Cisco Stock – dividend at all-time high – Time to buy?

After disappointing quarterly figures, the Cisco stock (CSCO) lost 11 percent at one blow. Revenues fell by 9 percent year-on-year and, according to management forecasts, are expected to fall by a further 10 percent in the current quarter. It seems that despite the strong demand for conference software such as WebEx, Cisco is more of a victim of the corona crisis than a beneficiary of the acceleration of digitization triggered by the virus.

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On the other hand, the plunge in the stock price pushed the dividend yield to an attractive 3.3 percent, close to an all-time high. This analysis will show you how the weak numbers can be explained and whether the Cisco stock is a bargain.

The Business: This is how Cisco makes money

Cisco is one of the dinosaurs of the Internet. For decades, its routers and switches have ensured that the flow of data from A to B works. Accordingly, Internet hardware is part of Cisco’s core business. However, this began to change with the strategy of “Intent-based Networking” introduced in 2017 at the latest. Intent-based networking attempts to master the increasing complexity of the configuration of the network landscape. In order to master this challenge, Cisco is simplifying the configuration using software. Instead of configuring the network landscape in a very technical and specific way directly, the software is programmed in a very general and at the same time simple way to setup the network. After that, the software takes care of the actual configuration. “Intent-based networking” also makes sense for Cisco from a commercial point of view. This is because software scales better than hardware, achieves higher margins and can more easily ensure predictable sales via subscription models.

Cisco stock
Logo
Country	USA
Industry	Hardware
Isin	US17275R1023
Market cap.	180,3 billion $
Dividend yield	3.3%
Dividend stability	0.91 of max. 1.0
Earnings stability	0.97 of max. 1.0

What sounds promising does not seem to be paying off currently. Why sales are slumping after a hesitant recovery becomes clearer when we look at Cisco’s individual segments.

Cisco Sales by Segments (Source: FactSet Workstation)

Infrastructure Platforms

This segment accounts for almost 60 percent of consolidated sales and includes classic Internet hardware such as routers and switches, but also the so-called “data center products” required for the operation of a data center. It covers server hardware such as storage, cooling systems, etc. as well as software, for example for firewalls. In the last quarter sales in this segment slumped by 16 percent (!). I suspect that many companies have postponed investments that were not absolutely necessary due to the rapidly deteriorating order books.

This assumption is underpinned by a report published in June by the Boston Consulting Group, which examined the IT budgets of almost 700 companies in response to the Corona crisis.  As a result, 54 percent of the companies postponed the purchase of new hardware and in particular cut back on infrastructure spending.

Boston Consulting Group – cuts in IT expenditure in the wake of the Corona crisis (Source: Boston Consulting Group)

Applications

The term “data center products” refers to the servers and their core functionality. In order for the customer to actually work with the servers, he/she needs additional hardware and software. This is sold in the Applications segment, which accounts for around 11 percent of total sales. One of the best-known software products in this segment is the WebEx communications software, which has seen double-digit growth in sales („strong double digit growth“ – see Q4 Prepared Remarks, p. 7). Overall, however, sales in this segment also fell by a significant 9 percent. From my point of view, this is not surprising. Because if less server infrastructure is purchased, there is less demand for additional services.

Services

Software neither installs itself nor can employees simply use it. In addition, the configuration of servers or a network topography is not intuitive. Cisco supports its customers here with in-house experts and charged the same amount for this service as in the previous year’s quarter. A quarter of the company’s turnover was made this way.

Security

Revenues in the (data) security segment increased by 10 percent. It is pleasing that this segment was able to escape the downward trend caused by corona, especially as security is a fundamental topic that promises further growth and stable revenues and high margins due to the high proportion of software solutions. The Security segment is contributing 5 percent of Group revenues.

In my view, the almost 10 percent decline in revenues at Group level is mainly due to postponed investments in server infrastructure that have an impact on related segments. According to CEO Chuck Robins, the ongoing trade war with China has also been weighing on business for almost a year.

Is Cisco a Dino?

After the publication of the last quarterly figures, groups on Facebook and Co. discussed Cisco, with very critical comments also being made about the Dinosaur of the Internet. Here are some of the critical statements:
“Cisco is a Dino like IBM or Intel”.
“In my opinion Cisco seems to be “zero” innovative and in my perception knows little to do with itself and its future”.
“In my opinion, Cisco is on the way to becoming a second IBM”.

In fact, Cisco’s sales since 2014 seems to symbolize stagnation:

Stagnating sales – Are the golden years over for Cisco?

