A Technology "Utility" with Upside Potential

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Cisco (CSCO) is the largest networking company in the world with a dominant position in the segments it operates in. The company has stopped trading as a growth stock as its huge scale makes high double digit growth difficult, if not impossible. However, the company is still managing to grow revenues and earnings at around ~10%, which is great for a dividend investment. Like other older technology stocks such as Intel (INTC) and Microsoft (MSFT), Cisco has started giving a handsome dividend yield as the cash hoard grows larger and larger. Value and dividend investors have generally stayed away from technology stocks and have preferred safer utility and consumer goods companies. However, it may be time for them to reexamine their strategy and invest in these “technology utilities”. Traditional power utilities face new threats from rapid changes in energy technology such as fracking and solar power. Consumer goods companies also face threats, such as static growth and increasing competition from emerging markets. But these technology companies have huge moats around their business models in the form of thousands of patents, brand name etc. No big company can function without these technology utilities. It is difficult to imagine a single big corporation that does not use a product made by these technology giants.

Why We Like Cisco

  1. Dividends and Valuation – Cisco trades at a forward P/E of just ~10.1x, with a projected dividend yield of ~2.7%. Cisco did not give a dividend till 2010, focusing only on share buybacks till that time. However, the company has started giving dividends since 2010 and the management has committed to return 60% of the FCF to shareholders, through dividends and buybacks. This implies that the company will return an average of $5.5 billion annually to shareholders. The company has net cash of more than ~$29 billion on its balance sheet, which implies that ~30% of its stock price is accounted by cash alone. The company can easily service its dividends and buybacks through its cash flows and the cash on its balance sheet.
  2. Good solid growth – A company with Cisco’s size and market share cannot grow at a rapid pace like Priceline (PCLN) or Amazon (AMZN). However, the company manages a decent double digit growth, with 8.5% growth in revenues and a 12.5% growth in earnings over the last 3 years. The company is expected to grow by 8-9% in the next 5 years as well.
  3. No Complacency, Rapid expansion into new areas – Cisco is not resting on its laurels, but is rapidly expanding into new fast growing technology segments. The company is showing rapid growth in Data Center (61% growth), Wireless (38% growth) and SP video revenue (30% growth). This shows that despite its large size, the company is constantly innovating and investing resources into fast growing technology areas. The company is acquiring companies in the software defined networking (SDN) area, to bolster its product line and stave off competition from Juniper (JNPR) and VMWare (VMW) in that area.
  4. Global Leader in Networking – Cisco is a leader in the networking industry, with leading market share in switches, routers etc. The company has a strong competitive position in the segments it operates in, with a global marketing and sales force. It has a leading brand name, which is synonymous with trust and high quality. The company does not face any big competitive threat, as it’s biggest competitor Juniper is much smaller in size. Other competitors like Alcatel-Lucent (ALU) and Ericsson (ERIC), have been beaten down in recent years, due to their telecom dependence. The company spends ~$5 billion in R&D every year, to maintain its ~70% global market share in the network switching and routing markets. Note Cisco’s R&D spend is almost 5x times what Juniper spends on R&D.
  5. High Margins – The company has gross margins in excess of 60%, which it has maintained over the last decade with net margin of 16.7%. Like other dominant technology players, high margins reflect the high competition barriers in this industry.
  6. Balance Sheet – Cisco has a rock solid balance sheet, with net cash of ~$29 billion and total debt of ~$16 billion. The company has kept the cash and debt relatively stable over the past 5 years. The company has been using its massive cash flows to acquire companies. Cisco is one of the most prolific acquirers in the technology industry, spending almost $68 billion in the last decade.

Cisco Negatives

  1. Repeated entries into Consumer Technology Space have failed – Cisco’s entry into the consumer technology space has been a disaster, with the company having to sell off those assets. The company first tried to enter the home Wi-Fi router market by buying Linksys, but that foray has been a failure with the company looking to exit this market. The company also bought Flip camcorders which had revolutionized the consumer camcorder market because of its small size. However, this venture too proved a failure with the company shutting this product line as well.
  2. Stock Compensation – Cisco’s share count has remained largely unchanged over the past 5 years, as the company gives out high stock compensation to its executives. This has meant that share buybacks have not managed to dent the total share count by much. The company has received a lot of criticism for this already. We think going forward investor pressure will force more FCF going back to shareholders in the form of dividends. This trend started in 2010 and we expect this to continue in the future.

Stock Performance

Cisco has traded in a range of $14 to $28, over the last five years and is currently lying in the middle of that range at ~$21. Cisco has given a decent ~10% return in the last year, though it is less than the ~15% return given by NASDAQ. In the last 5 years, the company has given a loss of 20% which is in line with Juniper’s, but much below the returns given by the broader market. It is interesting how the other technology mega caps like Microsoft and Corning (GLW) have given a similar performance as their valuation multiples have compressed. The stock is currently trading near its 52 week high.

Summary

We like Cisco because of its cheap valuation and growing dividend yield. Cisco has a huge moat around its business model unlike traditional dividend stocks. Cisco’s products and services are a necessity for corporations around the globe. The company also has a strong diversification across consumers and geographies which makes it less vulnerable as well. Cisco is generating billions of dollars each year in Free Cash Flows, which it is increasingly returning to shareholders in the form of dividends.

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