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Cisco's Dividend Growth Appeal

Cisco (CSCO) 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 and services 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 and routers, which are Cisco’s largest product segments and part of its infrastructure platform business segment.
Source: Cisco
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.

Besides routers and switches, which act as the backbone of Cisco's infrastructure platforms, the rest of the firm's revenue is spread among a number of faster-growing segments – applications (10% of revenue, growing at 18%), security (5% of revenue, growing at 11%), and services (26% of revenue, growing at 3%). 

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

Most of Cisco’s products and services are sold through channel partners such as telecom providers and systems integrators.
Source: Cisco Annual Report
Cisco's stated goal is to shift away from cyclical hardware sales and focus more on recurring software and service revenue (32% of revenue is now from recurring sources). This helps to stabilize cash flow over time and supports a safe and consistently growing dividend.

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. Cisco's overseas business is its fastest growing with EMEA sales rising at 11% and Asia Pacific reporting 12% growth in the first quarter of fiscal 2019 (versus 5% in the Americas).

Cisco only began paying a dividend in 2011, but the tech giant has raised its dividend (at a double-digit annualized pace) for seven consecutive years.

Business Analysis
Cisco dominates most of its core markets. According to market research firm IDC, Cisco’s share in the Ethernet switching market was about 54% at the end of the  third quarter of 2018. The company’s market share in routers and services stood at approximately 43%. 

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

However, Cisco is aware of the secular industry trends away from in-house IT and towards cloud computing. Thus it's adapting to this new paradigm to future-proof its business. 

Cisco’s competitive 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 offering 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 (security, switching, wireless, routing, collaboration, etc.), making them less of a factor in these lucrative deals.

Cisco has spent over $18 billion on research and development over the last three years combined (about 13% of revenue annually) 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. And in fiscal 2018 the company made no less than eight bolt-on acquisitions and continues to steadily do so. 

In fact, to keep rounding out its portfolio to meet the market’s evolving needs, Cisco has spent more than $80 billion since 1995 to acquire over 250 companies. The firm has also partnered with major technology players such as EMC, VMware, Ericsson, Apple (AAPL) and Microsoft (MSFT).

The most recent example of the kind of acquisitions the company makes is chipmaker Luxtera, which Cisco bought in late 2018 for $660 million. Luxtera chips use silicon photonics to provide integrated optics capabilities for data centers.

Essentially, Luxtera's technology helps increase data transmission speeds over farther distances, a major challenge facing network equipment manufacturers according to TechCrunch. That's been a key focus for Cisco in recent years in order to adapt to the future of the industry. 

These deals are part of Cisco’s multiyear 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. 

Mr. Robbin has also adopted a balanced and shareholder-friendly capital allocation policy of returning at least 50% of free cash flow to investors via dividends and buybacks.

In early 2018 Cisco repatriated $67 billion in overseas cash to help fund more aggressive shareholder returns of $44 billion in the coming years (mostly buybacks including a $25 billion boost to its repurchase authorization). And over the past 15 years, Cisco has reduced its share count by 34% via buybacks and has grown its dividend by 15% annually over the past four years.

But while generous returns of capital to shareholder are great for mature businesses, Cisco hasn't shirked on investing in key growth areas either. 

For example, in 2016 the firm acquired Jasper Technologies for $1.4 billion. Jasper appealed to Cisco because the company is a leader in the "internet of things" or IoT. 

Specifically, Jasper is focused on internet-connected cars and has partnerships with GM (GM), Ford (F), Honda (HMC), Hyundai, and Nissan. In total, Jasper works with over 3,000 companies around the world (including 23 of the largest automakers) and wants to cash in on the large growth market that connected vehicles will likely represent in the future.

And while Cisco has a long ways to go to future-proof its business by investing in growth areas, its efforts to expand its recurring software and subscription businesses have started bearing some fruit. About 33% of Cisco’s revenue is now recurring (up more than 300 basis points versus 2017), and sales from subscriptions represent 57% of its software revenue. By 2022 the company expects 37% of revenue to be recurring.

The reason Cisco is seeing a return to strong sales growth is thanks to its new hybrid approach to combining hardware (its traditional strength) with software (security, analytics, etc.) sold under multiyear agreements.

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 Investor Presentation

In recent years, Cisco's new Catalyst 9000 switches represent the firm's most notable traction with management's hybrid approach. According to CEO Chuck Robbins, the Catalyst 9000 series of switches "has become the fastest ramping product in Cisco's history" and grew 100% in 2018. 

What's more, Cisco's new integrated switching platforms are cloud platform neutral, meaning they are compatible with all three of the largest cloud computing systems (Amazon, Microsoft, and Google). Cisco is also partnering with lesser cloud computing providers like IBM and Oracle to ensure that it will profit from the future growth of this industry.

Importantly, growth of Cisco's Catalyst 9000 customer base has helped the company maintain a solid gross margin between 62% to 64%. Given that Cisco has been facing incredible competition from lower-cost rivals like Huawei, Juniper Networks (JNPR), and Arista Networks (ANET), this ability to hold margins is a good sign that Cisco's hybrid hardware/software approach is working. 

In fact, the success of this approach is why Cisco expects high-margin software revenue alone to grow from 22% of revenue today to 30% by 2022.

But ultimately the biggest reason to like Cisco is that its legacy domination of IT data connection hardware means that it enjoys a sticky ecosystem.

IT departments usually replace hardware every three to seven years. However, due to the fact that the vast majority of IT transitions are done manually (an often complex and time-consuming job), many of Cisco's customers are loath to switch over to new hardware suppliers.

That's because errors and troubleshooting problems during such transitions can cost a business dearly in down time. In fact, about $45 billion a year is lost to corporate America each year via trying to transition to competing IT vendors.

Cisco estimates its new hybrid software/hardware offerings are saving customers substantial amounts of time and money via fewer problems, faster issue resolution, and far lower operating expenses.

That's the benefit of integrating hardware and software, which is the key to Apple's historically strong and immensely profitable "walled garden" business model which Cisco is now emulating in certain ways.
Source: Cisco Investor Presentation

Thanks to Cisco’s enormous breadth of hardware products and software services, along with some of the headaches involved with switching networking suppliers, it’s difficult for competitors to match the company’s lineup and ongoing convenience.

By focusing on developing extremely reliable hardware, building a brand based on quality, and using its economies of scale to keep costs low, Cisco typically enjoys price premiums and very healthy margins on its products (a 26% 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 20 most valuable brands in the world.

At the end of fiscal 2018, Cisco’s worldwide sales and marketing departments had approximately 25,200 employees and field sales offices in 96 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 and software is also needed to handle the traffic and keep it secure, 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.
 
Looking ahead, for fiscal 2019 management expects about 6% revenue growth, and over the long term analysts think that, even accounting for the cyclical nature of IT spending, Cisco should be able to deliver roughly 3% to 4% annual revenue growth and about 8% growth in earnings, free cash flow, and dividends. 

However, Cisco does face several meaningful risks. 

Key Risks
Cisco's biggest growth markets are in emerging economies like Brazil, India, China, and Mexico. However, not only do such economies tend to be more cyclical, but the company's faster sales growth in these markets means its sensitivity to currency fluctuations is increasing over time. 

If the U.S. dollar rises significantly against local currencies in these countries, then Cisco's U.S. dollar-denominated results could take a hit. Fortunately, currency translation issues tends to cancel out over time.

More importantly in the short term, 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. 

While Cisco's evolving business model with a focus on integrated hardware has helped it grow relatively quickly in recent years, Arista (who is growing revenue five times as fast) announced in 2018 that it too will be pursuing an identical approach.

The rapid pace of technological change is the key 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 firm's 2015 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 somewhat 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). 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:
Barron's

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 about 10% in 2017 while Cisco’s share has fallen from about 80% to the mid-50% range.
Source: The Wall Street Journal
The Wall Street Journal published a great article in August 2017 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 the cloud, mobile devices, 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.

Closing Thoughts on Cisco
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 (software-defined networking, the cloud, etc.).

It will also take time for the company to achieve needle-moving success in faster-growing areas such as security, which face immense competition (including from more focused pure-play rivals like Palo Alto Networks) and are far from guaranteed profitable 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 very safe with solid growth prospects. Assuming Cisco shows continued stability in its core hardware businesses and greater traction in its faster-growing segments, which provide nice recurring revenue, the company seems like a reasonable holding for a diversified dividend growth portfolio.

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