notice that each quarter, the total dividends paid by the company declined, despite the constant per-share rate (until the recent increase).

The decline in total dollars is due to the declining share count each quarter.

The only negative in the record is the fact that Cisco has only been paying dividends for 6 years.

(My minimum for consideration is 5 years.)

Cisco is one of several tech companies over the past decade that have moved into a more mature stage of life and begun not only to pay dividends but also to increase them annually.

Six years is too short a time to say that annual dividend increases are baked into the corporate culture, but few companies have gottten off to a better start as dividend growth companies than Cisco.

Business Model: How Does Cisco Make Money?

Cisco was founded in 1984. The company designs, manufactures, and sells networking products, services, and integrated solutions around the world. Its products and systems are integral to the Internet. The company has > 70,000 employees in > 400 offices worldwide. About half of its employees are in the USA.

Cisco is organized and operates through three geographic segments:

• The Americas (60% of sales)
• Europe, Middle East, and Africa (25%)
• Asia Pacific, Japan, and China (15%)

Cisco groups its products and technologies into various categories. Switches (29% of product sales) and routers (26%) are Cisco’s largest product segments. Cisco’s market share surpasses 50% in both product types.

• Switches connect devices (workstations, servers, and phones) on a computer network. They help receive and forward data to the right device.
• Routers pass data packets between computer networks. They essentially direct data traffic to the appropriate destination.

Morningstar awards Cisco a narrow economic moat. They believe that Cisco’s huge installed base of equipment, combined with the company’s established expertise in support and services, gives Cisco a significant advantage in maintaining customers. Cisco certification has become, in effect, an industry standard.

Cisco benefits from its ability to offer customers entire suites of solutions with network equipment and services. These architectural packages allow customers to deal with fewer vendors and potentially to have a lower cost across their systems.

As stated in Cisco’s 2015 annual report:

Our differentiation comes from our ability to deliver integrated architectures at scale, with speed and with security. These architectures combine multiple industry-leading technologies, services, and software with unique go-to-market models and partnerships. We bring these architectures to market in solutions that deliver business outcomes to our customers. In our view, this architectural approach allows us to deliver value greater than the sum of the parts and is enabling us to pull away from the competition and gain wallet and market share. We believe that an architectural approach is essential when it comes to tackling our customers’ top concern: security.

Cisco’s worldwide sales and marketing departments employ approximately 25,000 employees, and there are field sales offices in more than 90 countries. Beyond that, a substantial portion of Cisco’s products and services are sold through partners like AT&T and Verizon and systems integrators.

Cisco divested its consumer products several years ago, and it is focused strategically on high growth business areas: data centers, software, and security.

Risks to the company’s business model include:

• The risk of obsolescence, technology shifts, and commoditization inherent in almost all tech companies.
• Competition from lower-cost providers and “white box” manufacturers.
• Volatility in information technology spending trends. Morningstar rates Cisco as a cyclical stock type, meaning that it tends to be sensitive to changes in economic conditions.

CaptureCisco’s Financials

CaptureCisco has a nice financial picture to back up its good dividend resume.

At 17%, Cisco’s ROE is solid, and the value for the past few years has been in that general range. Cisco has maintained operating margins in the 20% range for at least a decade.

Cisco’s EPS growth rate of 6% per year over the past 5 years is OK for a company of its size. Earnings growth has tended to hop around, but I don’t see this as a major concern, as the overall trend has been upward. Free cash flow, from which dividends are paid, has followed a similar trajectory.

CaptureAnalyst’s projected EPS growth, at 11% per year, is very good for a company of Cisco’s size.

Cisco finances itself with little debt by comparison to other companies these days. Its debt-to-equity ratio, at 50%, compares very favorably to the average D/E ratio of all Dividend Champions, Contenders, and Challengers, which is 109%.

S&P grants Cisco an AA- credit rating, which is a solid investment grade rating. Cisco carries in excess of $60 Billion in cash on its books.

Cisco’s Stock Valuation

My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.

Step 1: FASTGraphs Default. The first step is to compare the stock’s current price to FASTGraphs’ theoretical estimate of its fair value. The theoretical estimate is based on a price-to-earnings ratio (P/E) of 15, which is the long-term average P/E of the stock market as a whole.

That is shown by the orange line on the graph (note the scale to the right).

CaptureBy this first method of appraising valuation, Cisco is underpriced. Its actual price (the black line) is more than 10% below its fair value when calculated by this method.

