A High Yield Stock With a Fast-Growing Dividend and Low Expectations

Cisco (CSCO) is a rather unusual dividend stock because it offers a relatively high yield near 4% but has grown its payout at a fast clip, including a 12% boost earlier this year.

In fact, the company’s quarterly dividend payment has increased from 6 cents per share in 2011 to 29 cents most recently, nearly quintupling over the course of six years.

With Cisco’s stock trading off on the company’s latest earnings report and sporting at a relatively low forward P/E ratio of 14.3, let’s take a closer look to see if this company is appealing for conservative investors living off dividends or if it could be a value trap.

If you are interested in Cisco because of its yield, you might also consider reviewing some of the best high dividend stocks here.

Let’s review Cisco’s business.

Business Overview
Cisco was founded in 1984 and has grown to become one of the most important technology companies in the world.

While the business sells a wide variety of products (74% of FY17 sales) and services (26%) to businesses of all sizes, its main offerings connect computing devices to networks or computer networks with each other.

Cisco DividendThe company’s website provides an overview of switches (29% of sales) and routers (16%), which are Cisco’s largest product segments.

Switches are used in buildings, campuses, offices, and data centers to connect devices such as workstations, servers, and phones together on a computer network. They help receive and forward data to the right device.

Routers pass along data packets between computer networks to connect wireline and mobile networks used for mobile, data, voice, and video applications. They essentially direct the internet’s traffic to the appropriate destination.

The rest of Cisco’s product revenue is spread among a number of faster-growing segments – Collaboration (9%), Data Center (7%), Wireless (6%), Security (4%), and Service Provider Video (2%). Most of Cisco’s products and services are sold through channel partners such as telecom providers and systems integrators.

The company’s service revenue consists of technical support, subscriptions, and software that are spread across its various segments.

By geography, approximately 59% of Cisco’s sales last fiscal year were in the Americas with another 25% in EMEA (Europe, the Middle East, and Africa) and 16% in Asia.

Business Analysis
Cisco dominates most of its core markets. According to IDC, Cisco’s share in the Ethernet switching market was 55.1% at the end of the first quarter of 2017. The company’s market share in routers and services stood at 43.9%.

As seen below, no other vendor comes close to Cisco’s dominance in these markets, even despite some of the market share losses Cisco has experienced in recent years.

Source: IDC

Why has Cisco been able to dominate these markets?

Cisco’s advantage starts with its ability to offer customers an entire suite of solutions with its network equipment and services.

The company has evolved from selling networking hardware into selling higher-value packages of complete architectures and solutions that improve customers’ businesses.

Selling architectural solutions is much more profitable for Cisco and allows the customer to deal with fewer vendors and potentially enjoy a lower total cost of ownership.

Most of Cisco’s competitors do not have the same breadth of products and services (e.g. security, switching, wireless, routing, collaboration), making them less of a factor in these lucrative deals.

Cisco has spent more than $18 billion on research and development over the last three years combined to stay relevant and build out its portfolio, a magnitude of spending that few companies can come close to matching.

Cisco also has about $2 billion in venture capital investments spread across more than 100 companies that help it gain forward-looking insights into the changes its markets are going through.

To continuously round out its portfolio to meet the market’s evolving needs, Cisco has spent more than $80 billion since 1995 to acquire over 250 companies and has also partnered with major technology players such as EMC, VMware, Ericsson, Apple, and Microsoft.

A recent example is Cisco’s $1.4 billion acquisition of Jasper Technologies in 2016 to become the largest cloud-based Internet of Things service platform provider. In analytics, the company has used its financial muscle to become a leading player by acquiring cloud and analytics company AppDynamics for $3.7 billion in 2017.

These deals are part of Cisco’s multi-year transition as it shifts its model from a primarily hardware business into more of a software and services business, which has been a top priority for CEO Chuck Robbin since he took the helm in July 2015.

While Cisco has a long ways to go, its investments in recurring software and subscription businesses have started bearing some fruit.

About 31% of Cisco’s revenue is recurring, and revenue from subscriptions represent over 50% of its software revenue. The company also registered 50% year-over-year growth in its deferred product revenue related to software and subscription businesses last quarter.

The diagram below shows Cisco’s increasing share of software and service revenue from its newer generation of enterprise switching products, for example.

