TipRanks Smart Dividend Newsletter – Edition #41
Hello and welcome to the 41st edition of TipRanks’ Smart Dividend – a weekly Newsletter providing you with investment ideas for safe-bet quality stocks that are outstanding dividend payers, compared to their peers.
Investment Thesis: Supporting Connections
In today’s fast-paced and interconnected world, the digital communications technology industry plays a critical role. With increasing demand for high-speed internet, cloud computing, Artificial Intelligence, and other advanced technologies, companies operating in this space are well-positioned to generate significant cash flow and reward their shareholders.
Let us present one such company, which is a compelling income investment idea.
This Week’s Quality Income Stock Idea
Cisco Systems, Inc. (CSCO) is an American multinational digital communications technology conglomerate, headquartered in San Jose, California. Cisco designs, develops, manufactures, and sells telecommunications equipment, networking products, software, and technology services. CSCO is the largest networking and communications infrastructure company in the world.
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Company Overview
Founded in 1984 by two Stanford computer scientists, Cisco rapidly grew and expanded its product suite, supporting computer network development. The company invented the concept of the Local Area Network (LAN), used to connect computers over large distances using a multiprotocol router system. Cisco System went public on the Nasdaq stock exchange in 1990 and became the dominant player in the networking industry later that decade.
The company rose to global fame during the dot-com bubble years, at one point becoming the most valuable company in the world. Its routers and switches proved crucial for connecting the world’s computer networks, allowing for the development of the World Wide Web.
Even though the company’s stock lost most of its value when the dot-com bubble burst, the company’s products remain the backbone of the Internet. Through the years, Cisco has continued to develop new innovative products in-house and expand its offerings through acquisitions, helping it to remain a market leader in its sphere despite the stiff competition.
Today, with a market capitalization of $196 billion, annual revenue of $57 billion, and a net income of $12.6 billion, Cisco Systems is one of the leading technology companies in the world, ranking #19 on the list of global tech giants. CSCO has been a Fortune 500 company since 1994; today it ranks #82 in the list of the largest U.S. firms by revenue.
Cisco’s products and services are used by businesses, governments, and non-profit organizations of all shapes, sizes and geographies.
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Business Prospects
Throughout its history, CSCO has continued to double down on innovation, developing several technologies that were irreplaceable for internet communications, like Voice over IP (VoIP). The company has also continuously expanded into new areas, staying on top of technological advancement. Today, in addition to its traditional products such as networking equipment, it also offers wireless and mobility products, cyber security products and solutions, collaboration platforms for hybrid work, data center and cloud networking systems and solutions, Internet of Things (IoT) platforms, as well as networking-as-a-service and other software and technology consulting services.
The company’s diversification into software and services beyond traditional hardware, as well as its adaptation of cutting-edge technologies, has proven to be a wise business decision, allowing the company to turn profits even when global telecommunications equipment spending slows down. This track record of innovation and adaptivity, coupled with strategic partnerships and effective cost management, permits an optimistic outlook regarding Cisco’s further trajectory, as these factors drive revenue growth and strengthen investor confidence.
In addition, while the telecom and cable service demand for Cisco hardware remains sluggish due to the sector’s downcycle, Artificial Intelligence (AI) applications have emerged as an important revenue supporter. Cisco has long been offering AI-ready infrastructure products and has recently announced the implementation of AI solutions across its entire portfolio.
Major cloud providers such as Microsoft, Amazon, and others, are accelerating spending on servers that power AI services, increasing potential windfall for “picks and shovels” providers like Cisco. The company has partnered with Nvidia to deliver customizable AI infrastructure solutions for data centers, enabling the massive computing power that enterprises need to successfully harness the power of AI. In addition, Cisco is developing its own AI applications, such as an AI-driven cloud security platform, automation tools, monitoring and analytics solutions, Generative AI-As-A-Service deployment tools, and other AI capabilities integrated across its entire portfolio. The growing efforts to implement AI across corporations and businesses, combined with Cisco’s dominance in the network infrastructure field, points to an outlook for the acceleration of AI-related revenue growth.
Cisco Systems has been transforming its business model, achieving accelerating growth in the proportion of recurring revenues out of total income, which vastly increases the company’s financial predictability and visibility. In 2023, 85% of the company’s $17 billion in software revenue (30% of total revenue) was recurring. Total subscription revenue, including services sold as subscriptions, was over $24 billion, which represents 43% of Cisco’s total revenue.
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Dividend Analysis
The stability and reliability of Cisco Systems support its capital allocation strategy, centered around returning capital to shareholders through dividends and buybacks, as well as investment in business expansion and maintaining a net debt-free balance sheet.
