In February, 2016, I bought 60 shares of Cisco Systems, Inc. (CSCO) for my Dividend Growth Portfolio, and I followed that up by buying 32 more shares that November.
On price alone, those purchases have been very good to me.
The blue dots mark my purchases, both made in the $25-$30 range. Cisco’s price as I write this is about $45. According to E-Trade, the aggregate price gain on the two purchase is about 54%. Not bad.
But that’s not the total return, because Cisco has been sending me dividends four times per year, increasing the payout rate each year. Here’s their dividend per share since I’ve owned the stock.
Altogether, my 92 shares of Cisco have pumped about $465 into my account. That’s another 17% of return, for a total return (price + dividends) of 71%.
Due to its so-so earnings report at the end of the first quarter of their new fiscal year, Cisco’s share price has dropped around 20% in the past few months. You can now buy Cisco for the same price you would have paid more than a year ago.
You often hear, “Buy on the dips.” Cisco has dipped. Is it a good buy? Let’s find out.
Cisco’s Dividend Record
Cisco presents an attractive dividend record. I would call Cisco a mid-yield, mid-growth company. That’s being conservative on the growth side, because until 2019, Cisco was increasing its dividend consistently in the 13%-14% range each year, which is fast growth.
It is too early to tell whether that is a one-off lower increase or the beginning of a new normal.
The only small flag in Cisco’s dividend record is its short string of dividend increases.
Their streak stands at 8 years.
The company has increased its dividend every year since it began paying one in 2011.
The high safety score from Simply Safe Dividends, based on their thorough analysis of factors that impact dividends, suggests that Cisco’s dividend is safe and unlikely to be cut.
Cisco’s Business Model and Company Quality
Cisco is a technology infrastructure company. Its products and services are integral to the Internet, networking, and integrated solutions around the world. It is the world’s largest supplier of high-performance computer networking systems.
Cisco was founded in 1984. The company has about 76,000 employees, more than half of whom are based in the USA.
Cisco designs and sells networking, security, collaboration, applications and cloud products and services. Increasingly, its products are delivered as software via subscription.
Cisco is organized in two ways, by geography and product type. These are Cisco’s geographic segments:
• Europe, Middle East, and Africa (EMEA)
• Asia Pacific, Japan, and China (APJC).
These are Cisco’s product/technology groupings:
• Infrastructure Platforms (57% of revenue) – Includes software and hardware for switching, routing, data center, and wireless applications
• Applications (11% of revenue) – Includes analytics, Internet of Things, collaboration software, and Augmented Reality.
• Security (6% of revenue)
• Other Products & Services (25% of revenue)
Cisco’s customers include enterprise, commercial, service provider, and public sector customers of all sizes. Its customer base is not limited to any specific industry, geography, or market segment. No single customer accounts for >10% of revenue.
Cisco has identified three strategic priorities going forward:
• Accelerating its pace of innovation – Introduced in 2017, Cisco employs what it calls “intent-based networking” that is designed to be intelligent, highly secure, able to constantly learn, adapt, and automate.
• Increasing the value of the network – Cisco is focused on delivering the infrastructure necessary to navigate complex IT environments. One focus is on supporting customers who deal with multiple hybrid cloud environments.
• Transforming its business model – This mainly refers to transforming its buying plans to emphasize software and subscription-based offerings. Subscriptions now account for 71% of software revenue.
Cisco’s networking products are typically upgraded every 3-7 years. Their products are “sticky” in that customers are reluctant to switch vendors. Cisco’s entrenchment is reflected in its pricing power; the company typically enjoys 60%+ gross margins.
Following industry trends, Cisco is shifting product delivery into subscription modes, such as 3-, 5-, or 7-year packages. New products are sold this way, and the company is working on applying the model to existing installations.
At its recent fiscal Q1 2020 earnings call, Cisco noted that it is on track to reach its 2020 software goals, which are to have 30% of total revenues coming from software and 65% of those revenues coming from subscriptions. The latter number is already at 71%.
Cisco’s business is facing headwinds from the trade wars. China has become a challenging market. However, overall Cisco’s business remains strong, and it is the preferred supplier for most of its customers. The company is likely to benefit from secular expansion in technology spending, continuing high demand for data center solutions, and the worldwide migration to cloud networking.
Morningstar awards Cisco a narrow economic moat, based on the following factors:
• Cisco’s franchise is protected by the switching costs that customers would experience if they change networking vendors. Cisco’s technologies are entrenched in data center networks.