Source: Cisco Presentation

Cisco announced a new security service in June to help improve sales of its switches, which have stagnated in recent years.

In fact, Cisco’s annual switching hardware revenue has remained about flat from 2010 through 2016 while the market for switching hardware has risen about 16% to $24.4 billion.

Incorporating more software and services directly into its core hardware products is necessary to protect market share and support profitable growth.

Another example was Cisco’s recent acquisition of Springpath for $320 million in August 2017.

Springpath provides so-called hyperconverged systems, software which essentially combines data storage and computing to help companies save costs by reducing the amount of hardware needed to operate data centers.

Thanks to Cisco’s enormous breadth of hardware products and software services, it’s difficult for competitors to match the company’s lineup.

By focusing on developing extremely reliable hardware, building a brand based on quality, and using its economies of scale to keep costs low ($48 billion revenue base last year), Cisco typically enjoys price premiums and very healthy margins on its products (a 25% operating margin last year).

Beyond its technology portfolio and unique ability to deliver architectural solutions, Cisco is a sales and marketing juggernaut that has established one of the 16 most valuable brands in the world.

At the end of fiscal year 2016, Cisco’s worldwide sales and marketing departments had approximately 25,500 employees and field sales offices in 95 countries.

However, a substantial portion of Cisco’s products and services are sold through channel partners, such as telecom providers (e.g. Verizon and AT&T) and systems integrators.

Cisco has maintained these relationships for a very long period of time and is uniquely positioned to meet the needs of its biggest partners thanks to its broad portfolio, brand strength, and ability to deliver high volumes of product.

As a result, the company has built up a massive installed base that provides steady revenue opportunities.

Overall, Cisco just does a great job of providing cost-effective, reliable, and integrated solutions at scale to customers.

Given the perceived similarities between many of the products in Cisco’s markets, its branding and long-lasting channel partner and customer relationships are especially important.

In addition to possessing a clear economic moat, many of the best dividend stocks also operate in industries characterized by a slow pace of change. After all, change is often the enemy of predictable cash flow generation.

Cisco’s core markets are no doubt characterized by a faster pace of change than other industries such as trash collection, but their importance should not be overlooked either.

Cisco’s networking products are extremely important for any infrastructure environment and are necessary for virtually any business. Without Cisco, much of the country’s communications infrastructure would not function.

As the use of data and bandwidth continues to see exponential growth, more networking infrastructure is also needed, providing a long stream of demand.

There seems to be no end in sight to the number of consumer and business devices needed to be connected to a network. While this certainly doesn’t guarantee Cisco’s future success, the mission-critical nature of most of the company’s products and services provides some comfort.

However, Cisco does face several meaningful risks.

Key Risks
Volatility in IT spending trends can impact demand for Cisco’s products and services any given quarter and cause the company to miss near-term earnings estimates. However, this risk doesn’t have any bearing on Cisco’s long-term earnings potential.

The bigger concerns in most technology markets are changing trends that make a company’s products irrelevant, as well as increased competition that commoditizes previously profitable technologies.

For example, Cisco’s largest product segments, switching and routing, have lost market share and struggled to achieve profitable growth in recent years.

This has been driven in part by intensified competition (e.g. Arista) and the rise of the cloud, which generally shrinks companies’ data centers (and need for switches), reduces network complexity, and provides more opportunity for tech giants such as Amazon and Google to handle companies’ networking requirements.

There’s a reason why Warren Buffett tends to shy away from technology companies in his dividend portfolio – change can happen fast.

Technology shifts constantly threaten Cisco and require the company to continuously innovate to remain dominant in its markets. In the company’s shareholder letter, Cisco’s CEO notes that much of the company’s “success has come from [its] ability to lead market transitions.”

That’s why Cisco is shifting focus from its traditional business (switches and routers) to emphasize investments in high-growth emerging areas such as security, IoT, and cloud computing.

Perhaps the most discussed technological risk facing Cisco is the rise of software defined networking (SDN). Essentially, SDN is part of the market’s transition to more programmable, flexible, and virtual networks.

SDN essentially moves some networking functions away from hardware to software, reducing demand for networking equipment (or at least reshaping it) and enabling the substitution of lower-priced, unbranded gear. Unbranded systems can also provide an opportunity for customers to customize their systems based on their unique computing needs.

