Dividend Growth Stock of the Month for February 2021: Cisco Systems (CSCO)

Cisco Systems (CSCO) is a technology infrastructure company. Its major products include switching, routing, wireless, and data center products; collaboration products such as WebEx; security products for networks, cloud, email, and identity/access; plus a range of technical support services. Cisco was founded in 1984 and is headquartered in San Jose, CA.

Cisco’s Dividend Record

Cisco’s yield (3.2%) is a solid, mid-range yield. Its 5-year dividend growth rate (12% per year) has been fast. Its dividend safety score from Simply Safe Dividends (SSD) is a very high 91 points on a 100-point scale, meaning that the dividend seems very safe and unlikely to be cut.

There are soft spots in Cisco’s dividend record. Its 2021 increase (announced in late 2020) is just 2.9%, which is not fast for a stock yielding under 4%. For several years, Cisco’s dividend growth trend has been downward, as illustrated by this snip from the Dividend Champions document:

Notice that each shorter period’s annualized dividend growth rate (DGR) is less than the longer period to its right. Now, it is not unusual to see a relatively new DG company exhibit a pattern like this. Indeed, we see it quite a bit among “old” tech companies that are maturing into dividend payers. That said, one would like to see such a company’s DGR settle in around 5%-6% per year, not 2.9%. I give Cisco a pass this year based on the pandemic’s impacts on its business.

Cisco’s excellent safety score (91/100) suggests that the downward trend does not signal a dividend that is in danger, but rather that the company is being prudent in its increases while it finds the right level and waits out the pandemic.

Overall, I would categorize Cisco as a mid-yield, mid-growth DG stock with a very safe dividend.

Business Model and Company Quality

Cisco describes itself as the worldwide leader in technology that powers the Internet. It designs and sells a broad range of technologies that have been powering IT systems since 1984.

Cisco is managed by geography, but it tends to be analyzed more by its product groups: Infrastructure Platforms (switches and routers), which provides over half of the company’s revenue; Applications; Security; and Services.

Cisco is a leader in on-site tech infrastructure. For example, its share in the Ethernet switching market is about 50%; in routers and services it is about 38%.

Such infrastructure products are cyclical, and Cisco’s revenues have been significantly impacted by Covid-19. Weak demand from some large enterprises and small/midsized businesses has caused declines in sales of both switching and routing equipment, although some large customers have continued to modernize their infrastructures.

Cisco faces secular changes in technology itself, as more firms move away from their on-premises IT operations and turn to the cloud for its capacity and functionality.

Cisco has spent more than $18 billion on research and development over the last three years to stay relevant in the cloud-based era.

They recently announced plans to accelerate the transition of R&D spending into cloud security and cloud collaboration offerings.

One of Cisco’s strategic goals is to shift away from cyclical hardware sales and focus more on recurring software and service revenue. Cisco has recently seen reduced demand in Applications, although a bright spot has been WebEx collaboration software, which has registered solid growth partly fueled by the pandemic and greater work-from-home activity.

Cisco continues to move toward subscription software distribution, now up to 78% of software sales. It is targeting software to rise to 37% of overall sales by 2022.

The Security unit has been resilient, with sales rising in the most recent quarter.

Management has been steadily taking costs out of its operations, including via layoffs, with the goal of providing greater flexibility as the business continues transitioning.

Morningstar awards Cisco a Narrow moat, based primarily on:

The switching costs for customers to change network infrastructure vendors. Enterprise IT operations are often upgraded on 3- to 7-year cycles, and migrating to entirely new systems is a daunting task. Customers tend to stick to Cisco when they upgrade.
Intangible assets such as Cisco’s strong brand reputation with IT decision-makers. Cisco’s new approach to selling enterprise solutions (including software, services, and security) in multi-year packages has further embedded the company within its customer base.

Cisco rates high on common measures of excellence as determined by independent stock-information providers.

Financials

As seen in the table above, Cisco gets an A++ financial grade from Value Line, which is their highest grade. In fact, Value Line has Cisco as the top-graded telecom-equipment company in its coverage universe for financial strength.

