Can Cisco Still Make Your Portfolio Future Proof?

In recent years, it has managed to grow revenues despite a threat to its core business. That changed in 2017. Revenues have started to drop, and they have had to cut thousands of jobs. Does it make sense to keep Cisco in your portfolio for the long term?

Cisco is heavily dependent on the Americas region (60% of revenues) and, as you would expect, on its core business of switching and routing products (total of 60% of revenues). This area has been under threat from competition for the last few years from cheaper hardware alternatives and software defined networking (SDN) products. The company has managed to maintain its switching category revenue at around 40%, but the routing business has shrunk from 23% in 2012 to 20% in 2016. The service provider video category has also shrunk from 10% to 6.5% due to a number of new entrants in the space.

To counter this trend, the company has innovated and grown other categories, including wireless (4.6% to 7%), data center (3.6% to 9%) and security (3.7% to 5.3%) in the same time period. Like a lot of product companies (e.g., Apple (AAPL ), IBM (IBM )), Cisco has also been turning to services as a growth area. The company has grown services from $9.7 billion in 2012 (21% of revenue) to approximately $12 billion in 2016 (24.4% of revenue). It has also talked about pushing an operating system for networking devices (that can be used in a competitor’s hardware products). This move is widely seen as a disruptive move for not just the industry but also its own networking business (clients can opt for cheaper options from competitors with the white label Cisco software). This will impact revenues in the short term but, given that software brings in more margins and is less capital intensive, the net income is likely to improve in the long term. So far, the transition period in the last few years has yielded results with overall revenues, operating margin, net income and EPS growing in the last four years.

For a company like Cisco that has come to exist at the epicenter of modern technology, continuous innovation is crucial to survival. It is therefore important for long-term investors to track how the company is placed regarding the future. To that effect, it is not a secret that Cisco takes long-term investing seriously. In the last five years, Cisco has acquired close to 50 companies; in 2016 alone, it purchased 12. The company has lined up several others in the growth areas of security, collaboration, services and the Internet of Things (IoT). Examples include Jasper for cloud-based IoT software-as-a-service platform and Lancope for increased ability to respond to modern threats on enterprise networks. On top of that, the company has spent an average of $6 billion/year (about 12% of 2016 revenue) on research and development over the last three years.

Broadly speaking, Cisco defines its innovation strategy as build, buy, partner, invest and co-develop. As part of this strategy, the company has made close to 150 investments in startups and acquired close to 190 companies.

As technology shifts to a cloud-based software-as-a-service world, Cisco’s dependence on hardware products is a risk for the company. The stock dropped almost 5% in May this year when the forecast was reduced for the near term. To deal with the shortfall in revenues, the company announced a cut of 1,100 jobs in addition to the 5,500 job cuts it announced last year. Cisco has been moving its business away from hardware and toward software and services. If things go as per plan, software and services will contribute 50% of its revenue by 2020.

Cisco is far away from the valuation super spike it witnessed during the Internet boom of the 2000s. Like a lot of tech companies, it does not feature in the list of dividend aristocrats. It was listed on NASDAQ in 1990 but only started paying dividends in 2011. It has grown its dividends aggressively since then from $0.12 in 2011 to $0.94 in 2016. Today, the current yield stands at 3.65% and future payouts look encouraging for long-term investors with a payout ratio of 54% and gradual increase of free cash flow in the last ten years ($8.8 billion in 2007 to 12.4 billion in 2016).

Find the dividend yield of the technology sector on our dedicated page here. You can also get an individual company count and a dividend yield of industries within the technology sector.

Despite revenue pressure in its core business, Cisco has been able to grow the EPS in the last five years by 80% from $1.17 in 2011 to $2.11 in 2016. This has been achieved by maintaining healthy margin discipline (gross margin maintained around 64%, reduction in Opex/revenue), the increase in net income ($6.5 billion to $10.7 billion) and a reduction of shares outstanding (5.5 billion to 5 billion) in the last five years. The growth in EPS has been rewarded with a 95% increase in stock price from August 2011. The San Jose-based company has a current P/E of 14, which is at par with Juniper Networks (JNPR ), and higher than IBM (IBM ) and HP (HPQ ) but lower than Citrix (CTXS ).

Read about Cisco’s $15 billion share buyback that was announced last year here.

Cisco is currently going through a period of transformation and investors can expect a revenue drop in the next few quarters. Given their strong sense of innovation, fundamentals and intent to grow dividends, the stock represents good future value for investors. The recent drop in stock price represents a buying opportunity for investors.

You can find an updated list of companies that recently announced changes in their payout policies, along with their ex-dividend dates, in our Dividend Payout Changes and Announcements tool. Check out our Best Dividend Stocks page by going Premium for free.

The views expressed in the article are my own and do not represent the views of my clients. Follow me on Twitter @tanmoyroy for more frequent updates.