Cisco has historically been strongest in branded networking hardware, which is why SDN gets so much attention.

Cisco is responding to this risk by building and acquiring new software and services and is actually a leading player in SDN today with its own solution.

It’s also important to realize that most companies implementing SDN still require a lot of networking hardware.

While Facebook introduced its own networking-equipment system for use in its data centers, non-branded, ”white box” equipment seems unlikely to ever dominate the market.

The following comments are from Cisco in a Barron’s article and highlight the downsides of using non-branded equipment:

“It is our belief that the open source switch market, sometimes called the “white box” market, is largely only attractive to a small, highly-resourced subset of the overall I.T. market. That’s because the approach is loaded with hidden hard and operational costs. For example, networking capital equipment outlays typically constitute only 30% of the cost of running networks. Labor costs constitute 50%, and will increase with the white box approach as IT departments are required to install, integrate and update separate network operating systems and network virtualization software. The largest hidden cost comes from network virtualization software licenses. VMware NSX, for example, charges a per-virtual-machine licensing fee ranging from $10-$50 per month. The combined cost of increased labor, network operating systems licenses, and per port “VM tax” leads white box networking costs to be 75% higher than for Cisco networks.”
Source: Barrons

It’s also important to keep in mind that the majority of businesses considering a move to SDN likely have Cisco hardware already installed (remember Cisco’s 40-50%+ market share in routers and switches?). These customers will likely find it more cost-effective to continue using Cisco’s hardware.

Beyond the SDN trend, competition in Cisco’s markets is fierce. Whenever the company misses earnings or sees growth slow, fears crop up that its dominant market share could finally be eroding at a faster pace – either due to SDN or competitive pressures.

That’s been true in recent years. Rival Arista Networks has seen its share of the data-center switching market grow from nothing in 2010 to over 9% in 2016, while Cisco’s share has fallen from about 80% to the mid-50% range, according to data from research firm International Data Corp that was cited by Fox Business.

Cisco’s switching business also saw its biggest revenue drop in more than three years last quarter.

While management attributed the weakness to a major update to its switching product line in June that caused new sales to pause, Arista Networks continued generating double-digit growth, taking more share.

Source: The Wall Street Journal

The Wall Street Journal recently published a great article about Arista and Cisco that you can read here. It’s hard for technology giants to stay nimble and adapt to changing technology trends in a timely and profitable manner.

Simply put, the rise of cloud, mobile, and big data are certainly forcing IT architectures and computing to evolve and become more flexible, forcing Cisco to adapt quickly if it wants to remain relevant.

To sum it all up, Cisco’s technologies will continue facing functional and pricing pressures as its markets continue evolving. The company seems to have the strengths (financially, technologically, and strategically) necessary to remain a large cash cow, but its sheer size also causes it to move slowly.

Cisco can’t be as cutting edge as some of its smaller rivals, but its entrenchment with customers should also not be underappreciated.

Cisco’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

Source: Simply Safe Dividends

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

Despite Cisco’s relatively short track record of paying a dividend (its dividend was initiated in 2011), the company scores very well for Dividend Safety with a rating of 83.

As seen below, Cisco’s favorable rating begins with its healthy payout ratios. The company’s free cash flow payout ratio was 38% last fiscal year, which is up significantly from several years ago as Cisco’s dividend growth outpaced its cash flow growth.

However, this is still a relatively low payout ratio for a stable business like Cisco and provides plenty of safety and room for further dividend growth.

A reasonable dividend payout ratio can be riskier than it appears if a company is highly cyclical. For example, a business with a 50% payout ratio that sees its earnings decline by 50% in a recession would see its payout ratio spike to 100%, potentially jeopardizing the safety of its dividend.

In Cisco’s case, the company performed well during the last recession. As seen below, Cisco’s sales fell by 9% in fiscal year 2009, and the company’s free cash flow per share dropped by 14%. IT spending does track GDP growth, but many of Cisco’s products and services are essential to keep a business running.

Going forward, Cisco’s recession performance could be even better. The business is expanding its mix of recurring software and services revenue, which provides greater cash flow stability and visibility. Recurring revenue now accounts for 31% of the company’s total revenue.

Cisco’s strong Dividend Safety Score is also backed up by the company’s outstanding free cash flow generation, which is needed to fund the dividend. Cisco has generated steady, growing free cash flow in each of its last 12 fiscal years. Few businesses have demonstrated such consistency.