• Cisco’s strong brand and reputation, built over decades, helps make it the provider of choice. Customers often look to Cisco as a strategic partner to help them design and use their IT systems. In a recent earnings call, Cisco’s CEO stated that Cisco’s technology “is fundamental to how [customers are] running their organizations.”
Cisco spends about 13% of revenue on research and development, making it an innovation leader, advance their technologies, and drive upgrade sales.
Cisco’s worldwide sales and marketing departments employ about 26,200, with field sales offices in 97 countries. A substantial portion of sales come via systems integrators, service providers, other resellers, and distributors.
Value Line gives Cisco its highest Financial Strength grade of A++. The company has held that grade since 1996.
Let’s look under the hood at some of Cisco’s key financial categories.
Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity.
The average ROE for all Dividend Champions, Challengers, and Contenders is 10%-11%, and for S&P 500 companies it is 14%. The following chart shows Cisco’s ROE 2009-2018.
[Source of all yellow-bar charts in this section: Simply Safe Dividends]
Cisco’s ROE has normally been a little above average in most years. It took a dip in 2018, but rebounded strongly in fiscal 2019. (Cisco’s fiscal 2019 ended in June.)
Debt-to-Capital (D/C) ratio measures how much a company depends on borrowed money. Companies finance their operations through a mixture of debt and equity (shares issued to the open market) as well as their own cash flows.
A typical D/C ratio for a large, healthy company is 50%. D/C is a measure of financial risk. All else equal, stocks with high D/C ratios are riskier than those with low D/C ratios.
Cisco historically comes in better than average, with D/C ratios below 30% most years. Debt has been rising in recent years (which is true of companies generally), but even at 42% in fiscal 2019, it is a relatively low-debt company.
And as noted earlier, Cisco sports an excellent AA- credit rating. Attesting to its strong balance sheet, Cisco has a cash balance of more than $33 billion.
Operating margin measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses?
Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range.
Cisco’s profit margin is outstanding, running steadily in the 20’s over the past decade. This reflects its strong competitive position and the pricing power that goes with that. The ongoing changeover to subscription business models does not seem to have impacted its profit margins in the least.
Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has had years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.
Cisco’s offical profits show lots of variability, although they have always been positive over the past decade. Profits rose in 5 of the past 9 years.
In its recent Q1 2020 earnings report, Cisco’s Q2 guidance was for year-over-year revenue declines of 3-5% and bottom-line growth of 4.1%. The figures were lower than analysts expected, and that has influenced the sell-off in Cisco’s stock over the past few months. On the other hand, thinking long-term, Cisco’s guidance, while perhaps disappointing, still points to bottom-line growth, not decline.
Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules, cash flow is a more direct measure of money flowing through the company. It’s the cash a company has available for dividends, stock buybacks, and debt repayment.
Cisco’s FCF record is outstanding, being steadily positive with increases in most years. Some might call this the picture of a cash flow machine. As noted earlier, Cisco has $33 billion cash on hand, ranking 9th among publicly traded companies.
Share Count Trend shows whether the company’s outstanding shares are increasing in number, decreasing, or remaining flat.
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.
Cisco has been steadily decreasing its float for more than a decade. Its share count at the end of fiscal 2019 was 24% less than at the end of 2010. The company has an ongoing share repurchase program in place, with $12.7 billion remaining authorized for buybacks in the current phase.
Here is a summary of the items above:
That is a very good financial record. On a simple A-F scale, I would give Cisco an A- for its financials.
Cisco’s Stock Valuation
I use four different valuation models, then average them out.
Model 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.
The basic model uses a price-to-earnings (P/E) ratio of 15, which is the historical long-term P/E of the stock market, to create a basic fair- value reference line.
In the following chart, the fair-value reference line is orange, and the black line is Cisco’s actual price. I highlighted both Cisco’s current P/E ratio and the reference ratio of 15 used to draw the orange line.
Since the black price line is below the orange fair-value reference line, Cisco is undervalued by this first assessment method. But the degree is slight.
To calculate the degree of undervaluation, we make a ratio out of the P/Es.
Calculating Valuation Ratio from FASTGraphs
Actual P/E ratio / Reference P/E ratio
14.4 / 15 = 0.96
That suggests that Cisco is undervalued by 4%.
We calculate the stock’s fair price by dividing the actual price by the valuation ratio. We get $45 / 0.96 = $47 for a fair price.
Remember, valuation is an estimate or assessment, not a physical trait like length or width. We are making a judgement.
