Should Investors Continue To Expect Strong Dividend Increases From Cisco Systems?

Apr.10.14 | About: Cisco Systems, (CSCO)

Summary

At 3.3%, the dividend yield of Cisco Systems is at its highest level ever.

The company's dividend has grown at double-digit rates each year since the company started paying dividends in 2011.

With dividends currently occupying less than one-third of free cash flows, along with low single-digit earnings per share growth on the horizon, substantial dividend increases should be able to continue.

If you're looking to buy a partial ownership stake in a publicly-traded company, then there are a number of things that you should consider before doing so. These things include the company's business model, historical earnings growth and corporate governance. Another thing that you may want to consider is the dividend.

Dividends are very important as they can provide some cushion for investors to the downside and can also signal confidence from management in the company's future. Many investors pursue dividend-paying stocks to augment their returns with a nice income stream. Most of them prefer to diversify into many different sectors of the economy in order to spread out their risk.

Today, let's take a look at Cisco Systems (CSCO), a huge player in the technology sector of the economy. Let's see how the dividend of Cisco Systems stacks up in terms of strength and sustainability and what investors can expect going forward.

Before we go any further, it should be said that the dividend is usually not the biggest appeal of tech stocks. However, with substantial dividends from the likes of Cisco, Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), Apple (NASDAQ:AAPL), and others, dividend-oriented investors may want to consider some of these stocks in the name of diversification if nothing else.

Dividend Yield

The first and most obvious consideration when evaluating a company's dividend is the dividend yield, which represents the percentage of your investment that you'll receive back over the next 12 months at current share prices and dividend payouts.

Cisco Systems currently yields 3.3%. This is the forward yield that is based on the company's most recent 19 cents per share dividend that was declared back in February. At 3.3%, the dividend yield of Cisco Systems is the highest that it's ever been.

Dividend Growth

When analyzing a dividend, it's not all about the yield. As an income investor, you want that dividend to grow over time in order to protect your income stream from the erosive effects of inflation as well as to show confidence from management in the company's outlook.

2014 2013 2012
12% 55% 83%
Click to enlarge

Table 1: Dividend Growth Rates Of Cisco Systems

Table 1 shows the dividend growth rates that Cisco has posted over the last few years. Cisco Systems has increased its dividend each year since the company began paying dividends in 2011, including two increases during 2012.

Free cash flow payout ratio

While high dividend yields and strong dividend growth are nice, we need to make sure that the company in question can generate enough cash flow to cover its dividend payment. The free cash flow payout ratio tells us what percentage of the company's free cash flow is eaten up by dividend payments. Lower free cash flow payout ratios are better as they leave more room available for future dividend increases or other uses of the capital.

Free cash flow is the cash flow a company generates in its operations minus capital expenditures.

TTM 2013 2012 2011
32% 28% 14% 7%
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Table 2: Free Cash Flow Payout Ratios Of Cisco Systems

Table 2 shows the free cash flow payout ratios of Cisco Systems over the trailing 12-month period, as well as during the last three full fiscal years. While the free cash flow payout ratio has been growing, there is still plenty of room for dividend increases in the future, with dividends currently consuming less than a third of free cash flow.

From looking at the company's free cash flow payout ratios, it can be concluded that the dividend is in no danger at this point in time.

Interest Coverage Ratio

One of the ways in which we can determine whether or not a company will have trouble paying its dividend in the future is by looking at how much interest it has to pay every year. More money spent on interest means less money that is left for dividends. To determine the effect that debt has on a company's ability to pay its dividends and fund other activities, I calculate the interest coverage ratio. This ratio is calculated by dividing the company's earnings before interest and taxes by its interest payments over the year. You generally like to see this ratio at or above 2. If it's below this figure, then that may signal trouble ahead for the company in question.

Fortunately, this is not a problem at all for Cisco Systems. Over the last 12 months, the company's earnings before interest and taxes covered its interest expenses almost 19 times. This shows that the company's debt should not have a detrimental effect on the dividend anytime soon.

Earnings per share growth forecasts

While it's good to look at what past dividend payouts have been and how they relate to past earnings, we need to get an idea as to what future dividend payouts are going to look like. One of the ways in which we do this is by looking at analyst forecasts for earnings-per-share growth. This year, analysts expect Cisco to post an earnings drop of 2% for fiscal 2014, followed by a 5.6% gain during fiscal 2015. It should be mentioned that these projections are based on non-GAAP earnings.

While those projections are less than inspiring, it should still be enough to at least maintain the dividend for the time being.

Conclusion

The stock of Cisco Systems currently packs a dividend yield that is at its highest level ever. Since the company started paying dividends in 2011, it has increased the dividend each year by substantial amounts. In spite of relatively uninspiring earnings per share forecasts for the next couple of years, low to mid single-digit earnings per share growth along with a very low free cash flow payout ratio should be enough to support high single-digit to low double-digit dividend increases in the near term, depending on how much management wants to expand its payout ratio.

Many will point to the company's $47.1B in cash and short-term investments. However, over $43B of this is held by foreign subsidiaries, and can't be used to pay dividends unless the money is repatriated to the United States. On the other hand, the company may be able to use some of this cash pile to help fund its foreign operations, freeing up more of its operating cash flow for dividends and other value-creating activities.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.