Despite carrying the label of an “old” tech hardware company, Cisco’s operating margins have also been outstanding. The business makes a lot of money from selling its architectures and turn-key solutions. Growth in higher-margin recurring revenue will hopefully continue to support the company’s nice margins, which are indicative of an economic moat.

Cisco’s balance sheet is rock solid and virtually guarantees the safety of its dividend. The company has $70.5 billion in cash compared to $25.7 billion in debt, and it has nearly $13 in cash for every $1 it paid out as a dividend last year. Cisco has ample capacity to continue acquiring businesses, repurchasing shares, and paying higher dividends.

Overall, Cisco’s dividend payment looks extremely safe. The company has relatively low payout ratios, generates predictable free cash flow, has a steady business model, and maintains an outstanding balance sheet.

Cisco’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Cisco’s healthy payout ratio, strong cash balance, and excellent free cash flow generation make for a stock with solid dividend growth potential, which is reflected by Cisco’s Dividend Growth Score of 67.

Cisco most recently raised its dividend by 12% in February 2017 and has aggressively boosted its payout every year since 2011.

Cisco expects to return 50% of its free cash flow to shareholders in the form of share buybacks and dividends, so dividend growth will likely follow growth in underlying earnings and free cash flow more closely over the coming years (i.e. mid to high single-digit growth) since its payout ratio is already close to 50%.

Valuation
Like some other mega cap, “old” technology companies, Cisco’s valuation looks rather undemanding. The company’s stock trades at a forward P/E ratio of 14.3, which is lower than the S&P 500’s 17.4 multiple.

If the company’s $8.90 per share net cash is excluded, CSCO trades at a forward P/E ratio of approximately 10.2, although most of its cash is held overseas.

Cisco’s healthy dividend yield of 3.7% is near the highest it has been since the company started paying dividends in 2011, too.

Whenever a stock looks this cheap, especially one with a great balance sheet and consistent free cash flow generation, it’s usually because investors don’t believe the company can generate profitable long-term growth. IBM has been treated the same way, for example.

The market is clearly expressing some concern about Cisco’s long-term relevance in the ever-changing world of technology, especially as its recent quarterly results have shown market share losses in core hardware product categories.

With the company’s business mix in a multi-year transition toward more higher margin software and subscription services, it might be difficult to deliver any near-term upside to its numbers.

Given the company’s long history, substantial financial resources, and capabilities in eventually assimilating new technologies, I’m willing to give management the benefit of the doubt as Cisco looks to expand in fast-growing (and competitive) areas such as IoT, SDN, cloud computing, collaboration, and security.

However, given the headwinds it faces in legacy hardware networking products, it’s hard to imagine Cisco’s bottom line growing by more than a low to mid-single-digit annual pace, including annual share buybacks of around 1%.

With an undemanding valuation multiple and relatively high yield, Cisco’s stock has potential to deliver annual total returns between 7% and 9% (3.7% dividend yield plus 3% to 5% annual earnings growth) over the long-term.

If investors regain confidence in the company’s long-term growth potential, the stock’s price-to-earnings multiple would likely expand as well. But I wouldn’t count on that.

Overall, Cisco’s valuation seems reasonable given some of the growth concerns surrounding the company, balanced by its excellent cash flow, sturdy balance sheet, vast resources, and healthy yield.

Conclusion
Cisco’s investment case certainly isn’t perfect. Some of Cisco’s legacy businesses have been under pressure for years as competition has intensified and technology trends have evolved (e.g. software-defined networking; the cloud).

It will also take time for the company to achieve needle-moving success in faster-growing areas such as security, which face immense competition and are far from guaranteed growth opportunities.

Fortunately, Cisco appears to have a strong foundation in network equipment and services (a large and growing market), as well as the necessary financial firepower, business partners, installed base of customers, and brand recognition to make the investments necessary to stay relevant over time.

As a result, Cisco’s dividend continues to look extremely safe with solid growth prospects, especially given its above-average yield. The stock’s valuation also appears to be reasonable, assuming Cisco starts showing more stability in its core hardware businesses and greater traction in its faster-growing segments.

Cisco could be a name for dividend investors to consider as part of a well diversified income portfolio.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends