Updated on June 20th, 2019 by Jonathan Weber
Cisco Systems (CSCO) is one of the largest technology companies in the world. Over the last couple of years, it has managed to achieve a strong dividend growth track record, which is why the stock is part of many retail investors’ portfolios.
Cisco stock has a current dividend yield of 2.5%. It is among the Dow 30 stocks that pays a dividend to shareholders.
Trading at $56, Cisco’s shares look substantially overvalued right here, which is why we believe that it is not a good time for investors to enter or expand a position right now.
Cisco is fundamentally attractive due to factors such as high returns on capital, a strong balance sheet, and a strong market share, and Cisco has a solid growth outlook over the coming years, which is why Cisco would be a buy at or below our fair value estimate of $47 per share.
Business Overview and Recent Events
Cisco is a technology company that designs, manufactures, and sells networking and products as well as other communications related products around the globe. Its main offerings include switching and routing products, data center equipment, wireless access points for a number of different technologies such as voice and video, and products that are related to the emerging Internet of Things.
On top of that Cisco has been building out other businesses over the last couple of years, partially via acquisitions, including security products such as network and data center security, threat protection, web security, and more.
Cisco was founded in 1984 and is headquartered in San Jose, California. Cisco’s share price has risen substantially over the last year, but shares still trade well below the highs that the company’s stock reached during the “dot.com” bubble of the late 1990s and early 2000s.
Cisco reported its third quarter (fiscal year 2019) earnings results on May 15. The company reported that it had generated revenues of $12.96 billion during the quarter, which beat the analyst consensus estimate easily, and which represented a growth rate of 4.0% versus the previous year’s quarter.
Cisco continued to generate the vast majority of its revenues with product sales, which made up $9.7 billion, or roughly 75% of the company’s sales, while service revenues totaled $3.2 billion during the third quarter.
Source: Cisco investor presentation
Cisco was able to grow its revenues at an even higher pace when we adjust the previous third quarter revenues for the divestment of the Service Provider Video Software Solutions business. On an adjusted basis, revenues were up 6% year over year during the most recent quarter, which we deem an attractive top line growth rate for a mature tech company.
Cisco’s growth during the third quarter was broad-based, as the company was able to grow across geographies and business units. Cisco’s security business, in which the company has invested billions of dollars through acquisitions over the last couple of years, once again was the fastest-growing unit, as it delivered a 21% revenue growth rate during Q3. The above-average growth rate in this segment shows that management’s decision to prioritize this high-growth market with its M&A strategy seems like a good idea.
Cisco’s growth was highly profitable, as the revenue growth rate of 4% translated into a net profits growth rate of 13%, while earnings-per-share grew at an even more attractive rate of 23% versus the previous year’s quarter.
Earnings-per-share growth was positively influenced by a meaningful reduction in Cisco’s share count, thanks to Cisco’s fast pace of share repurchases throughout the last year. Cisco’s GAAP earnings-per-share totaled $0.69 during the third quarter, while adjusted earnings-per-share came in at an even higher $0.78.
Guidance for the fourth quarter of fiscal 2019 looked highly positive, as Cisco expects revenues of $13.4 billion to $13.7 billion, which would represent a growth rate of 4.5%-6.5% versus the previous year’s fourth quarter. The revenue guidance range was higher than the analyst consensus estimate at the time of the earnings release, which is why Cisco’s share price reacted positively to the announcement.
Earnings-per-share, meanwhile, are forecasted in a range of $0.80 to $0.82 for the fourth quarter, which means further growth on a quarter-to-quarter basis. All in all, Cisco’s had a solid third quarter, and management’s comments about what to expect from the remainder of the fiscal year was better than what the market had expected.
Following a dividend increase in February, Cisco has not raised its dividend further during the most recent quarter, but that was to be expected. Investors should count on another dividend increase in February 2020, if management sticks to its historic pace of dividend increases.
With the majority of its revenues still coming from connectivity products such as routers and switches, Cisco’s growth is still heavily dependent on how these markets perform over the next couple of years. The secular megatrends are favorable for Cisco.
An increasing number of people around the globe use an ever-growing amount of devices and tech products that have access to the Internet, and smartphones become ever more important in our daily lives. This means that the underlying demand for connectivity solutions remains very strong, and this will likely remain true going forward.
Cisco is the market leader in the switching and routing industry, although competitors such as Arista Networks (ANET) have been gaining market share in some product segments over the last couple of years.
The strong underlying demand for connectivity products such as switches and routers is reflected in the fact that the Ethernet switching and routing market recently climbed to an all-time high. Cisco owns more than half of this market, the company’s very strong market position will likely mean that Cisco will be able to benefit from ongoing market growth to a significant degree.
Analysts forecast that the commercial router market will grow by 7% annually, between 2017 and 2021, which bodes well for Cisco’s future revenue growth in this product segment. The data center switching market is forecasted to grow at a meaningful page of ~5% annually between 2018 and 2023 as well, which means that Cisco should be able to continue its growth across these business segments.
Cisco’s security business is significantly smaller than its products businesses, but security is a highly attractive growth market, where market participants can count on compelling market growth rates. The global cybersecurity market is forecasted to grow from $153 billion in 2018 to $248 billion in 2023, which represents a growth rate of more than 10% annually.
With Cisco’s dominance in the switching and routing markets, which will continue to grow, and with its exposure to the higher-growth security market, the long-term growth outlook is promising.