At an actual P/E of 12.6, the company would be considered undervalued by 12.6 / 15 = 0.84 = 16%. Working backwards, Cisco’s fair price by this method calculates out to $35.

Step 2: FASTGraphs Normalized. The second valuation step is to compare Cisco’s price to its own long-term average P/E ratio. This step lets us adjust for the fact that some stocks, according to the “wisdom of the market,” always have a high valuation, while others always have a low valuation.

CaptureAs I usually do, I have used Cisco’s 10-year average for this step. We can see that Cisco has, in fact, been a little undervalued on average, with a 10-year P/E = 14.4. That is a bit lower than the ratio of 15 used in the first step.

That said, Cisco still comes across as undervalued currently. Using the ratio of the P/Es, I calculate a fair value of $33. Cisco’s actual price is about 12% under that right now.

Step 3: Morningstar Star Rating. Morningstar uses a comprehensive net present value (NPV) technique for valuation. Many investors consider this approach to be superior to using P/E ratios as we just did with FASTGraphs.

In its NPV approach, Morningstar makes a projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.

CaptureOn Morningstar’s 5-star system, Cisco gets 3 stars. That means that they believe the company is fairly valued. They calculate a fair value of $27.

Step 4: Current Yield vs. Historical Yield.

Finally, we compare the stock’s current yield to its historical yield. It is better to be near the top of that range than the bottom.

Cisco is undervalued by this method. Its current yield of 3.6% is far above its average 5-year yield of 2.4% (per Morningstar). The ratio of those two yields is 1.5x, but for this method of valuation, I cut off the maximum difference at 1.2x, or 20%. I do that because the ratio is often disproportionately afffected by the company’s most recent dividend increase. As noted earlier, Cisco’s most recent increase, a couple of months ago, was 24%.

Using the 20% maximum ratio, I get a fair price for Cisco of $36 under this valuation approach.

Valuation Summary:

In computing valuations, I consider prices within 10% of the calculated fair value to be within the fair value range. Assessing valuation is inherently imprecise, so rounding prices to the nearest dollar and using sensible ranges is, in my opinion, better than trying to achieve false precision.

Using the 4 approaches just described, our valuation summary for Cisco looks like this:

CaptureFor a reality check, I also looked at S&P Capital IQ’s fair value estimate. Their 12-month price target for Southern is $31, and they have a “buy” rating on the stock.

Miscellaneous Factors

There are a couple of factors that do not fall into the earlier categories.

CaptureBeta measures a stock’s price volatility relative to the market as a whole. Most dividend growth investors like to own stocks with low volatility, because then you are less likely to become emotional about them when their price drops.

Cisco is more volatile than the market. That is typical of cyclical and technology stocks. Cisco is in both categories. If you are the kind of investor who frets over price drops, Cisco is not for you. If you are the type who does not worry much about price volatility, but instead focuses on rising ividends and other fundamentals, Cisco may be a good choice.

The analysts’ recommendations come from S&P Capital IQ. Their most recent report on Cisco shows the opinions of 40 analysts. Their average recommendation is 3.9 on a 5-point scale, where 3.0 = Hold and 4.0 = Buy. Most analyst reports are tilted toward short-term trading expectations rather than the long-term dividend growth goals that I have in these reports.

Bottom Line

Here are Cisco’s positives:

• Good yield at 3.6%.
• Dividend safety high, protected by very good cash flow and earnings.
• Short but strong dividend growth record: 6 years of dividend increases (since it began paying a dividend), growing at 42% per year. That rate of growth is unsustainable, but this year’s increase clocked in at 24%. I expect Cisco’s dividend growth rate will decline in the coming years toward a level commensurate with its earnings growth.
• Stock is undervalued by about 12%.
• Projected earnings growth of 11% per year is strong.
• Dominant business position in switches and routers. Strategically focusing on next generation technologies.
• Steadily declining share count as the company buys back and retires shares.
• Strong balance sheet, with relatively little debt and $60 Billion in cash.
• Decent financials: Cyclical medium-growth company.

Here are Cisco’s negatives:

• Inherent riskiness in technology companies. Competiton always lurks from low-cost and generic providers.
• Only 6 years of dividend increases. Company may not be deeply committed to annual increases.
• Stock has above-market price volatility, which could be a worrisome factor for some investors.

As always, do your own due diligence, and please do not take this article as a recommendation to buy Cisco. Instead, use it to inspire your own research and decision. Always invest with an eye to your tolerance for price volatility and in a manner that advances your goals.

– Dave Van Knapp

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