Mr. Valuation’s Best Valued Ideas For Retirement And Dividend Growth Portfolios: Cisco

2015-03-27

Introduction

This series of articles is designed to identify attractive, blue-chip, higher-yielding dividend growth stocks that are currently available at sound valuation. Consequently, the primary determinant for a company to be included in this series is sound and attractive current valuation.

In other words, the research candidates presented in this series should not be thought of as the absolute best dividend growth stocks on the planet. Instead, they should be thought of as the best dividend growth stock opportunities available at reasonable valuations in today’s moderately overheated market.

As I indicated in my first article in this series found here, finding high-quality stocks, especially dividend growth stocks, in a fully-valued market environment like we have today is difficult to say the least. Adding fuel to the fire is the current low interest rate environment. This makes matters more complex in several ways. Not only are investors looking for better yields, but they are also looking for better total returns.

Consequently, there are many investors who believe that the quest for return and yield has elevated the demand for equities, thus driving valuations too high. Many believe this is especially relevant with blue-chip dividend growth stocks such as those found on fellow Seeking Alpha author David Fish’s CCC lists of companies with consecutive dividend increase streaks. However, the truth is that some blue-chip dividend growth stocks are in fact overvalued, but not all of them. It is a market of stocks, not a stock market.

Cisco Systems, Inc. (CSCO) is the dividend growth stock I will be featuring in this article and has recently qualified to be included on David’s “Dividend Challengers” list of companies that have increased their dividend for 5-9 straight years. Although it is difficult to find high-quality, high-yielding dividend growth stocks in today’s market environment, I believe Cisco represents an excellent long-term opportunity. Furthermore, I believe it is a potential low-risk, high current yield and high long-term total return opportunity based on its current low valuation, above-average current dividend yield, and attractive prospects for future earnings and dividend growth.

The Power and Protection of Investing in a Stock When Valuation is Low

Before I turn to highlighting the attributes of Cisco Systems, Inc., I would like to offer a few general remarks on the benefits of investing in stocks at sound valuation. These remarks were prompted by comments that were made on my previous article where I covered the Dividend Champion Emerson Electric (EMR).

In calendar year 2013, Emerson Electric was very popular and its price rose to a premium valuation based on its earnings and dividend justified value. Then, in calendar year 2014 Emerson’s stock price gradually descended back to fair value. This recent weak price action instigated negative comments about its short-term stock price performance.

Apparently, it is a common human reaction to like a stock when its price is rising, and to dislike a stock when its price is weak. Yet, common sense and age old investment wisdom promote and support the benefit of buying low and selling high. Unfortunately, applying common sense is not always common practice for many investors.

Therefore, I felt compelled to highlight and offer the benefits, safety and opportunity that investing in a blue-chip stock when its valuation is low provides. As legendary investor Warren Buffett once so aptly put it: “You cannot buy what’s popular and expect to do well.” Or another favorite Warren Buffett quote of mine is also appropriate: “Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

But the real purpose of this section of this article is to provide some insights into why the above advice is wise. There are many important advantages and benefits that investors gain from being disciplined about valuation. When you invest in a company at sound valuation, you are simultaneously receiving both a higher current earnings yield and a higher current dividend yield than you would by investing at higher valuations. Therefore, you are positioned to receive higher returns with less risk. To me, that indicates investor Nirvana.

Furthermore, when you invest in a company when its valuation is sound, you can expect to receive the full measure of the company’s future operating results. In the long run, earnings determine market price and dividend income. When you pay a fair price to buy those earnings, your future capital appreciation and dividend growth rates will correlate closely with the business results the company generates. When you pay too much, you can end up receiving lower results than the operating business produces.

If you are a day trader or momentum investor, it might make sense to look for stocks that are currently rising in value. However, in order to succeed with that strategy, you have to be nimble and correct. Momentum can change in an instant, and often without warning. In contrast, a long-term investor in a high-quality, blue-chip company with a great record of growing dividends year after year puts time on their side. When you buy low, you might not be required to sell high in order to make money. Instead, you can succeed from an “invest and own” (a.k.a. buy-and-hold) prudent strategy.

Finally, buying at sound valuation, or even better when a stock is undervalued, provides what I like to think of as the opportunity to benefit from “natural leverage.” When you are “greedy when others are fearful,” you position yourself to participate in potential P/E ratio expansion when an unpopular stock becomes popular again. With blue chips, this is more often the norm than it is the exception. Consequently, the earnings you originally bought at a lower P/E ratio are positioned to be capitalized at a higher P/E ratio in the future. When this occurs, you potentially earn even more than the full measure of the business results that the company achieves.

Cisco Systems, Inc.: A High Conviction Pick for Retirement and Dividend Growth Portfolios

Cisco Systems is not the classic example of a pure blue-chip dividend growth stock. The company has only been paying a dividend since July of 2011, and therefore, does not have the long streak of increasing its dividend that many dividend growth investors require and covet. However, it has increased its dividend and its payout ratio aggressively since it began paying a dividend. More importantly, management has publicly announced its commitment to shareholders in its most recent (2014) annual report as follows (emphasis added is mine):

“We remain focused on shareholder value creation by maintaining the flexibility to make the right long-term strategic decisions for our company, driving efficiencies in our cost structure and returning capital through dividends and share repurchase to our shareholders.