Well, it’s not what it looks like. In fact, the reorientation towards “intent-based networking” initiated in 2017 is actually paying off. For example, sales from 2017 to 2019 rose by a good 8 percent and operating margins by 1.5 percent, whereas Cisco’s margins are generally very stable and are currently close to an all-time high of just under 29 percent:

Cisco shines with stable margins near the all-time high

As part of the realignment, the company also succeeded in raising the share of software in total revenue to the 30 percent target they´ve set in 2017:

We set a goal of 30% of our revenue to come from software, and while we achieved 29% in fiscal year ’20, we did achieve 31% in Q4

Source: Prepared Remarks for Q4 2020, p. 2

In my opinion, the successful realignment of the corporate strategy is more in favor of Cisco than against them. The fact that sales have recently fallen back to 49.3 billion USD after rising from 48.0 to 51.9 billion USD is attributable to the Corona crisis and, to a lesser extent, to the ongoing trade dispute between the US and China.

Is Cisco´s dividend safe?

Despite generally stagnating sales since 2014, Cisco continued to increase profits, cash flow and dividends per share.

Despite stagnating turnover, per-share figures at Cisco continued to rise

This was due to rising margins and, primarily, share buybacks. According to the annual report (p.52) of 2018 the cash for the buybacks were sourced when Cisco repatriated $70 billion of foreign subsidiary earnings to the U.S. (in the form of cash, cash equivalents, or investments) as a result of the tax act in 2017. The  chart below shows that since 2017, the number of shares outstanding has been reduced by 16 percent from 5,094 billion to 4,244 billion, driving up earnings per share by approximately $0.43:

Massive share buybacks at Cisco-Systems – also thanks to the US tax reform

The next chart shows you in more detail where Trump’s tax gifts to the economy went at Cisco over the last two years:

Use of cash at Cisco in 2018 and 2019 (source: annual statements)

Dividends, acquisitions and debt repayment accounted for only a fraction of all spendings. More than half of all cash was used for share buybacks to keep shareholders happy. I think the level of share buybacks is understandable. The alternative would have been special dividends, but unlike share buybacks, these are a one-time benefit to shareholders, which are also taxable. Share buybacks, on the other hand, increase the per-share key figures of any future fiscal year. A second alternative would have been a higher debt repayment. But the combination of cheap money and high and stable cash flows (0.97 of a maximum of 1.00 on DividendStocks.cash) does not make this necessary. With an amortization power of currently USD 8.6 billion annually, Cisco-Systems would have completely repaid its debts within 7 years and could continue to pay dividends in parallel.

Cisco could repay its debts within 7 years with regular earnings

The high amortization power and almost USD 30 billion available in the cookie jar show that Cisco´s dividend is safe. Nevertheless, the dividend growth has flattened out considerably from an average of 12 percent annually to tiny three percent. With a payout ratio of just 41 percent on free cash flow, management seems to be guided in increasing the dividend not by what is feasible but by the actual growth in absolute profits and cash flow, which I believe is reasonable because it is a sustainable approach.

Cisco Systems Dividend History

Is the Cisco-Stock a bargain?

With growth rates in the single digits, the best way to achieve a high return with Cisco is to buy the stock cheap when undervalued. In the Dividend Turbo, the historically high dividend yield of 3.3 percent indicates that the Cisco stock could be favorably valued:

Cisco’s historic dividend yield

An even more precise statement regarding the right time to buy is provided by the Dynamic Fair-Value Calculation. This calculates the average valuation of a stock in the past (e.g. the average P/E ratio of the last 10 years) and compares the result with the current valuation (e.g. the current P/E ratio). This comparison is carried out in parallel for the reported profit, adjusted profit, operating cash flow and dividend yield. The result is easy to interpret:

Cisco’s stock in the Dynamic Fair-Value calculation

With a price of USD 42.50 and fair values between USD 41.50 and 43.50 for the current fiscal year, the Cisco stock seems to be valued exactly fair. Only the fair value dividend is significantly higher at USD 56. We have already seen that the amount of the dividend at Cisco is largely at the discretion of the management, which is why it seems rather unsuitable for determining the fair value. After all, it is not the management that determines how much the company is worth through an arbitrary decision, but the actual success of the company, which is measured in terms of profits and cash flows.

After another weak fiscal year 2021, analysts expect demand to pick up and consequently profits and cash flows to increase. Based on this estimation, a return expectation of 7 percent by the end of the second following fiscal year – July 31, 2022 – can be calculated, which is equally divided between dividends and price gains. Overall, the expected return is therefore rather modest.

In a nutshell: Cisco stock – solid, but don’t expect any outperformance

In the 90s, Cisco´s stock was one of the best investments in the world. Alongside the rise of the Internet, the stock price rose within a decade from 8 US cents to almost 80 USD before the burst of the Dotcom Bubble. The Cisco stock of today is no longer a speculation, but an investment in a solid dividend payer. However, the price for the 3.3 percent dividend is moderate growth and modest returns to expect. If you are interested in high and secure dividends, Cisco comes into consideration for you. If you look for outperformance, on the other hand, the stock is rather second choice.