After a Strong Increase, Cisco Shares May Still be A Buy

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Cisco is the leader in its core market of switches and routers for network connectivity but has also made significant progress to expand its product offers into other categories. The company’s other business lines include data center, enterprise wireless and security. In the past, these were primarily ancillary offerings that were basically add-ons to the core products but have grown to be relatively healthy stand-alone businesses.

High costs to change a company’s network infrastructure mean that Cisco benefits from stable revenues and has strong bargaining power with customers. Cisco has a proven track record for quality and connectivity and enterprise customers are reluctant to switch to an unproven vendor even for a price discount. Cisco was a quick mover in industry certifications and the Cisco Certification is the standard for networking credentials. With much of the industry trained on Cisco products, it creates a continual supply of technicians that will push for their business IT departments to use Cisco products.

Growth in China has been called into question lately on an escalation of tensions between the United States and the country over cyber-spying. China recently accused Cisco of deliberately installing backdoor surveillance tools into China’s internet infrastructure that enable U.S. cyber-spying. While near-term revenue in China may need to be evaluated, Cisco’s long-term growth in the country is probably more secure.

Fundamentals

Corporate spending on networking solutions has remained relatively strong compared to other IT spending and Cisco has been able to grow revenue by an annualized 6.6% over the last three years. The company has done a good job managing operating expenses, which have only increased at a 3.4% pace over the period, but the amount the company pays its suppliers has increased at a much faster 9.9% annual pace. Overall, operating income has grown nearly 7% a year and the company continues to produce strong cash flows from operations.

Balance sheet health is not normally an issue with mega-cap companies anyway but Cisco’s balance sheet looks especially strong. The company has amassed more than $50 billion in cash against long-term debt of just $20 billion. In fact, nearly 40% of the company’s $126 billion market capitalization is backed by cash on the balance sheet. Current liabilities are under $20 billion and the company booked free cash flow of $11.4 billion over the last four quarters.

Over the past five years, Cisco has spent an average of $1.1 billion a year on capital expenditures and $41.1 billion a year on investments in technology and other companies. Even on aggressive spending for future growth, cash has consistently increased and the balance sheet.

Dividends and Growth

The company initiated its first dividend in March 2011 with a payment of $0.06 per share. The quarterly dividend has been boosted by more than three-fold since then for a growth rate of 46% over the three-year period. Strong cash flows should allow Cisco to keep increasing its payment but that rate of growth is not sustainable. In its last increase this April, the company increased its annual dividend per share by 11.7% from the year ago payment.

Even on a brief history, Cisco’s 3.1% dividend yield is attractive and well above others like Microsoft (MSFT) and Apple (AAPL). The company is paying out approximately 47% of its earnings out as dividends, relatively high for a technology company so may limit dividend growth sooner than cash flow would imply. More likely, Cisco will use its large cash reserves to buy back shares and only gradually increase the dividend payout. Cisco has decreased its share count through repurchases by an annualized 2.3% over the last five years.

As we have seen in most of the large tech companies over the past year, the risk to Cisco shares is a shift in product demand and the lack of flexibility. Many of the tech giants have seen their shares plummet or stagnate on the shift from desktop computers to mobile technology and cloud-based applications. Cisco
Cisco recently dropped its WebEx enterprise social service and will start selling services from Jive Software (JIVE) as it improves its offering to help employees collaborate at work. The companies will also work together on joint product engineering and could eventually mean the smaller company is folded into Cisco through an acquisition. Cisco recently acquired mobile connectivity company Collaborate.com in its push to expand its reach into mobile and social.

It is through partnerships and acquisitions like these that Cisco has been able to expand its product line into other categories and decrease the risk that weakness in any one category will significantly reduce cash flows.

Valuation

Shares of Cisco are trading at 16.6 times trailing earnings and only just above the average multiple of 16.0 times over the last five years. While the stock trades well below the industry price-earnings average, it trades more closely with other mega-cap technology companies like Intel (INTC) and Microsoft (MSFT) due to their more mature product categories and slower growth.

While the shares may be fairly valued on a price-earnings basis, there is reason to believe that upside exists when you look at future cash flows. The high amount of cash on the balance sheet is worth more than simply its potential use for acquisitions and earnings growth. Cisco has more than enough cash on hand and it will likely need to start returning it to shareholders at a faster rate.