During fiscal 2014 we delivered strong operating margins. Additionally, we were very pleased to have substantially exceeded our goal of returning a minimum of 50% of our free cash flow annually to shareholders by returning $9.5 billion through share buybacks and $3.8 billion in dividends, totaling a record $13.3 billion returned to shareholders in the fiscal year.”

Live Fully Functioning Earnings and Price Correlated Historical F.A.S.T. Graphs On Cisco

If you believe management’s commitment to shareholders is real, as I do, then Cisco currently offers very compelling valuation and yield attributes. At the time of this writing, Cisco is available at a current blended P/E ratio of 12.9 and provides prospective investors a current yield of 3.1%. Consequently, if the company was to trade at a fairer P/E ratio of 15 in the near future, this would indicate the potential for double-digit total annualized rate of returns over the intermediate term and over the longer term. Assuming, of course, that operating results continue as expected.

In addition to a 15 P/E ratio being a rational and an earnings justified expectation of fair value, the following live and fully functioning earnings and price correlated F.A.S.T. Graphs clearly illustrates that Cisco’s P/E ratio has, in fact, been steadily expanding to its current level of approximately 13 since fiscal year-end 2011 when its P/E ratio was below 10. In my experience and long observations, high-quality, blue-chip companies rarely stay undervalued forever. Recent evidence suggests that Cisco is no exception.

For additional evidence, you can click on the orange 5Y (5-year) time frame on the live graph below and you will see clear evidence of the above statement. You can also place your cursor on the black price line and run it from left to right and you will see visual evidence of the recent P/E ratio expansion I am talking about.

I have prepared a very short video on how to utilize and navigate the F.A.S.T. Graphs historical earnings and price correlated research tool. I highly suggest that the reader take the time to learn how to utilize and benefit from this tool:

Thesis for Future Growth: Live Fully Functioning Forecasting Calculators

Cisco is no longer the powerful and compelling growth juggernaut that it once was. However, since 2011, the company has morphed into an interesting, and based on its current valuation, I believe a compelling dividend growth stock. On the other hand, even though it’s not the growth stock it once was, I believe there is still solid growth in store for Cisco going forward.

Thanks to its advantages of scale and a durable moat based on the high cost of customer switching, coupled with superior security versus its lower cost competitors, positions Cisco as the gold standard one-stop shopping option for routers and switches.

According to MorningStar:

“Cisco’s dominance in data networking is clear. Its Ethernet switches, which move data along local computer networks, are ubiquitous in corporate data centers. The firm enjoys a substantial market share advantage over Hewlett-Packard, its most significant competitor. Cisco’s routers, used by telecom and cable service providers to move data across long distances, are also the market favorite. While Huawei and Alcatel Lucent have made recent inroads, Cisco still maintains more than 50% global market share in carrier routers, with particular strength in North America.”

Even though the company has and will continue to face competition, management has responded in a meaningful, and so far, successful way. The company has focused on priority growth areas as it recently realigned its human resources to focus more on the rapidly evolving technology landscape. The company sees long-term growth opportunity in several technology trends that it has identified. These include but are not limited to the Cloud, the Internet of Things (IOT), Mobility and Software Defined Networking ((SDN)).

Additionally, the company’s recent restructuring and realignment enabled it to reduce operating expenses by approximately $1 billion per year while still maintaining high gross margins in excess of 60%. Consequently, Cisco appears well positioned for profitable growth as the world evolves into a more and more interconnected world. Cisco envisions a world where our homes, our businesses and even our cars will all be connected, and the company expects to competitively participate in that enormous growth potential.

For example, from its website, Cisco expressed its views of the opportunities and the potential of the Internet of Things as follows:

Seize New Product and Revenue Opportunities with the Internet of Things

Cisco estimates that 50 billion devices and objects will be connected to the Internet by 2020. Yet today, more than 99 percent of things in the physical world remain unconnected. The growth and convergence of processes, data, and things on the Internet will make networked connections more relevant and valuable than ever before. This growth creates unprecedented opportunities for industries, businesses, and people.

The IoT can potentially transform nearly every industry-locally and globally. It brings networking technology to places where it was once unavailable or impractical. The challenge is to build the right infrastructure. Your company faces changing requirements of scale and data management, and needs standards-based infrastructure that is highly secure and interoperable.

Cisco offers new ways to manage and store data in the cloud and data center. Learn about Cisco products, services consulting, and industry-specific solutions that can improve productivity and efficiency in manufacturing, mining, oil and gas, transportation, and utilities.”

In spite of all the growth opportunities cited above, prospective investors need to consider that Cisco already has a market cap in excess of $140 billion. Therefore, due to its sheer size, it requires a lot of opportunity to grow. Nevertheless, the consensus of leading analysts following the company expects intermediate-term future earnings growth of 5%-6%, and similar long-term earnings growth.