The short-term outlook for Cisco’s revenue growth rate is also positive, as can be deducted from Cisco’s order intake during the third quarter:
Source: Cisco investor presentation
Order volume did not grow in the Americas during the third quarter, but the Europe, Middle East, and Africa region, as well as the Asia-Pacific, Japan, and China regions saw solid order intake growth compared to the previous year’s third quarter.
Lower order volumes by Service Providers were somewhat of a drag during Q3, but that was more than made up by growth from other customer segments. The combination of a solid overall order intake growth rate and management’s strong guidance for Q4 result in a positive picture for the near term outlook for Cisco.
Cash Generation And Shareholder Returns
In recent years, Cisco’s earnings-per-share growth has not only rested on business growth, but the company also shrank its share count substantially during that time frame. In 2009, Cisco had 5.8 billion shares outstanding. That number fell to 4.7 billion shares at the end of fiscal 2018.
The approximately 20% reduction of the company’s share count has increased each share’s portion of the company’s net earnings by ~25% during that time frame, which equates to an annual tailwind of roughly 2.5% to the company’s earnings-per-share over those nine years.
During the most recent quarter, fiscal Q3, Cisco continued to return a lot of cash to its owners, as referenced by the following presentation slide:
Source: Cisco investor presentation
Cisco’s most recent increase to its share repurchase authorization, which was announced in February, and which expanded the program by $15 billion, to $24 billion, was utilized in Q3 to a large extent. Cisco has bought back shares worth $6 billion during the third quarter, which equates to an annual repurchase pace of $24 billion. At this pace, Cisco would buy back almost exactly one-tenth of the company’s shares a year. All else equal, this would result in 11% annual earnings-per-share growth.
One should note that not all shares that Cisco buys back do really lower the company’s share count, though, as Cisco also issues a large number of shares to its employees and executives regularly. According to the company’s most recent 10-K filing, the current stock incentive plan allows for the issuance of up to 694 million, or roughly 15% of the company’s share count (over a time frame of more than one decade, though).
This plan covers more than one decade, though, thus the maximum annual dilutive impact is less than 1.5%. Cisco still has to spend several billion dollars a year just to keep the share count from rising, which is why the large amounts of money that Cisco spends on share repurchases, such as Q3’s $6 billion, should be taken with a grain of salt.
Cisco not only returns cash to its owners via share repurchases, but the company also pays a steadily rising dividend to its owners. Cisco started to make dividend payments in 2011. Since then, the dividend has been increased by several hundred percent. At a level of $0.35 per share per quarter, Cisco’s stock offers a dividend yield of 2.5% right now.
This is more than what investors can get from the broad market and many other technology stocks, yet still, this alone is not a reason to buy Cisco’s shares, especially when we account for the fact that Cisco’s shares were yielding almost 4% just a couple of years ago. During the last couple of years, Cisco’s share price has risen at a faster pace than its dividend, which made the dividend yield decline substantially during that time frame.
Valuation And Expected Returns
Cisco will earn about $3.10 during the current fiscal year, according to our estimates. With shares trading for $55 right now, this means that Cisco’s stock is valued at 17.7 times this year’s profits right here. A high-teens earnings multiple is not a low valuation in absolute terms, and the current valuation also represents a premium compared to how Cisco’s shares were valued in the past.
Over the last decade, Cisco’s stock has been trading at a low-teens price to earnings multiple mostly. Thanks to the fact that the company’s growth has accelerated during the recent past, partially due to Cisco’s exposure to the security market, we believe that a somewhat higher valuation of 15 times the company’s net profits would be justified. This still means that shares are substantially overvalued right here. Cisco currently trades almost 20% above our fair value estimate of $47, which would already represent a 15 earnings multiple.
If Cisco’s valuation declines to a 15 times earnings multiple over the coming five years, this would have a negative impact of 3.1% on Cisco’s annual total returns. Cisco’s valuation, which is above the norm right now, could therefore pose a substantial headwind to shareholder returns over the next couple of years.
Our forecast sees Cisco’s earnings-per-share growing at a pace of 6% annually going forward, which will be somewhat offset by a declining valuation multiple. Combined with a dividend that yields 2.5% right now, investors can thus expect annual total returns of 5%-6% over the coming five years.
This does not represent a poor return at all, but we also don’t believe that a forecasted mid-single digits annual return is a reason to enter or expand a position at today’s price, even when we factor in Cisco’s low-risk nature. After all, Cisco is an established company that is active across diverse geographic markets, that benefits from secular megatrends, and that has a strong, low-risk balance sheet with a cash position of $35 billion.
If Cisco’s share price declined to $47, which is our current fair value estimate, we would expect annual total returns in the high single digits from there, as multiple compression would not be a headwind, while earnings-per-share growth of 6% and a higher initial dividend yield of 3.1% would allow for total returns of ~9% a year. This is a total return pace that we deem attractive, especially when accounting for Cisco’s low-risk nature.
Following a long period of time when Cisco’s share price languished after the dot.com bubble burst, Cisco’s stock has awoken over the last couple of years. More recently its share price has been growing at a compelling pace, partially driven by the fact that Cisco’s earnings growth has accelerated. Cisco’s successful move towards a subscription model for its software business, and its exposure to the high-growth security market, have resulted in a rising valuation.
The earnings growth outlook is positive, but due to the fact that Cisco’s shares look quite expensive right here, we do not deem Cisco a buy right now. We rate Cisco a hold for those that want a low-risk investment with a strong balance sheet. We believe that Cisco stock is a buy at $47 per share or below.