Cisco: Tilting The Odds In Your Favor

About: Cisco Systems, Inc. (CSCO)
by: Eli Inkrot

Cisco has a relatively short dividend history.

However, the company has done a solid job of getting it “up to par” rather quality.

This article looks at how you can get paid to agree to buy shares on your terms.

Over the last four quarters Cisco (NASDAQ:CSCO) has returned nearly $5 billion dollars in cash dividends. As a point of reference, the firm also allocated $3.9 billion toward share repurchases during that time - a total of about $8.9 billion combined - against underlying earnings power of around $12 billion per annum.

With those sort of numbers, a total payout near 75% and a dividend payout ratio just above 40%, it might seem like this type of allocation has been old hat for this now stodgy technology firm. Yet that hasn't really been the case - generating a cash flow component has been a rather recent endeavor for Cisco.

The dividend was initiated back in 2011 at $0.06 per quarter, representing a payout ratio of about 15% at the time. Even comparing this to the low of the year would only get you to a starting yield of about 1.8%.

Thereafter the payment was boosted significantly: by 33%, 75%, 21%, 12%, 11% and most recently by 24%. During this same period per share earnings have grown by a solid 7% to 8% annually, but it's plain to see that the dividend growth easily exceeded this. In turn, we also know that the payout ratio has increased - rising from 15% up closer to 40% of earnings.

And with the share price increasing in-line with earnings, we also know the dividend yield has gone up as well. Indeed, that 1.8% yield that existed for a brief moment back in 2011 now sits at 3.5% as I write this today.

Cisco was able to get its payout up to a respectable level in short order. The bad news is that this doesn't leave much history to review. Something close to a starting 3% yield or above has been fairly typical in the last few years, but those are limited data points (especially with an increasing payout ratio). And for a brief moment, in early 2016, the yield actually got over the 4% mark. So when you're thinking about an "appropriate" yield for the security, you might want to bake in a bit of caution.

Naturally you should come up with your own expectations, but perhaps you find Cisco to be solid investment candidate - with an exceptional balance sheet and interesting valuation - but you'd prefer to own shares with a bit higher starting yield to compensate for some of the uncertainty.

Specifically, suppose you believe today's valuation is fine, but you'd be much more interested if shares were to once again yield 4%. Instead of a share price near $30 today, this would require a future price of about $26 (prior to a potential dividend increase this year) - roughly 13% below where shares currently sit, but something that actually occurred in the last 12 months.

You have some possibilities as you seek out this request. For one thing, you could simply wait and see; periodically checking in on the price. The benefit to this approach is that it gives you ultimate flexibility, the downside is that it doesn't generate anything if you don't do anything.

Another possibility is to set a limit order, at say $26 and once again wait and see. The downside is that this price may never come, but the upside is that you've put your request out there and it could be triggered in due time. Sort of like requesting a book at the library and finding out its on back order - with a slight difference being you may never actually get your shares.

These two alternatives are perfectly fine and a lot of people use them. However, there is a third possibility: you can agree to buy at your price and get paid for making this sentiment known.

The upside is the upfront cash flow that you will generate. The downside is tying up your capital. Let's take a closer view at what this could look like.

Here's a look at some available put options for Cisco expiring in January of 2018:

Note that I have no special preference for this expiration date but it does highlight a good annual example. The first column indicates the strike price, or the price at which you would be agreeing to buy at least 100 shares of Cisco. The next column highlights the "net" premium, which takes the most recent bid less $0.12 per share for frictional expenses.

After that you have the premium yield, which denotes the amount of upfront cash flow that you would receive in relation to the amount of capital needed to "cash secure" the agreement. The fourth column shows the discount that the given strike price and option premium would represent based on today's price of just under $30. And the next two columns tell you what this cost basis would represent in terms of a starting P/E ratio and dividend yield.

You can think about the above table like this. The first two columns indicate the terms offered. The third column details the upfront cash flow that you will generate immediately. And the last three columns show you the rough security terms if, and only if, the option is actually exercised.

Let's run through an illustration.

You're happy to partner with Cisco, but you're not especially compelled by a price near $30. Instead, looking at the possibilities above, you'd be much more enthused if your cost basis was closer to say $25.50 representing a 15% discount to the current quotation. This possibility, if exercised, would equate to starting earnings multiple under 11 and a beginning dividend yield of over 4%. (The last time that was available was a year ago and prior to that you can't find a yield that gets up that high.)

You could sell the $27 put and get paid for making this sentiment known. In this case you would be agreeing to buy 100 shares of Cisco at a price of $27 per share. Immediately upon agreement you would receive ~$160 in cash flow, or a 6% yield on your capital. That's yours to keep regardless of what happens, and you can spend it or reallocate those funds at your discretion.

Now there are two basic things that could occur: either the option will be exercised or it will not.

If the option is not exercised you still have your ~$160 in upfront option premium and the $2,700 you had set aside will be "released" and available to be redeployed once more. The downside is that you don't yet own shares in a business that you'd be happy to partner with. Moreover, shares could later trade at say $35 or $40 and you'd be "stuck" with "just" a 6% return for the year. That's not a terrible consolation prize, but it's not exactly the sort of thing that you might be striving for either.

If the option is exercised, you'd purchase shares at $27. With the option premium already received, your taxable basis would be closer to $25.50 (with an assignment fee added in). If you are truly happy to own shares at this lower price, this is fine news. And it should be underscored that this is fine news whether shares are momentarily lower - say $24 - as well. Instead of buying at today's price near $30, you got paid to buy at a much lower price, in turn setting yourself up with much better yield and valuation starting points.

And obviously you're not limited to this single strike price or expiration date - there are plenty of different combinations that might be of interest. The takeaway is not that you should make this particular agreement. Instead, it's about reflecting on your investing goals and seeing what options (in this case literally) are out there to help you toward your goals.

If you only want to buy shares of Cisco should with a 4% yield, expressing that willingness can generate a reasonable upfront cash flow. And if you're content with a higher price / lower starting yield, the premiums start to get even more interesting. It's not talked about as often, but you can generate a solid cash flow stream and occasionally "tilt the odds in your favor" as a result of agreeing to buy securities you're happy to own at lower prices.

Disclosure: I/we 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.