Cisco DiviendCisco (CSCO) has been nothing short of an impressive dividend growth stock since it began paying dividends in 2011.

 

The company’s quarterly dividend payment has increased from 6 cents per share in 2011 to 26 cents most recently, including management’s 24% boost to the dividend in February 2016.

 

With a low price-to-earnings multiple, a dividend yield near 4%, and very strong Dividend Safety (87) and Dividend Growth (80) scores, Cisco has caught the attention of many income investors.

 

Let’s take a closer look at the investment case for Cisco as we consider the stock for our Top 20 Dividend Stocks and Conservative Retirees dividend portfolios.

 

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 (77% of sales) and services (23%) to businesses of all sizes, its main offerings connect computing devices to networks or computer networks with each other.

 

The company’s website provides an overview of switches (39% of product sales) and routers (20%), which are Cisco’s largest 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 between a number of faster-growing segments – Collaboration (11%), Data Center (9%), Wireless (7%), Service Provider Video (9%), and Security (5%). 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 60% of Cisco’s sales last fiscal year were in the Americas with another 25% in EMEA (Europe, the Middle East, and Africa) and 15% in Asia.

 

Business Analysis

Cisco dominates most of its core markets. According to IDC, Cisco’s share in the Ethernet switching market was 59.2% at the end of the third quarter of 2015. The company’s market share in routers is also in excess of 50%.

 

As seen below, no other vendor comes close to Cisco’s dominance in these markets.

 

Cisco Dividend

Source: IDC

 

Synergy Research reported similar figures and noted that Cisco is about seven times the size of its next largest rival in switching and routing technologies.

 

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 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, and Apple.

 

Simply put, it’s very difficult for competitors to match the company’s breadth of products and services.

 

By focusing on developing extremely reliable hardware, building a brand based on quality, and using its economies of scale to keep costs low ($49 billion revenue base last year), Cisco typically enjoys price premiums and very healthy margins on its products.

 

Beyond its technology portfolio and unique ability to deliver architectural solutions, Cisco is a sales and marketing juggernaut that has established one of the 15 most valuable brands in the world.

 

At the end of fiscal year 2015, Cisco’s worldwide sales and marketing departments had approximately 25,000 employees and field sales offices in more than 90 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, integrated solutions at scale to customers. The company has built a reputation for reliability and is trusted by 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.

 

As our readers know, in addition to investing in companies with a clear economic moat, we also prefer to buy businesses that 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 or packaged food, but their importance should not be overlooked.

 

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 literally 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, we appreciate the mission-critical nature of most of the company’s products and services.

 

Cisco’s 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 and increased competition that commoditizes previously profitable technologies.

 

There’s a reason why Warren Buffett tends to shy away from technology companies – change can happen fast. For this reason, technology is not one of the best stock sectors for dividend income.

 

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.”

 

Technology shifts constantly threaten Cisco and require the company to continuously innovate to remain dominant in its markets.

 

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, potentially reducing demand for networking equipment (or at least reshaping it) and enabling the substitution of lower-priced, unbranded gear. Unbranded systems can also provide 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.

 

The shift to more software and services is also improving the company’s mix of recurring revenues, which adds stability to Cisco’s business model.

 

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 a year ago 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 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 – either due to SDN or competitive pressures.

 

The rise of cloud, mobile, and big data are certainly forcing IT architectures and computing to evolve and become more flexible. However, we have yet to see evidence that Cisco is losing market share or seeing its margins erode.

 

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 strength (financially, technologically, and strategically) to remain relevant, 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.

 

Dividend Analysis: Cisco

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Cisco’s long-term dividend and fundamental data charts can all be seen by clicking here.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

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 87.

 

As seen below, Cisco’s favorable rating begins with its healthy payout ratios. The company’s free cash flow payout ratio was 36% 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.

 

Cisco Dividend

Source: Simply Safe Dividends

Cisco Dividend

Source: Simply Safe Dividends

 

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, we believe 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. One analyst from Oppenheimer estimates that Cisco’s recurring revenue has doubled since fiscal year 2008.

 

Cisco Dividend

Source: Simply Safe Dividends

 

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 11 fiscal years. Few businesses have demonstrated such consistency.

 

Cisco Dividend

Source: Simply Safe Dividends

 

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 Dividend

Source: Simply Safe Dividends

 

Cisco’s balance sheet is rock solid and virtually guarantees the safety of its dividend. As seen below, the company has $60 billion in cash compared to $22 billion in debt, and it has nearly $15 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.

 

Cisco Dividend

Source: Simply Safe 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.

 

Dividend Growth Score

Our 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 great dividend growth potential. The company’s Dividend Growth Score is a solid 80, and management has aggressively raised Cisco’s dividend since the business began paying one in 2011.

 

Cisco most recently raised its dividend by 24% in February 2016 and has 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 and seems poised to continue delivering strong dividend growth.

 

Cisco Dividend

Source: Simply Safe Dividends

 

Valuation

Like some other mega cap, “old” technology companies, Cisco’s valuation looks rather undemanding. The company’s stock trades at 12x forward earnings estimates and has a healthy dividend yield of 3.7%.

 

If the company’s $7.50 per share net cash is excluded, CSCO’s stock trades for approximately 9x forward earnings estimates.

 

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.

 

Cisco has managed to squeeze out modest revenue growth and higher earnings in its recent quarters, but the market is clearly expressing some concern about the company’s long-term relevance in the ever-changing world of technology.

 

If Cisco can continue compounding its earnings per share at a mid-single digit rate like it has historically, the stock appears to offer annual total potential of 8-10%. If investors regain confidence in the company’s long-term future, its earnings multiple would likely expand as well.

 

In our view, Cisco’s valuation is quite reasonable and seems to have somewhat limited downside risk.

 

Conclusion

Cisco’s dividend looks great, and had the company started paying dividends much sooner than 2011, it would probably be in the same discussion with other blue chip dividend stocks. Regardless, Cisco’s dividend looks extremely safe with above-average growth prospects.

 

While we think Cisco has built up a durable franchise in network equipment and services, it’s hard to not wonder why the market is so pessimistic about the company’s future.

 

Business trends and market share are currently stable, and there is no end in sight to the gobs of cash Cisco is generating.

 

Technology trends are certainly evolving and we remain in the early days of software-defined networking, but Cisco would seem to have the financial firepower, partners, installed base, and brand recognition to remain relevant.

 

We will add Cisco to our Watch List and become particularly interested if its dividend yield crosses the 4% mark.

 

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