Undervalued Dividend Growth Stock of the Week: Cisco Systems, Inc. (CSCO)

December 4, 2016
By

How good does it feel to get a good deal on something?

Doesn’t it feel great?

Although I spent the day after Thanksgiving relaxing, it only took me a few minutes of watching the local news to see that there were millions of people out there practically trampling each other to get good deals on merchandise on Black Friday.

I think there’s an inherent desire there, where people innately want to pay less for things.

More specifically, we want to pay less than that which something is worth.

Price and value are inextricably linked on one hand; on the other hand, they’re rarely (if ever) one and the same.

While value gives context to price, allowing one to decide what they should pay, the value of something may be very, very different than its price.

And this is perhaps never more apparent than when buying stocks.

Whereas most goods that you’ll ever come across in the world usually sport fixed prices for at least a short period of time, stocks are being repriced constantly… every single trading day.

But it’s quite obvious to me that the value of major companies can’t possibly be changing so rapidly and substantially from one day (or even one hour) to the next, outside of some type of value-changing event(s).

That’s why I focus on valuing stocks before I ever decide whether the price being asked interests me.

Easier said than done, right?

Well, maybe not.

For instance, fellow contributor Dave Van Knapp put together a great tutorial on valuing stocks. This tutorial is part of an overarching series of lessons on dividend growth investing.

While the attractive nature of buying stocks for less than they’re worth is probably very innate, it’s also something that’s objectively beneficial in certain ways to a long-term investor.

Now, I focus on high-quality dividend growth stocks.

I’m talking about stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list – a document that contains pertinent information on more than 700 US-listed stocks with at least five consecutive years of dividend increases.

You’ll see that this isn’t just lip service, as you can freely check out my personal portfolio.

It’s a real-life and real-money example of dividend growth investing at work. And the dividends the portfolio generates is enough to cover the vast majority of my core personal expenses, rendering me effectively financially free.

I think high-quality dividend growth stocks are more or less the crème de la crème.

Companies that are able to pay out increasing cash dividend payments for years on end are generally only able to do so because they’re producing the increasing sales and profit to sustain those ever-larger checks to their respective shareholders.

For me, it’s a pretty good initial litmus test of quality, knowing that there are a number of other fundamental metrics to evaluate from there.

But getting back to “getting a good deal”, buying a high-quality dividend growth stock when its price is below its intrinsic value (buying when it’s undervalued) is beneficial in a variety of ways.

First, you have to consider that you’re looking at a higher yield.

All else equal, a lower price equals a higher yield. That’s because price and yield are inversely correlated.

So if a stock was priced at $55 but worth $50, a drop in price to $45 is going to increase the yield on that stock (all else equal). This increases your immediate dividend income and your ongoing dividend income. It could very well affect the lifetime aggregate income from that investment.

Second, the long-term total return prospects are given a boost.

Yield is one of two components of total return. With that one component increases, the odds are already tilted in your favor.

But capital gain, the other component, is also given a potential boost via the upside that exists between the price paid and the intrinsic worth.

If a stock that was priced at $55 but worth $50 drops to $45, there’s $5 per share worth of possible upside, if/when the market realizes the value and reprices that stock appropriately.

Third, you’re taking on less risk.

Paying $45 per share rather than $55 per share (using the same example as above) means you’re shelling out less coin per share.

That’s less potential downside (on a per-share basis) and more potential upside, which provides one with a margin of safety.

Just in case something goes awry, or perhaps if you’re wrong about your investment thesis and/or valuation, you’ve created a buffer when you pay significantly less than a stock is deemed to be worth. It’s a cushion.

With all that said, you should be able to see by now why I’m always on the lookout for a high-quality dividend growth stock that appears to be undervalued.

Well, I think we might just have one on our hands…

Cisco Systems, Inc. (CSCO) is the world’s leading designer, manufacturer, and supplier of data networking equipment and software.

I’ve mentioned numerous times over the years (for those of you who follow my writing) that I’m not enamored with the idea of investing in technology companies.

Tech can change fast. And the last thing you want to happen is for a company that you’re invested in all of the sudden start to look obsolete. That can quickly start to make your money look obsolete.

Nonetheless, there are a few high-quality technology companies out there that generate huge sales and massive profits from a number of ubiquitous (and arguably necessary) products and/or services, and they’ve been extremely consistent with that over many years. Moreover, this select group also pays out growing dividends to their shareholders.

What I do is invest in these selective technology companies in small increments, diversifying and limiting my exposure.

Cisco is one of those select companies.

With a dominant position in routers and switches, Cisco is positioned very well as the world continues to move toward a future where the world runs on the Internet of Things.

Let’s first consider that the stock offers a very appealing yield of 3.53% right now.