The following live and fully functioning F.A.S.T. Graphs “Forecasting Calculators” will allow the reader to produce precise future return calculations to include expected capital appreciation and dividends based on those estimates for future earnings growth. I think this is extremely important, because I personally never enter into an investment without having a precise potential return number in mind. These calculators easily and efficiently facilitate that process. I have prepared a very short video on how to utilize and navigate the 5 forecasting calculators. I highly suggest that the reader take the time to learn how to utilize and benefit from these tools.

For additional color and information relating to Cisco’s growth potential, I suggest following this link and going through the slides from its second-quarter fiscal-year 2015 conference call. It’s important to consider that this is the same presentation that analysts review in order to make their earnings forecasts cited above.

Cautionary Remarks on Cisco’s Dividend Growth Rates

Analyzing historical data and statistics is an important part of a comprehensive research and due diligence process. However, prudent investors need to be aware that when analyzing such information, that the devil is in the details. In other words, in addition to knowing a specific statistic, it is often more important to know how, why and from where the statistic was generated. Cisco’s average dividend growth rate and its compound annual dividend growth rate (CAAGR) are cases in point representing an extreme example of my point. I have often found that some of the clearest insights can be gained from examining extreme examples.

Although Cisco’s dividend growth rates have been exceptional since it began paying one in 2011, it would be unrealistic to think they would continue at such high rates. This is the danger of a simple statistic. Cisco’s extraordinary dividend growth rate has been a function of two important factors. As the company has morphed into a lower-growth dividend growth stock, both initial dividend increases were very large, and its payout ratio has also grown exponentially. In the future, I would expect future dividend growth to be more aligned with future earnings growth. In other words, future dividend growth of approximately 6% per annum seems reasonable to me going forward.

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CSCO1

Short Business Description, Courtesy S&P Capital IQ:

“Cisco Systems, Inc. designs, manufactures, and sells Internet Protocol ((IP)) based networking products and services related to the communications and information technology industry worldwide. It provides switching products, including fixed-configuration and modular switches, and storage products that provide connectivity to end users, workstations, IP phones, wireless access points, and servers; and NGN routing products that interconnect public and private wireline and mobile networks for mobile, data, voice, and video applications.

The company also offers service provider video infrastructure, including set-top boxes, cable/telecommunications access products, and cable modems; and video software and solutions. In addition, it provides collaboration products comprising unified communications products, Web-based collaborative offerings, and telepresence systems; data center products, such as blade and rack servers, fabric interconnects, software, and server access virtualization solutions; security products, including network security, Web and email security, cloud Web security, advanced malware protection, and data center security, as well as network admission control and identity services; and other products, such as emerging technologies and other networking products. Further, the company offers wireless products consisting of wireless access points; network managed services; and standalone, switch-converged, and cloud managed solutions.

Additionally, it provides technical support services and advanced services. The company serves businesses of various sizes, public institutions, telecommunications companies, other service providers, and individuals. Cisco Systems, Inc. was founded in 1984 and is headquartered in San Jose, California.”

Cisco Systems, Inc.: Fundamental Underlying Numbers

The Balance Sheet

Cisco has a healthy and solid balance sheet as depicted below. The metrics shown are as follows:

Assets per share (atps), cash and equivalents per share (cashps), common equity or book value per share (ceps), debt long-term per share (dltps), debt per share (dtps) and invested capital per share (icaptps).

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CSCO2

Levered Free Cash Flow and Dividends

Cisco generates significant levered free cash flow (lfclfps), which is cash flow available left over for shareholders after all obligations have been paid. Clearly, Cisco has ample free cash to cover and support its dividend (dvxps).

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CSCO3

Gross Profit Margin and Net Profit Margin

Cisco’s recent restructuring initiatives have enabled it to maintain healthy profit margins. Both gross profit margin (GPM) and net profit margins (NPM) remain consistent since fiscal-year 2005.

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CSCO4

Shareholder Committed Management Team

As previously discussed, Cisco’s management is currently committed to shareholders. The company has been aggressively buying back shares as the stock has been undervalued since 2011. I believe buying back shares when a company’s stock price is undervalued is an excellent policy and strategy. Cisco’s dividend growth since initiating one is also a strong sign of a shareholder-committed management team.

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CSCO5

Summary and Conclusions

Retired investors and dividend growth investors alike face many challenges in today’s economic and investment world. Interest rates are extremely low relegating fixed income instruments to, based on historical standards, low-return vehicles. The stock market, as represented by the S&P 500, is hovering near all-time highs, and its valuation moderately higher than historical norms. All this has resulted in many of our best, blue-chip, dividend-paying stalwarts moving into overvalued territory.

However, not all dividend paying stocks are overvalued today. This series of articles is offered to identify high-quality, above-market yielding and reasonably valued high-quality investment prospects for further research and due diligence.

Even though Cisco Systems has only recently become a dividend paying stock, its current attributes appear very attractive. The company is awarded a very high S&P credit rating of AA-, has a debt-to-capital ratio of only 25%, and above-market dividend yield exceeding 3%, and a compelling current valuation. Consequently, I present it as one of my high-conviction, long-term dividend growth selections for both above-average growing dividend yield and above-market future total return.

Disclosure: Long CSCO at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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