My Dividend Portfolio: Adding Cisco

| About: Cisco Systems, (CSCO)
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I am a self directed dividend investor who manages my own portfolio. My aim is to leverage dividend income and other tax sheltered accounts to achieve early financial independence. The portfolio is currently on track to deliver over $26,000 in dividend income for 2013. My goal is to try and achieve $50,000 annually in dividend income. Cisco (NASDAQ:CSCO) was a recent addition to my portfolio.

Cisco is one of the largest providers of networking infrastructure, routing and switching gear in the world. While it provides consumer networking products, its corporate grade Ethernet and routing solutions offer the company a level of stickiness and dependency for customers. This is because Cisco's product range is mission critical, core infrastructure. Cisco's revenue is dominated by core switching and routing (close to 50% of revenue), with emerging businesses in service provider video (10%) and data centre (5%) providing the greatest opportunities for further growth in my opinion.

Cisco has a market capitalization of $109B with revenues of $49B and a gross margin in excess of 60%. Cisco generates a net income of almost $10B. Cisco currently trades at a forward PE of 10 and a dividend yield of 3.2%.

There are some compelling arguments to support the investment case in Cisco.

Strong Moat

I am focused on businesses with strong underlying moats to power long-term earnings growth and dividend growth. The fact that Cisco is selling routers, switching equipment and cloud solutions into enterprise markets creates a far stickier customer with higher switching costs than in its consumer business.

The migration path for an enterprise or service provider to replace core routing and hardware in a network, enterprise environment or data centre is a costly and time consuming process. It involves undertaking an extensive diligence process to identify other relevant vendors, putting together a business case to justify a potentially costly rip and replace program and having to map out a schedule to migrate mission critical infrastructure.

That's not something a service provider or any enterprise takes lightly. Given this, the switching costs of displacing a provider like Cisco are very high, which leads to a high degree of retention and ability to sell additional services into existing customers over time.

The suggestion of a moat is apparent in Cisco's continuous revenue growth for the better part of a decade, with only 2009 resulting in a revenue decline (although 2013 has certainly been sluggish).

Core IP Traffic growth will continue

Cisco's VNI (Visual Networking Index) suggests a strong continuation of IP traffic growth, much of which will be driven by increasing consumption of video traffic. Global IP traffic is expected to triple over the next 5 years, driven by more global internet users, more devices and connections and increased use of video services and applications.

All of these trends bode well for Cisco's core role as an internet traffic cop, in providing core router and switching technology to Service Providers, enterprises and Internet Service providers.

The VNI study also suggests there will be strong growth in IP traffic over service provider core networks with wifi and mobile connected devices generating almost 70% of IP traffic by 2017, placing a huge burden on mobile operator networks. This trend will play well into Cisco's emerging service provider video business and data centre business.

Service provider video business & data centre business

While still a small portion of Cisco's overall revenue today, Cisco is well positioned in the emerging growth segments of the service provider video business as well as core networking technology for data centers.

Video traffic accounts for close to 50% of traffic going across mobile networks today among US operators. Given most of this traffic is "over the top" traffic and not readily monetized, service providers are increasingly interested in reducing the effective cost of video delivery to preserve overall margins. To that end, there has been increasing willingness on the part of operators to adopt strategies that minimize the traffic load on their networks.

Cisco offers solutions in the core operator network that allow transrating and transcoding of video content (modulating the bit rate of the video stream, or changing the video format into another less data intensive format) as well as caching popular content at the edge of the network, which helps conserve network resources in delivering content to subscribers.

All these solutions help service providers manage video deployment with existing network resources, rather than need to incur the expense of upgrading networks. Of course, Cisco isn't alone in offering these solutions. Juniper (NYSE:JNPR) and other smaller solution vendors are also entering this market. The significant advantage that Cisco has, however, is that service providers are loath to work with small vendors that are not well known, with the need to add yet another hardware appliance into the network. As the incumbent, Cisco is well placed to capture more of this market as video consumption over mobile networks increases.

Cisco also offers compelling solutions for data centre virtualization and networking. Cisco virtualization solutions allow data centers to better optimize existing computing power to deliver data to customers as needed. Significantly, Cisco is also developing enterprise customers to operate in cloud environments, enabling private and hybrid cloud solutions. This will be an area of significant growth moving forward.

Valuation & Yield

Cisco's valuation is attractive. At just 11x earnings, Cisco is trading well below its 5 year average of 16x earnings and the S&P 500 average of 17.9x earnings. It is also trading well below averages on other measures including price/book and price/sales.

I try and focus on businesses that have the potential to provide a total return of 13% or greater based on my dividend zone. With a dividend yield of 3.2% and recent dividend growth exceeding 10%, Cisco falls within my dividend zone, and I'd expect a total return exceeding 13% in the medium term. With a payout ratio of only 35%, Cisco can amply afford to maintain and increase the current dividend on offer.

In spite of the positives, there do remain some risks to the investment case with Cisco.

Margin Compression and near term growth headwinds

Cisco has been increasingly caught in a fairly bruising battle in international markets with Huawei. Huawei has made significant inroads in emerging markets selling low end routers and switches. It's increasingly also been moving into more sophisticated and advanced markets such as the service provider space. While Huawei's inroads into the US in the service provider segment have been fairly limited, its solutions have won over enterprise customers and service providers in more price sensitive emerging markets.

Increasing price competition combined with Cisco's push into emerging markets has pushed down Cisco's margins almost 10% over the last decade. Gross margins have declined from 69% in 2004 to just over 60% today. Cisco has responded by providing increasingly feature rich platforms and adding significant value to basic switching products to demonstrate value to enterprise customers, as seen with its approach to service provider video solutions.

There are also some near term revenue and earnings headwinds for Cisco. The company has reduced its medium term forecast revenue rate to a range of 3-6%, down from 5%-7%. A slowdown in penetration in emerging markets account for much of this decline. In spite of the downgrade in revenue growth, I still believe that Cisco is poised to ride the growth trends in Service Provider Video and Data Centre growth.


Cisco is a wide moat business with a very sticky enterprise and service provider customer that is reliant on Cisco for the delivery of mission critical infrastructure. Cisco currently trades well below its 5 year average valuation ratio and offers an attractive 3.2% dividend yield. While there are near term growth headwinds, Cisco will still see modest revenue growth, and is favorably poised to ride trends in consumption of service provider video and data centre growth. Additionally the long term growth trends for increasing IP traffic are also firmly in place, which should provide additional support for Cisco's core switching and routing business.

I recently purchased 400 shares of Cisco at $21.00.

Disclosure: I am long CSCO. 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.