Let’s look at specific financial categories and see if we agree.

Revenue is where all financials start for a company. Cisco’s revenues have been flat for several years, which is the result of both the secular headwinds facing enterprise networking in the rising era of cloud solutions, plus the pandemic over the past 12 months.

I see Cisco’s flat revenue as the weakest aspect of its financial situation.

(Source of all graphics in this section: Simply Safe Dividends)

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 about 14%-15%, which is similar to the ROE for S&P 500 companies generally. Companies in the Info Tech sector tend to run higher.

Over the past three years, Cisco’s ROE has run around 30%, which is very good.

Debt-to-Capital (D/C) ratio measures how much a company depends on borrowed money. Companies finance their operations through a mixture of debt, equity (new shares), and their own cash flows.

A typical D/C ratio for a large, healthy company is 50%, meaning equal dependence on debt and equity. Debt is an indicator of financial risk. All else equal, stocks with high D/C ratios are riskier than those with low D/C ratios.

Cisco has essentially no net debt (debt minus cash on hand), and it hasn’t had net debt for years, giving it a D/C of zero. Cisco has not followed the trend among many companies to use more and more debt in an era of low interest rates. Cisco ended its most recent quarter with about $30 billion of cash compared to less than $15 billion of total debt. The company’s S&P credit rating is AA-, putting it in the top tier of investment-grade categories.

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 10-11% range. Cisco’s results are much higher, with margins in the high 20s.

Earnings per Share (EPS) is the company’s officially reported profits per share. We want to see if a company has years when it officially lost money, or if its earnings are steadily increasing, declining, or flat.

Cisco has shown steady earnings growth over the past decade, with a slight decline over the past year due to the pandemic.

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, which shift the recording of money around (as with depreciation rules pertaining to capital equipment, for example), cash flow is a more direct measure of money flowing through the company on a real-time basis. FCF is the cash that a company has available for dividends, stock buybacks, and debt repayment.

Cisco’s cash flow has been strong for many years, even during the pandemic. This strength is one reason that Simply Safe Dividends awards such a high score for dividend safety (91/100).

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. By retiring its own shares, the company is investing in itself, expanding each remaining share into a larger piece of the pie, and improving all of the per-share statistics.

Cisco’s share count has been steadily declining over the past decade. With the pandemic, the share repurchase program has been paused. I would expect it to resume after the effects of the pandemic are past. The company has 24% fewer shares outstanding now than it did 10 years ago.

Here is a summary of the items above:

I think Value Line has over-graded Cisco on its financials by giving it the highest grade on their scale. While the company has a strong balance sheet, little leverage, and generates steady profits and cash flows, its lack of revenue growth in the face of secular changes surrounding networking (i.e., the cloud) is a flag.

It seems like the company needs to adjust (over time) more to cloud-based realities and thus return to growth in order to merit a top-end financial grade.

Valuation

Stock valuation is separate from evaluating a company. In the evaluations above, we graded Cisco as to its dividends, quality, and financials.

In this section, we see whether its stock is fairly valued to buy or hold.

I use four models in valuing companies, then average the results. See Dividend Growth Investing Lesson 11: Valuation.

Models 1 and 2: FASTGraphs relative P/Es

These first two models compare the stock’s current price to (1) FASTGraphs’ basic estimate of its fair value, and (2) the stock’s own 5-year average valuation. Using an 8-year display period causes the software to display the stock’s 5-year average valuation.

The orange line is Model #1, FASTGraph’s default valuation reference line based on a standard “fair” price-to-earnings ratio of 15. The blue line is Model #2, based on Cisco’s own average 5-year P/E, which is 14.3.

The black line is Cisco’s actual price. The right end of the black line (most recent price) represents Cisco’s current valuation, which is 14.2. Just from simple observation, we can see that Cisco’s price is close to both of the fair-value reference lines.