For the analysis below, a conservative 14% dividend growth rate was used for the first five years. This was estimated as roughly 12% dividend growth and 2% share repurchase. The growth rate was reduced to 10% for the second period and 3% into perpetuity. Cisco has a slightly higher cost of capital compared to other tech firms its size, largely due to higher stock volatility and a higher cost of equity. The company finances 27% of its capital structure with debt and issues 10-year notes at a 3.5% rate.

Even after a strong 12% increase in the share price since the beginning of this year, Cisco is still undervalued on a discounted cash flow basis. The amount of cash on the company’s balance sheet and regular free cash flow make it probable that the company will increase its cash return policy aggressively. This may happen through a higher share repurchase, a special dividend or simply through a strong increase in the quarterly dividend over the next few years. Beyond the immediate ability to return more cash, the company also has a strong diversity of products that should provide a safety net to cash flows if weakness hits any particular product group.

Best of Breed Dividend Investing

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Sometimes, it seems there are more methods to pick stocks than there are stocks themselves. Investors have to decide whether to focus on top-down or bottom-up analysis then must continuously monitor the economy and events internal and external to the companies in their portfolio. Investing in Best of Breed companies makes the whole process a little easier. While past results are no guarantee of future performance, companies that have outperformed peers in sales growth and asset returns in the past may be able to build momentum in operational efficiency.

Best of Breed Investing

What is the difference between Best Buy (BBY) and RadioShack (RSH)? Both have fallen victim to consumer trends and have seen their shares plummet in recent years. Only Best Buy has been able to claw its way back and will report positive earnings this year while RadioShack faces an expected loss of more than $200 million. The difference is that Best Buy has been able to right the ship through better strategic positioning and operational efficiency. Best Buy is a Best of Breed in its sector.

Through all the financial statement analysis, ratios and research one of the best investment ideas is to put your money in the Best of Breed within each sector. These companies that have been able to beat the peer average for revenue growth and asset returns are the ones that will best be able to provide investment returns in any market.

There is no definite criteria for selecting leaders but I like to look to three areas: revenue growth, return on assets, and operating margins. Revenue growth has been hard to come by for most companies over the last couple of years. According to FactSet data, sales growth for companies in the S&P 500 was just 0.7% in the fourth quarter. Earnings growth is good but companies need to also be able to grow their top-line. I like to see three-year average revenue growth above the sector average and most recent year’s revenue growth above a company’s own three-year average. This tells me that sales have been growing faster than peers and the trend is improving.

I consider return on assets (ROA) as a more pure measure than the more popular return on equity (ROE). Return on equity can be skewed higher by a higher use of leverage which can get a company in trouble if the market for their products turns south. Return on assets is what management is able to produce off of the resources they have, without having to leverage those assets. If a company is a Best of Breed, then it should be able to generate a higher-than-average return on its assets.

Two Sectors, Two Strong Companies

AvalonBay Communities (AVB) is a $16.8 billion developer and owner of multi-family communities in the United States. The company’s return on assets of 1.3% doesn’t sound so strong until you consider apartment REITs have an average return less than half that at 0.5%. Revenues grew by 41% in the last fiscal year and have averaged 18.7% growth over the last three years. Shares pay a 3.6% dividend yield and trade for 1.94 times book value.

The company has been aggressively developing properties lately, rather than acquiring already developed communities. This is a riskier strategy but also drives higher earnings and management has the experience to be successful with the program. The company will need this advantage as home ownership rates may be as low as they are going to go. Apartment REITs have done well over the last few years as millenials and baby boomers chose multi-family living rather than their own homes but the trend may reverse eventually. A Best of Breed like AvalonBay should outperform peers when it does.

Duke Energy (DUK) is a $49.5 billion utility operating in the United States and Latin America. Management is able to produce a 3% return on assets, well above the 2% average for the sector. Revenue grew by 25% in 2013 and has average 20% growth over the last three years. The shares pay a 4.4% yield and trade for just 1.2 times book value.

Duke Energy is expected to sell 13 power plants in the Midwest after regulators denied a rate increase. Analysts expect other companies to follow suit as a lower industrial demand and cheaper gas weigh on returns for producers in the region. The sale should improve the company’s financial position and return metrics.

The biggest hurdle with investing in Best of Breed companies is that you must keep an eye on management and developments within the company. While the shares should continue to outperform peers around external forces, management still needs to execute on its plans. Once a company has outperformed peers for a while, the corporate culture of success and efficiency advantages helps keep the momentum going.