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

The Internet has rapidly and radically changed the world.

Something that didn’t exist just 50 years ago is now vital to our society.

But the Internet is not something that exists or operates magically.

A number of global companies produce the products and/or services that allow the Internet as we know it to run.

And these companies can be phenomenal long-term investments.

However, some investment opportunities look much better than others.

Even in technology. Especially in technology.

The tech companies that are paying reliable and rising dividends could be the best long-term opportunities of all.

Technology changes fast.

Tech companies come and go.

But those that have longstanding track records of growing dividends have demonstrated a certain amount of durability and worthiness.

The Dividend Champions, Contenders, and Challengers list says all you need to know.

There are some technology companies on the list.

But it’s not loaded with names in the tech space, partly because of the ever-changing nature of technology.

The tech names that have made it to that list are usually world-class companies.

Jason Fieber's Dividend Growth PortfolioIt takes being a world-class company in tech to be able to fund growing cash dividends to shareholders.

This is why I’ve always focused on the highest-quality names in technology as I built my FIRE Fund.

That Fund is my real-money portfolio.

It generates the five-figure passive dividend income I live off of.

I retired at only 33 years old and now live off of growing dividends.

My Early Retirement Blueprint lays out exactly what I did and how I did it.

A major aspect of the Blueprint is the investment strategy I used to get here.

That strategy is dividend growth investing.

Dividend growth investing advocates buying and holding shares in high-quality companies that pay rising cash dividends.

It’s a phenomenal strategy for building lasting wealth and passive income.

But dividend growth investing is a lot more than just picking the right companies.

It’s also about picking these companies at the right valuations.

Price is what you pay for a stock. But value is what you get for your money.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk. 

This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Buying an undervalued high-quality dividend growth stock in technology can totally change your life.

Fortunately, undervaluation is not extremely difficult to discern.

Fellow contributor Dave Van Knapp’s Lesson 11: Valuation, part of a more comprehensive series of “lessons” on dividend growth investing, deftly explains how to go about discerning undervaluation.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Cisco Systems, Inc. (CSCO)

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

Cisco Systems operates across five groups: Infrastructure Platforms, 58% of FY 2019 sales; Services, 25%; Applications, 11%; Security, 5%; and Other Products, 1%.

Founded in 1984, Cisco Systems has become a $200 billion (by market cap) monster by providing infrastructure components that allow the Internet as we know it to work.

It’s the major supplier of switches, routers, firewalls, and supportive networking products. The company’s various products are vital for network performance and security.

And as the Internet morphs into the Internet of Things, a ubiquitous interconnection of computing devices into everyday objects, the company’s products will become even more critical.

This bodes well for increasing profit… and increasing dividends.

Dividend Growth, Growth Rate, Payout Ratio and Yield

As it sits, they’ve increased its dividend for ten consecutive years.

Cisco Systems announced a dividend increase less than two weeks ago, but the CCC list hasn’t been updated yet for March.

The five-year dividend growth rate shows as 13.3%; however, that’ll be negatively impacted by the 2.9% dividend increase the company just announced.

This ~3% raise was undoubtedly disappointing, but I don’t think it changes the long-term appeal of the business as a dividend growth investment.

Long-term investing is thinking in terms of decades, not individual years.

Moreover, the small increase didn’t come about because Cisco Systems is in any kind of trouble with the dividend.

The payout ratio is at a moderate 57.1%. Free cash flow easily covers the dividend.

Rather, the company is simply being conservative for the time being in the face of lower near-term demand around certain areas of the business.

I believe the dividend growth will pick back up again and normalize soon. Cisco Systems has a history of going into these short-term lulls, then accelerating once again.

Meantime, investors are getting a pretty juicy yield of 3.11% here.

That’s certainly a lot higher than you’ll get with the broader market. And it beats a lot of other lower-yielding stocks in tech, too.

Also, this yield is slightly in excess of the stock’s own five-year average yield.

Revenue and Earnings Growth

Let’s now take a look at the business growth that supports this dividend growth, which will also help us value the stock.

I’ll first show you what Cisco Systems has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a near-term professional forecast for EPS growth.

Blending the proven past with a future forecast in this manner should help us reasonably extrapolate out a growth trajectory.

Cisco Systems increased its revenue from $40.040 billion in FY 2010 to $51.094 billion in FY 2019.

That’s a compound annual growth rate of 2.93%.

I usually look for mid-single-digit top-line growth from a mature business such as this.

They fell a bit short, but a company such as this always has numerous levers to pull that can drive excess bottom-line growth.

And that’s exactly what they did.

Earnings per share expanded from $1.33 to $2.61 over this period, which is a CAGR of 7.78%.

That’s more like it.

Buying back stock and expanding margins greatly aided their cause.

The outstanding share count is down by more than 25% over the last decade, which is rather substantial.

