Cisco stock: overflowing cash cow, mediocre dividend yield (NASDAQ: CSCO)

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Investment thesis

Cisco Systems (NASDAQ: CSCO) operates a strong business with high profitability and free cash flow generation. However, this becomes a problem when growth prospects are limited and market expectations for shareholder returns are potentially mismanaged. We do don’t see a positive risk-reward balance for stocks offering a 2.8% dividend yield and price the stock as a sell.

quick primer

Cisco Systems has been designing and selling a wide range of technologies from routers to security software that have powered the Internet since 1984. In 2017, the company set a goal to transform its revenue mix to have 50% software and services , and this was achieved in 2020 via organic and inorganic revenue streams.

Cisco is no longer considered a technology leader, but its key competitive strengths are: 1) a very broad end-to-end product portfolio, making it an ideal partner, and 2) highly regarded, industry-leading customer service. order and reports. Its main peers are Huawei, Fujitsu (OTCPK: FJTSF), Juniper (JNPR), HP (HPE), Extreme Networks (EXTR) and Dell/EMC (DELL).

Key financial data, including consensus forecasts

Cisco Key Financials

Key Financials (Company, Refinitiv, prepared by Karreta Advisors)

Our goals

Cisco is doing well with double-digit operating margins, high ROE, good free cash flow generation and consistent cash return to shareholders. Despite these credentials, over the past 5 years Cisco Total Return has underperformed the NASDAQ Composite by 61%. This highlights that any investment in the business had a relatively high opportunity cost.

Cisco Stock vs. Nasdaq Total Return
Data by YCharts

There seems to be an expectation gap between what Cisco is perceived to offer and how the market values ​​the stock. In this article, we want to assess how sustainable free cash flow generation is in the business and how that capital is allocated to shareholder returns and future growth.

spend more than generate

Cisco’s net cash balance of $13.0 billion in fiscal year 7/2021 represents only 5.6% of current market capitalization. The net cash balance has been steadily declining since FY 7/2018, implying that there are more disbursements than cash generated.

Change in net cash at the end of the year

Cisco Net Cash Balance Trend at Year End

Change in net cash at the end of the year (Company)

When looking at how capital has been allocated over the past 10 years, the company has allocated more capital than it was able to generate organically (even ignoring repayments of debts).

Cumulative capital generation and allocation over the last 10 years

Cisco - Cumulative capital generation and allocation over the last 10 years

Cumulative capital generation and allocation over the last 10 years (Company, prepared by Karreta Advisors)

It’s good to see a company use its capital to generate growth through mergers and acquisitions and return money to shareholders. However, we see some red flags. First, if Cisco were to maintain historical spending levels, it would fall into a short to medium term net debt position. With this, shareholder returns may have to be externally funded, which is a negative view. Second, there is a risk that shareholder returns that were perceived to be sustainable will become more volatile, which would be negative for equities. Historically, Cisco’s dividends have been stable with greater volatility in share buybacks.

Despite management’s focus on shareholder returns, total cash distributed in fiscal year 7/2021 was actually lower than the level seen in fiscal year 7/2017.

Annual cash spent on dividends and redemptions

Cisco - Annual Cash Spent on Dividends and Buybacks

Annual cash spent on dividends and redemptions (Company)

The key question is whether free cash flow can be generated sustainably and whether there will be strong growth in the future. We believe Cisco will continue to generate free cash flow with a strong track record of converting free cash flow (consistently around 120%+), but in terms of growth, we are less positive because 1) rates conversions shouldn’t increase much from here and 2) earnings forecasts don’t expect a big increase in sales or profits.

We assume Cisco has a fundamentally good business, but risks raising market expectations of its ability to consistently allocate more cash to shareholder returns.

Evaluation

According to the current consensus forecast, stocks are trading on a free cash flow yield of 7.3% for fiscal year 7/2023. This is an attractive valuation, but we believe this estimate is overly optimistic given that there is little evidence to demonstrate why free cash flow will grow 13% year-over-year with only 5% growth in revenue, 7% year-on-year growth and consensus capital expenditure forecasting a 16% increase. % Annual. The prospective dividend of 2.8% is not very high.

Risks

The upside risk stems from Cisco performing well and increasing its market share, given Huawei’s lower status in Western markets. Cisco can capitalize on its global sales and service network to drive growth.

With the market currently favoring stable companies with high recurring revenue at lower valuations, Cisco shares may look relatively attractive as an investment compared to other tech peers.

Downside risk arises when the market perceives that the company has allocated capital to shareholder returns in a way that is unsustainable, given future limits to increasing its free cash flow.

Under growth pressure, the company could engage in more M&A activity, which could have mixed results and limit cash for shareholder returns.

Conclusion

Cisco is running a good business with high profitability and free cash flow generation. However, where this becomes a problem is when growth prospects are limited and market expectations of shareholder returns are mismanaged. Total cash distributed to shareholders in fiscal year 7/2021 was down from fiscal year 7/2017, and consensus guidance for dividends per share shows low single-digit growth going forward. We do not see a positive risk-reward balance for stocks offering a 2.8% dividend yield and rate the stock as a sell.

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