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.
