A lot of cash rich companies have been returning cash to their shareholders recently as these companies realize that investors are putting heavy focus on regular income. Cisco Systems (NASDAQ:CSCO) is a relatively new entrant into the dividend club; however, the company has been able to raise its dividends substantially and reach the top-end of the list. The notion that the companies paying dividends do not have a lot of growth potential is old and outdated, in my opinion.
In my previous article, I discussed the growth opportunities for the company in detail - retaining cash is important for the companies to exploit future growth opportunities; however, sometimes the decision to retain or pay earnings should be made keeping in mind the short-term impact of the decision along with the long-term benefits. A lot of companies can benefit from paying a portion of their cash, which is sitting idle, and it can provide some support to their stock price.
In addition, if the company has the ability to generate enough free cash flows, then a company should not be reluctant in paying a larger chunk in dividends. In Cisco's case, we have a company with considerable growth opportunity, which is now transforming into an extremely attractive dividend pick. In this article, I will go deep in the cash flows statement as well as balance sheet of the company - according to my criteria, financial strength and cash flows generation ability is vital to be an attractive dividend pick.
Cash Flows and Debt Analyzed
The first component of the cash flows statement that I want to talk about is the cash flows from operations. In the past five years, cash flows from operations were the highest in 2008 - in the following year, operating cash flows fell by more than $2 billion and remained around $10 billion for the next three years. Dismal condition of the networking equipment business in the last four years is apparent from the fall in cash flows of the company. However, in 2012, an improvement in net income along with better management of receivables resulted in operating cash flows going above $11 billion. In addition, operating cash flows for the trailing twelve months have also gone close to $12 billion.
Going forward, Cisco's operating cash flows are expected to cross $12 billion for the full year - a 7.6% expected growth in earnings should take operating cash flows above $12 billion. Capital expenditures have been increasing steadily; however, the increase has been small, currently capital expenditures stand at $1.12 billion. Cisco has been returning cash to its shareholders through two mediums: dividends and stock repurchase program. However, stock repurchase program has been cut back in the last year when the company bought back shares worth $4.7 billion.
While share repurchase is a sensible idea for the company as it is done with the help of internally generated funds, I would like the company to direct more cash towards dividend payments rather than buy back shares. Share repurchase is eventually more beneficial to management than shareholders, in my opinion, as EPS is an important factor in determining the compensation of the management. On the other hand, big hikes in dividends too soon might become an issue for the stock price in the long-term - usually dividend increases are kept in low figures in order to maintain that growth rate in the long-term, otherwise, stock price can be negatively affected. Finally, free cash flows are extremely strong, and the payout ratio based on free cash flows is at 21.88%. Taking into account the stock buyback and dividends, Cisco is paying 51.56% of its free cash flows back to its shareholders.
Moving onto the debt of the company - total long-term debt has been fairly stable for the company over the past two years (a small increase in 2012 to $16.297 billion from $16.234 in 2011). However, total long-term debt has grown by about 200% from the levels of 2008. Although the debt has increased substantially over the past five years, the cash flows of the company are adequate to cover its debt obligations. So, the analysis of the cash flows and debt suggest that Cisco's recent dividend hike will not be the last and we will see double digit growth in dividends.
Personally, I am not a fan of share repurchase plans, especially when the company is growing and future earnings are expected to be better than the current earnings. I believe the incentive for the management is not there when the earnings are going to grow regardless of the share buybacks. As a result, I believe Cisco can pay more cash in dividends and increase its payout ratio to between 35% and 40% of free cash flows - that will leave a substantial amount of free cash flows for the company to expand. Payout ratios at about 40% of free cash flows will double the current cash dividends. Once the company reaches the above mentioned payout ratio, then it should try to maintain it at that level, which will result in slower but steadier growth in quarterly dividends.