Cisco (CSCO) began paying a modest dividend in 2011 to the delight of shareholders. It signaled perhaps that the tech giant had accepted its fate as a mature company and that its days of rapid growth were behind it. Regardless of the reasoning Cisco was producing so much extra cash that, despite its acquisitive nature, snapping up smaller companies left and right, it was stockpiling cash on its already robust balance sheet. The stock now yields a very respectable 3.3% with the current 68 cent annual payout. The question for investors is how safe is this yield and how much room does Cisco have to raise the payout in the coming years?
First, the short answer to the question of safety is, quite simply, yes the dividend is incredibly safe. In terms of how I came to that conclusion, we must look no further than the company's ability to generate cash from its business.
Inv CF Total
Inv CF Less ST Inv
This table shows the last three years of operating cash flows, investing cash flows and resulting free cash flow. Operating cash flows, investing cash flow total and net short term investments came straight from the company's 10-K. I then computed the investing cash flows net of the effect of short term investment purchases and receipts and finally, calculated free cash flows.
As we can see, CSCO produced $8.6 billion in free cash flows in 2011 and just over $10 billion in 2012. These are very strong numbers but we need to put them into context in terms of the company's ability to pay the dividend.
To do that, we will first look at the most common (and pointless) metric of dividend safety, the payout ratio. As we know, the payout ratio is simply the amount of dividends paid divided by net income; those numbers are below.
Cisco's payout ratios are quite modest indeed, starting with the introduction of the dividend in 2011 to a payout ratio of only a tenth of reported earnings. The dividend and payout ratio increased in 2012 but it is still sitting below one fifth of earnings. This is terrific as dividend investors love citing the payout ratio for dividend safety. However, the payout ratio is a pointless metric that compares an accounting metric to the amount of dividends a company pays. How this came to be is beyond me but the fact is that it is followed by investors, despite its mindlessness.
Using my preferred method of dividends paid in relation to cash flows, we get a more complete and relevant picture of just how much cash a company can afford to distribute. We will now view the dividends paid in the context of the free cash flow numbers we looked at prior.
We can see that the payout ratio in terms of free cash flow was only 8% in 2011 and 15% in 2012, contrasted with 10% and 19%, respectively, for the traditional payout ratio. Given that the numbers are so low, in Cisco's case, it may not make a huge difference but keep in mind that if net income takes a hit due to some accounting policy such as a goodwill write down, which is a significant part of Cisco's balance sheet, the traditional payout ratio will suffer substantially. It is important to ignore this and focus on cash flows as this is how a company pays dividends, not with some accounting metric used to track financial performance.
Given this information, we can attempt to figure out what Cisco can afford to distribute to shareholders annually. We all know Cisco loves to buy smaller companies in order to continue growing and acquire new technologies, processes and talent. This requires cash generated either from operating the business or some external source such as debt or stock issuances. Since Cisco produces so much cash internally, debt is relatively modest and equity issuances are only for employee compensation.
Now that Cisco is firmly into the "mature tech" stage where it has acknowledged growth is slowing and it is time to return cash to shareholders, one way to move the needle on the stock price is to make cash distributions to shareholders. Cisco does this via buybacks and dividends. The company has committed to a very nice dividend payment already of $0.68 per share annually but as we have seen, there is plenty of room to go up. Cisco could literally double its cash distribution and only use up 30% or so of its free cash flows. This is incredible and it means that a yield of more than 6% wouldn't put even the smallest amount of financial strain on the company. This is important for many reasons but it means a few things for dividend investors.
First, a special dividend is very possible due to the amount of cash the company generates. While Cisco loves acquiring smaller companies, it can't find a use for all the cash the business generates, which is why it began paying a dividend in the first place. Therefore, as the cash piles up, a special dividend could be in the offing. Second, it means that if CSCO shares begin to struggle, management can ride to the rescue and significantly increase the dividend with ease. Indeed, we saw this with Apple (AAPL) just this week.
The point of this analysis is to confirm that CSCO can afford whatever dividend it wants currently. Even assuming no free cash flow growth, CSCO is generated seven times the amount of cash needed to pay its dividend. This leaves plenty of room on the upside for the payout and creative ways to distribute cash such as special dividends. The bottom line is even if you don't believe Cisco will grow in the future, you can achieve greater than 3% current income at current prices and payouts but also know that Cisco can raise the payout to whatever it likes. I feel confident that the dividend will double in the next few years based simply on the fact that the company is generating a huge amount of cash each quarter that it cannot profitably invest in the business and dividend investors can be the recipients of said cash. When the dividend does double from current levels, the stock price will likely be bid up in sympathy in order normalize the current yield. When that happens, you will be paying much more to buy shares than you would today.