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Cisco's free cash flow and EPS growth prospects should allow for continued strong dividend growth at above 10% per annum over the next few years.

The current stock valuation implies a perpetual dividend growth rate of 7.5%-8.0%.

A dividend discount model suggests that the shares are 10% undervalued.

Cisco's (NASDAQ:CSCO) share price recently experienced a 5% pullback from its 52-week high. From a dividend investing perspective, I believe the hiccup presents a great buying opportunity for long-term income investors as the stock now trades at a solid discount to its fair value. In this article, I will elaborate on some cash flow and dividend analyses to support my buy thesis.

I performed a projection of free cash flows between fiscal 2015 and 2017 to gauge Cisco's capacity for near-term dividend growth. My analysis started with current consensus revenue estimates, which expect the top line to increase by 4.3% CAGR from $49.2B in fiscal 2015 to $53.6B in fiscal 2017. The company has been able to maintain a fairly steady operating cash flow margin over the past 5 years with an average at 25.3%. To be somewhat conservative, I assumed a flat cash margin of 25.0% through fiscal 2017 such that the operating cash flow will grow at the same rate as revenue. In terms of capital expenditure, I assumed the figure to gradually rise to $1.4B by fiscal 2017, which is slightly above consensus estimate of $1.3B. As such, free cash flow was projected to increase by 4.5% CAGR from $11.0B in fiscal 2015 to $12.0B in fiscal 2017, which is largely driven by the sales growth as well as the relatively slower capex growth (see chart below).

(click to enlarge)

Cisco raised its quarterly dividend by 11.8% to $0.19 per share in Q2 2014 and paid the same amount in Q3. For this analysis, I assumed a scenario that the company will continue to maintain a similar dividend growth pace at 11.0% per annum over the current and next 2 fiscal years. Thus, the annual dividend per share in the coming 3 fiscal years would turn out to be $0.80, $0.89, and $0.99, respectively (see the first chart). The reasonability of these dividend assumptions will be tested and analyzed under the context of my free cash flow projections.

Based on my average share count estimate in the forecast period (discussed later), total dividend spending will rise from $4.1B in fiscal 2015 to $5.0B in fiscal 2017, which can be fully covered by my forecasted free cash flows. Given Cisco's history of returning a significant amount of capital to shareholders through share buybacks while still being able to pursue tuck-in acquisitions in the past few years, I assumed that 70% of the after-dividend cash surplus will be spent on share repurchases. Based on an average buyback price assumption of $27 for fiscal 2015 and an annual growth rate of 10%, the average share count was forecasted to be approximately 5,080M for fiscal 2017 (see the first chart).

Compared with current consensus EPS estimates, my dividend per share forecasts imply that earnings dividend payout ratio will only increase modestly from 37% in fiscal 2015 to 40% in fiscal 2017, which remains below its actual level (48%) in fiscal 2014. Moreover, at the free cash flow level, the payout was projected to rise to 42% by fiscal 2017, which still provides sufficient cash flow coverage buffer. Both metrics suggest that Cisco is likely to maintain the dividend growth in the near term (see the first chart).

Over the long run, the consensus view calls for a 7% long-term EPS growth. The implication here is that the earnings payout will continue to rise if dividend growth remains at above the long-term EPS growth potential. Hence, it would be reasonable to expect that Cisco may try to slow down the dividend growth over the medium to long term to a rate that is more in line with the long-term EPS growth potential.

Based on the Gordon Growth Dividend Discount Model and an 11% cost of equity, Cisco's current share price of $25 implies a perpetual dividend growth rate between 7.5% and 8.0%, which is fairly close to the company's consensus long-term EPS growth estimate, but well below my near-term growth expectation (see chart below).

I then used a 2-stage dividend discount model to quantify the shares' fair value based on my dividend projections. The first stage incorporates my 11.0% annual dividend growth expectation through fiscal 2017 and the second stage represents a perpetual growth state with the perpetual dividend growth rate of 7.8% implied from the share price. Based on the 11% cost of equity, I arrived at a fair stock value of $28, which is approximately 10% above the current share price (see chart below).

(click to enlarge)

In summary, Cisco's current share valuation offers a fair margin of safety due to its discount to the intrinsic value from a dividend investing perspective. Given the current dividend yield of 3.1% and my estimated value gap of about 10%, a buy rating is warranted.

All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.