My practice is to consider any actual price within +/- 10% of “fair price” to indicate fair valuation, in order to be conservative about the process.
Model 2: FASTGraphs Normalized. In the second valuation model, we compare Cisco’s current P/E to its own long-term average P/E.
This model paints a slightly different picture. The price line is above the fair-value line, suggesting that Cisco is slightly overvalued. I circled Cisco’s actual P/E ratio plus its 5-year historical average valuation. The latter is a little below the P/E ratio of 15 used in the first model.
The calculations use the same formulas as in the first step:
• Valuation ratio = 14.1 / 13.8 = 1.02
• Fair price = $45 / 1.02 = $44
Step 3: Morningstar Star Rating. Morningstar takes a different approach to valuation. They ignore P/E ratios and instead use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.
The DCF model is based on the idea that a company is worth all of its future cash flows, discounted back to the present to reflect the time value of money.
Obviously, no one actually knows a company’s future cash flows. Estimates must be used. My experience with Morningstar is that they have a careful, comprehensive, and conservative process for determining the inputs that they use to their DCF formulas.
Morningstar gives Cisco 3 out of 5 stars, meaning that they consider the company to be fairly valued.
Here is a historical graph of their fair value estimates (black line) compared to the stock’s price (dotted).
As you can see, Morningstar calculates a fair price of $48, meaning that Cisco is slightly (6%) undervalued.
Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield. This way of estimating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued.
This chart shows Cisco’s current yield (green dot) compared to its 5-year average yield (black line).
[Source: Simply Safe Dividends]
Cisco’s 5-year average yield is 3.1%, the same as its current yield. So again, this model suggests that Cisco is fairly valued at its current price of $45.
All four models concur that Cisco is fairly valued. The average of the four fair prices is $46 compared to Cisco’s actual price of about $45.
Usually, I try to write about an undervalued stock as my Dividend Growth Stock of the Month. I made an exception this month, because as an investor, I am willing to pay not only fair value, but even a little above fair value, when an opportunity becomes available for a really high-quality company such as Cisco.
Cisco is not “on sale,” but its price is entirely fair for its overall quality and business prospects. Its yield (3.1%) is high enough for most dividend growth investors, and its dividend growth record is solid.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:
• They present fewer occasions to react emotionally to rapid price changes like price drops that can induce a sense of fear.
• There is industry research that suggests that low-volatility stocks outperform the market over long time periods.
Cisco’s 5-year beta is 1.3, which means its volatility has been, on average, 30% more than the market’s. This is a negative factor.
In their most recent report on Cisco, CFRA gathered the recommendations of 30 analysts covering the stock. Their average recommendation is 4.0 on a 5-point scale, where 4 = buy. This is a positive factor.
What’s the Bottom Line on Cisco?
• Good dividend resume, 3.1% yield with very safe dividend. Has increased dividend every year since it began to pay one.
• Technology infrastructure provider, world leader in networking equipment and software. Cisco’s products and services are integral to the Internet, networking, and integrated solutions.
• Successfully moving to subscription-based business model.
• High-quality company as reflected in wide moat rating, AA- credit rating, top ValueLine safety rating, and my own B+ business model rating.
• Very good financials: Moderate debt, outstanding profit margins, terrific cashflow generation, and consistent share-buyback program. A++ financial rating from ValueLine.
• “Buy” rating from sell-side analysts.
• Shares are fairly valued.
• Short dividend increase streak (8 years).
• Business model could be disrupted by trade wars with China.
• Beta (price volatility) has been higher than market’s volatility.
In my opinion, at its current pricing, Cisco presents an attractive opportunity to obtain a high-quality company with a good 3.1% yield. I already own Cisco, and I consider it to be in the running for my next dividend reinvestment in January.
Here are other recent discussions of Cisco on Daily Trade Alert:
• 3 of the Best 5G Stocks to Buy in 2020 (Daniel Smoot, November 2019)
• This Dividend Stock Is a Screaming Buy (And Is Ready to Break Out) (Garrett Baldwin, October 2019)
• 5 Dividend Stocks with Large Share Buybacks (Mark Hake, September 2019)
Cisco is a holding in Jason Fieber’s FIRE Fund.
Remember that this is not a recommendation to buy, hold, or sell Cisco Systems, Inc. Always do your own due diligence. Think not only about the company’s quality, yield, dividend growth outlook, and business prospects, but also about how it fits your personal financial goals and complements other stocks that you already own.
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