Looking forward, CFRA is predicting that Cisco Systems will compound its EPS at an annual rate of 5% over the next three years.

New products, increasing software sales, improved productivity, and headcount reductions are all cited as tailwinds.

Offsetting those tailwinds are macroeconomic uncertainty, especially regarding China. The recent concerns around the Covid-19 are hitting companies everywhere.

I think a 5% projection is fair, if conservative.

The long-term potential is, in my mind, much greater than this for Cisco Systems, as evidenced by their 10-year performance. And, in many ways, our usage and the power of the Internet is really just getting started.

Firms that are heavily tied to the rapid rise in bandwidth usage are almost certainly going to incredibly well over the long run.

However, even a 5% CAGR for the company’s EPS over the next three years gives them room to raise the dividend by at least that much.

The payout ratio is moderate. FCF is plentiful.

If Cisco Systems does better than this with EPS growth, which I think they will, the dividend could easily grow in the high-single-digit range.

Financial Position

Moving over to the balance sheet, Cisco Systems maintains a fantastic financial position. They have a fortress balance sheet.

The long-term debt/equity ratio is 0.43, while the interest coverage ratio is approximately 18.

If these numbers were it, they’d tell a great story.

But this isn’t the complete story at all.

Cisco Systems has more than $33 billion in total cash (as of the end of last FY).

That clears their long-term debt more than two times over.

This balance sheet gives them a coat of armor, while also giving them a lot of firepower to keep up with the ever-changing nature of technology. They can be nimble and scoop up fast-growth companies by virtue of their immense cash hoard.

Their profitability, as one might expect, is extremely robust.

Over the last five years, the firm has averaged annual net margin of 16.54% and annual return on equity of 15.63%.

These numbers are solid, but they belie the true power and progress of the company.

That’s because FY 2018 threw a monkey wrench into the numbers, artificially skewing the averages.

Suffice to say, Cisco Systems is regularly printing net margin well over 20%. That’s a good deal higher than where they were at a decade ago.

There’s much that is attractive about Cisco Systems as a long-term dividend growth investment, particularly if you’re interested in more tech exposure in your portfolio.

Patents, technological know-how, the necessity of their products, and switching costs that create sticky customers are all durable competitive advantages for the company.

The way society now practically revolves around the Internet means we cannot practically live without the products that Cisco Systems supplies.

Of course, there are risks to consider.

Litigation, regulation, and competition are omnipresent risks in every industry.

The very nature of the business model is also a sizable risk, as technology changes very quickly.

Covid-19 is a more short-term issue, but it could turn out to be somewhat disruptive for FY 2020.

And while Cisco Systems has a secular growth story, a global recession would likely reduce demand for many of their products.

Stock Price Valuation

Overall, I think this stock looks very appealing as a long-term investment.

And it’s one of the few high-quality tech stocks that hasn’t gone parabolic over the last couple years.

With the stock’s price moving down over the last 52 weeks, it now looks attractively valued…

The stock is trading hands for a P/E ratio of 18.02.

That’s certainly lower than the broader market.

It’s also notably lower than where many tech stocks are at right now.

In addition, the multiple on cash flow, at 12.7, is materially lower than the stock’s own three-year average P/CF ratio of 14.3.

And the yield, as noted earlier, is slightly higher than its own recent historical average.

So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7%.

This DGR is lower than what they’ve mostly produced over the last decade.

In addition, the payout ratio is moderate. And they have a lot of cash.

However, I’m also looking at the fact that dividend growth has decelerated in recent years. Plus, CFRA is anticipating a broader slowdown in EPS growth over the near term.

I believe the long-term thesis is intact, and Cisco Systems has a tremendous runway of growth and opportunity in front of them.

But I’m erring on the side of caution after taking a holistic view of the business.

The DDM analysis gives me a fair value of $51.36.

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.

I think it’s fair to say that I was being pretty conservative with my valuation, yet the stock still looks undervalued.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

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 3-star stock, with a fair value estimate of $48.00.

CFRA 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.

CFRA rates CSCO as a 4-star “BUY”, with a 12-month target price of $52.00.

We have a fairly tight consensus here. Averaging the three numbers out gives us a final valuation of $50.45, which would indicate the stock is possibly 9% undervalued.

Bottom line: Cisco Systems, Inc. (CSCO) is one of the highest-quality tech companies in the world. The products they supply are critical to making sure the Internet as we know it runs properly. As the Internet morphs into the Internet-of-Things, this company stands to profit even more. With a market-beating 3%+ yield, a moderate payout ratio, more than $30 billion in cash, double-digit long-term dividend growth, and the potential that shares are 9% undervalued, this could be one of the best dividend growth opportunities in tech right now.

-Jason Fieber

Note from DTA: How safe is CSCO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 91. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, CSCO’s dividend appears Very Safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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