To quantify that observation, I compute valuation ratios, which are the ratios of the actual P/E to the fair-value references. Here is the formula:

Valuation Ratio for FASTGraphs = Actual P/E divided by Reference P/E

Here are the valuation ratios for Cisco:

Model 1: Based on default (orange) line: 14.2 / 15 = 0.95
Model 2: Based on historical (blue) line: 14.2 / 14.3 = 0.99

Both of these results are very close to the fair value reference lines, and both of them suggest that Cisco’s stock is fairly valued.

Model 3: Morningstar DCF Valuation. Morningstar ignores P/E ratios. Instead, they use a discounted cash flow (DCF) model for valuation. As Warren Buffett said:

Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple…. [It] is an estimate rather than a precise figure.

The underlying idea behind DCF is simple: A company is worth all of the cash flows that you expect the company to generated in its operating life, discounted back to the present to account for the time value of money.

Morningstar makes conservative estimates and performs the necessary calculations, then they convert their result into a valuation ratio, the same as I did with the first two models.

Morningstar’s valuation ratio is 0.94, suggesting that they see Cisco as fairly valued (to be specific, 6% below their calculated fair value, which is within a fair price range).

Model 4: Current Yield vs. Historical Yield. Last, we compare the stock’s current yield to its historical yield. This model is based on the idea that if a stock’s yield is higher than normal, it suggests that its price is undervalued (and vice-versa).

Cisco’s current yield of 3.2% is right on its 5-year average. Once again, the stock computes as fairly valued, with a valuation ratio of 1.0.

Valuation Summary:

Putting the valuation models together, I arrive at a valuation ratio of 0.97, indicating that Cisco is fairly valued. I don’t recall ever valuing a stock with four different methods and having the results come out so close to each other.

Cisco’s recent price is $45. Its calculated fair price is $45/0.97 = $46.

Given the unusual agreement among the valuation models, I personally would not pay more than that for Cisco. Usually I consider a band +/- 10% around the calculated fair price to be the fair range, but I see no need to do that here. Maybe I’d pay a couple bucks a share more given Cisco’s high quality, but no more than that.

Fair value = $46. Top buy price = $46-48.

Miscellaneous Factors

Beta

Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility, because they are easier to live with.

Cisco’s 5-year beta of 1.01 compared to the market as a whole (defined as 1.0) means that its price has moved about the same as the market. This is a neutral factor.

Analyst’s Recommendations

Reuters’ current report on Cisco presents this table of analyst recommendations:

On a 0-5 scale, the average recommendation is 3.5, or “outperform” as they put it. This is a slightly positive factor.

The Bottom Line on Cisco

Positives:

Good yield (3.2%), historically good dividend growth rate, very safe dividend (91/100 SSD score).
Good business model, but geared more toward legacy tech than oncoming cloud-based tech. Dominant in routers and servers. Great quality grades from third-party sources.
Excellent financials except for difficulty growing revenue. Highly efficient, highly profitable, negligible debt, excellent credit rating.
Fairly valued.

Negatives:

Revenue growth has stagnated for past several years.

My broker (E-Trade) recently began to provide analyst reports from Morgan Stanley. I think that this little summary at the end of their report pretty well sums up Cisco.

I own Cisco, and I see it as a reliable dividend growth stock with moderate growth prospects. My current intention is to hold it, hopefully for a long time.

This is not a recommendation to buy, hold, sell, trim, or add to Cisco. Any investment requires your own due diligence. Always be sure to match your stock picks to your personal financial goals.

Get My E-Book for the Best Manual on Dividend Growth Investing in 2021

Top 30 Dividend Growth Stocks for 2021: A Sensible Guide to Dividend Growth Investing is packed with useful information, including an exclusive analysis of 30 top dividend-growth stocks plus a 200-page step-by-step investing manual. It is all presented in plain English with many helpful graphics.

Please click here to learn more about the new e-book.

Even if you don’t purchase the book, sign up for the e-mail list, which I am using to send monthly email newsletters containing educational content and information for DG investors.

— Dave Van Knapp

This article first appeared on Dividends & Income

We’re Putting $2,000 / Month into These Stocks
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.