In a low-rate environment, that’s pretty strong.

In addition, the five-year average yield for this stock is just 2.4%. So investors buying this stock today are locking in a yield that’s more than 100 basis points higher than the recent historical average.

I can’t visualize the concepts I mentioned earlier any better than that.

captureBut it’s not just the yield you’re getting.

Cisco has increased its dividend for the past six consecutive years.

And what they might lack in regard to a lengthy track record, they make up for in dividend growth: the three-year dividend growth rate is 31.6%.

While that’s highly unlikely to continue on like that much longer, the moderate payout ratio of 49.8% leaves a lot of room for future dividend increases.

But before we really make an assumption about future dividend growth, we first need to see what kind of underlying growth the company is generating. After all, those dividends aren’t funded from nothing.

So we’ll see what Cisco has done over the last decade, and then we’ll compare that to a near-term forecast. Blended together, we should have a good idea as to what to expect moving forward.

Cisco has grown its revenue from $34.922 billion to $49.247 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 3.89%.

Meanwhile, the bottom line grew more briskly due to significant share repurchases. Cisco reduced its outstanding share count by approximately 19% during this period.

The company’s earnings per share increased from $1.17 to $2.11 over that 10-year stretch, which is a CAGR of 6.77%.

So 7% bottom-line growth along with a 3%+ yield is a pretty good recipe for growing wealth and income, if you ask me.

Looking forward, S&P Capital IQ believes Cisco will compound its EPS at a 3% annual rate over the next three years, citing the benefit of new products in data centers, cloud networking, and security being somewhat tempered by an uncertain regulatory and political environment.

Oddly enough, however, they’re also predicting EPS of $2.47 in FY 2018, which would be a CAGR of over 8%.

I believe that prediction of 3% growth over the near term is very conservative, though Cisco could still hand out high-single-digit dividend increases and not even blink, as the payout ratio is still quite healthy. I find it more likely that the firm grows faster, which provides an even better case for solid dividend growth moving forward.

Now, I mentioned that I invest in small increments in some of the best tech companies in the world. And I already laid out a few reasons why.

However, another big reason for this is because these firms usually sport amazing balance sheets that feature a ton of cash.

This provides another margin of safety.

It allows for M&A activity to stave off the threat of becoming obsolete. And it also means that these firms are very capable of paying out increasing dividends for many years to come, even if growth slows.

For instance, Cisco has over $65 billion in cash on its balance sheet – an increase of almost 10% from last fiscal year!

Furthermore, the usual balance sheet metrics are otherwise phenomenal.

The long-term debt/equity ratio is 0.39, while the interest coverage ratio is sitting at right about 20.

Profitability is another big reason for exposure to these companies.

And Cisco is a great example of that.

Over the last five years, the company has averaged net margin of 18.95% and return on equity of 16.17%.

All in all, I really don’t see a lot to dislike.

You’ve got fairly large margins, a fantastic balance sheet, a big yield, solid underlying growth, and a dividend that’s likely to continue growing at a rate well in excess of inflation.

As such, one might expect this stock to be expensive.

But that doesn’t appear to be the case at all…

The P/E ratio for the stock is 14.08 right now. That’s substantially below the broader market’s P/E ratio. That’s also below the stock’s own five-year average P/E ratio of 14.5. And I already discussed how the stock’s current yield is much higher than its recent historical average.

So the stock does appear to be cheap. But how undervalued might it be? What’s a good estimate of its intrinsic value?

I valued shares using a dividend discount model analysis. I factored in a 10% discount rate. And I assumed a long-term dividend growth rate of 7%. I think this is an appropriate assumption, considering the moderate payout ratio, balance sheet, and historical underlying EPS growth. The DDM analysis gives me a fair value of $37.09.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

The DDM analysis looks pretty fair to me, yet the output indicates the stock is very undervalued right now. But just in case my thought process is way off, I think it’s always worthwhile to compare my conclusion with what professional analysts believe a stock is worth.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates CSCO as a 2-star stock, with a fair value estimate of $27.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates CSCO as a 3-star “HOLD”, with a fair value calculation of $35.40.

While I’m usually in harmony with Morningstar, our opinions on this particular stock diverge. Unless Cisco permanently slows down quite a bit, I think it’s unlikely the stock is worth that little. Regardless, averaging out the three numbers gives us a final valuation of $33.16. That indicates the stock could be 12% undervalued here.

csco_chartBottom line: Cisco Systems, Inc. (CSCO) is high quality across the board. Despite my apprehension regarding investing in the tech space, this company has the fundamentals and dividend growth prowess that I’m always searching for. With the possibility of 12% upside on top of a huge yield, long-term dividend growth investors should take a good look at this stock right now.

– Jason Fieber

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