- Cisco has substantially increased its dividend since 2011. Furthermore, a 26% hike was recently approved for dividend payout in April.
- Routing and switching margins will decline over time due to white box competitors. .
- The Internet of Things initiative is a calculated risk that has to be successful given the capital already deployed in this area.
Many investors are looking at Cisco (NASDAQ:CSCO) as an attractive income play at the moment especially considering its recent quarterly dividend hike to $0.26 a share. Cisco stock will be yielding just under 4% which is a very attractive rate in the technology sector. The dividend growth rate since the dividend was reinstated back in March 2011 has been truly explosive. Cisco commenced proceedings with a quarterly payout of $0.06 which will have more than quadrupled in 5 years when the company pays out $0.26 on the 27th of April.
Nevertheless, I would caution investors to do their homework before investing in Cisco stock for income. Why? Well, there is no point investing in an income stock if there is a possibility of substantial risk to the downside. Solely chasing yield is a fool's game as investors shouldn't be solely lured into investing in a stock just because of the dividend yield and dividend growth rate. This article will outline the areas and fundamentals where Cisco investors should keep an eye on especially if the investor in question is looking for a long term income solution.
The first is obviously free cash flow. As a result of Cisco's above average dividend growth rate, the cash flow statement has been affected in the respect that $4.09 billion was debited for dividends in 2015. Furthermore, $2.81 billion of the company's cash flows was used for share buybacks which brings the total payout for share buybacks and dividends to $6.9 billion.
Free cash flow reported in 2015 was $11.33 billion meaning that the payout ratio, when you include dividends and buybacks, comes to around 61%. Now let's see the trend in the company's first 2 quarters of fiscal 2016 so far. Free cash flow came in at $6.11 billion for Q1 and Q2. Dividend and buybacks cost the company $4.2 billion which means that the company has a current payout ratio of 68% which is 7% higher than the 2015 average. These metrics are a good place to start with for the long term income investor as sooner or later the overall payout ratio will have to come down if Cisco is to keep increasing its dividend robustly.
The company may have an exceptional balance sheet (over $60 billion in cash) but its cash balance essentially can't be used at the moment for tax reasons as $55 billion+ of it is overseas. Therefore, the company decided to issue debt recently ($7 billion in total) which it got at very favorable rates (2.95% over 10 years was the highest rate). Remember Cisco's dividend is almost 4% so the debt sale makes sense if the proceeds are invested back into the company in the right way.
However what will ultimately move the company's share price in the long term will be meaningful growth in top line and earnings which are metrics Cisco has been having trouble with as of late. Here is where Cisco's margins comes into play in a big way as the company has always had industry leading margins across its routing and switching divisions.
Well, this may not be the case anymore as white box solutions are continuing to gain more and more market share every year. As costs continue to mount up for companies (US carriers such as Verizon (NYSE:VZ) & AT&T (NYSE:T)) who require networking equipment I can only see margin contraction in these divisions going forward.
Cisco will continue to invest in software and SDV/NFV technologies in order to combat this problem but I feel the acquisitions will only delay the inevitable. Gross margins at Cisco have dropped from almost 66% in 2006 to around 61% today. It just depends on how much Cisco's customers balance sheets get squeezed over the next few years.
I acknowledge that Cisco's network equipment is a small percentage of spending budgets for many US carriers but its equipment still sells at a premium. Verizon, for example, has very high fixed costs for just maintaining its network quality and its debt to equity ratio has spiked over the last few years. Hence it will try to cut costs wherever possible. Therefore, watch the balance sheets of Cisco's customers especially on the hardware side because if routing and switching sales were to decline meaningfully, Cisco would drop its prices which would mean more margin declines.
Cisco is betting big on the Internet of Things phenomenon which was illustrated clearly by the recent Jasper acquisition of $1.4 billion. Here again is where Cisco's service division comes into play which almost topped $3 billion in turnover in the company's last fiscal quarter. This division is less volatile, more stable and carries high margins which eventually should be able to compensate for the predicted margin contraction in the products division.
What I liked about the recent Jasper acquisition was that Jasper's IoT platform doesn't compete directly with IoT services from the likes of Amazon (NASDAQ:AMZN) and IBM (NYSE:IBM) because Jasper's platform is more focused on service and automation. Companies which can differentiate themselves from the competition in this field stand most to gain as this phenomenon gains traction in the years to come.
Nevertheless fierce competition accompanies every growth trend. Investors should watch Cisco's security and wireless divisions because this is where the IoT growth will most likely show up. Cisco, if things go as per the plan, has much to gain from this initiative but new forms of technology in competitor's hands could easily stifle Cisco's $19 trillion market prediction. Watch the above-mentioned divisions to see if they can keep growing at healthy double-digit rates.
To sum up, Cisco stock at the moment looks a compelling value proposition with a present 4% yield. A strong balance sheet, excellent dividend growth rates and share buybacks all look great on the surface. So should the "yield" investor invest? Well, risks definitely exists as declining margins in routing and switching and big investment in IoT (Internet of Things) may or may not pay off going forward. Income investors always need to be mindful of the downside. Sales and earnings growth are needed from all these recent acquisitions. Margins also must remain elevated.