Cisco has been paying and increasing its dividend payments since 2011. In the past decade, the dividend has grown at a CAGR of 8.7%, slowing to a CAGR of 3.4% in the past five years as its dividend yield reached its current heights. The most recent dividend hike was in February 2023, when the payout was raised by 3%. The dividend is expected to continue increasing at a rate of ~2.5-3% for years to come. CSCO’s current dividend yield stands at 3.23%, far above the IT sector’s average of 1.02%.
The safety of the dividend is supported by the company’s moderate EPS-based payout ratio of 37.8% and cash payout ratio of 46.7%, which leave the company with ample capital and cash to pursue other important capital allocations.
Cisco’s robust financial health is another key factor supporting the outlook for continued dividend increases. The company has more cash than its total debt, and the obligations it does have are very highly rated by leading credit-rating agencies: “AA-“ by S&P Global Ratings and “A1” at Moody’s. The company’s balance sheet is a fortress, protected, among other things, by its large and growing cash position.
Cisco’s bonds enjoy strong investor demand, as the company’s debt is perceived as a safe and solid investment. In February, CSCO sold $13.5 billion of bonds to finance a part of its $28 billion acquisition of a big data monitoring firm Splunk, which is expected to be finalized this summer.
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Total Return Outlook
On February 14, the company reported its fiscal Q2 2024 (ended January 27, 2024). The report featured better-than-expected revenue and earnings results despite slight year-on-year declines. These were expected and primarily due to lower network systems revenue, though these shortcomings were partly offset by higher service revenue. In fact, Cisco has surpassed analysts’ EPS expectations in all quarters for which these estimates have been available. In the past three years, CSCO’s revenues grew at a CAGR of 6%, while earnings-per-share increased at a CAGR of 11.3%.
In the fiscal second quarter, Cisco reported further expansion to its already outstanding gross and net income margins, which are in the top 5% for its industry. The company also maintained or improved its industry-leading capital efficiency metrics, such as ROE, ROA, and ROIC. CSCO ended FQ2 with total cash, cash equivalents, and investments of $25.7 billion.
Despite better-than-expected results in FQ2, which followed five consecutive quarters of strong revenue and EPS growth, shares of the company fell. Investors were spooked by a lower FQ3, and FY2024 (ending in July) guidance than analysts anticipated. In addition, the company announced layoffs of 5% of its workforce as a part of its ongoing restructuring effort, aimed at maximizing long-term shareholder value.
It seems that disappointed market participants overlooked the management’s outlook for a more favorable hardware sale trajectory in FY2025, as well as the company’s strong market position, allowing it to capitalize on the multibillion-dollar AI infrastructure opportunity. The continued increase in recurring revenue, which supports the company’s confidence in its ability to return capital to shareholders, also flew largely under the radar. Analysts from Evercore ISI and other prominent Wall Street firms view Cisco’s emphasis on high-growth areas, cloud, and AI, as well as its strategic acquisitions and the ongoing transformation towards software and recurring revenue streams, as strong long-term growth-supporting factors.
The post-earnings negativity around the stock has further depressed its valuation. CSCO is about 40% undervalued compared to the IT sector, and trades at the bottom of the price range for its peers in the industry. In addition, CSCO trades about 45% below its fair value, based on future estimated cash flows. These factors position the stock within the value universe, increasing its potential upside. With all the negativity now priced in, the stock looks like a great buy-the-dip (and hold) opportunity.
Notably, in addition to potential stock price appreciation and high dividend payouts, Cisco’s shareholders are compensated through generous buybacks. The company is committed to returning a minimum of 50% of free cash flow annually to its shareholders. The company’s management confirmed the company’s commitment to providing a high degree of consistency in its stock repurchase program, as well as to consistent dividend increases. In FQ2, CSCO performed $1.23 billion of share repurchases after buying back $1.5 billion in FQ1. In FY 2023, Cisco repurchased its shares for an amount exceeding $4 billion.
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Investing Takeaway
Cisco is a long-standing pillar of the world’s connectivity with a profound impact on all things online. Despite its long history, wide market reach, and large size, it can perform fast changes to its business model to pursue growth opportunities. The blue-chip company is a profitability and cash-generation champion, with a clear commitment to long-term shareholder value creation. The stock’s current valuation suggests that CSCO combines both value and income propositions. Meanwhile, its potential to capitalize on the ongoing technological revolution supports a stronger growth outlook than currently envisioned by the market. These two factors combine to create the circumstances for a superb investment opportunity, which is why we believe that Cisco Systems is well-suited to be a part of long-term income portfolios.
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Disclaimer
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