Cisco: Substantial Capital Appreciation And Dividend Growth Upside Potential

Sep. 02, 2022 6:04 PM ETCisco Systems, Inc. (CSCO)16 Comments
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Summary

  • Cisco Systems is backed up by a fortress-like balance sheet given its large net cash position on hand at the end of fiscal 2022.
  • Cisco is working on growing its recurring revenue streams which provide for stronger cash flow profiles, with an eye towards growing its software subscription sales.
  • Cisco beat fiscal fourth quarter earnings estimates when reporting its latest earnings in August 2022 and provided favorable guidance for fiscal 2023 during that update.
  • As derived through our enterprise cash flow analysis process, we assign Cisco a fair value estimate of $56 per share with room for upside.
  • Cisco offers investors a nice combination of capital appreciation and dividend growth upside.

Cisco Systems San Jose Calfornia

JasonDoiy

By The Valuentum Team

Cisco Systems, Inc (NASDAQ:CSCO) offers investors a compelling combination of capital appreciation and dividend growth upside potential. Our fair value estimate for Cisco sits at $56 per share, as derived through our enterprise cash flow analysis process, with room for upside and we'll cover how we obtained that figure in this article. Additionally, given Cisco's fortress-like balance sheet and stellar cash flow profile, we see ample room for the company to boost its dividend over the coming fiscal years. Shares of CSCO yield a nice ~3.4% as of this writing.

Cisco's Key Investment Considerations

Investment Considerations

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Cisco sells Internet Protocol based networking and other products and provides a broad line of products for transporting data, voice, and video. It is #1 or #2 across a wide variety of architectures, and we like the progress it is making in its transition to a software and subscription based business model. It was founded in 1984 and is headquartered in California.

Historically, Cisco has been very acquisitive. Some of its recent deals include buying Opsani and replex to support Cisco's AppDynamic operations, and acquiring Involvio to support Cisco's ability to cater towards universities and colleges. The company is focused on growing its software and services businesses going forward, with an eye towards its collaboration, video conferencing, and cybersecurity offerings. These types of sales tend to be subscription-based, providing greater visibility as it concerns Cisco's future cash flow performance.

The company has been steadily buying back its stock in recent fiscal years and has increased its annual dividend over the past 10+ consecutive years as it aims to balance out its capital allocation priorities while continuing to invest heavily in its business. In our view, Cisco's payout growth trajectory is quite bright. Cisco’s growth story hit some speedbumps due to the COVID-19 pandemic, though its outlook has more recently started to improve. The firm forecasts that its revenues and EPS should post 5%-7% CAGR through fiscal 2025, as laid out during its big 2021 Investor Day event.

Earnings Update

On August 17, Cisco reported fourth quarter earnings for fiscal 2022 (period ended July 30, 2022) that beat both consensus top- and bottom-line estimates. The company also issued out guidance for fiscal 2023 that called for nice revenue and earnings growth going forward during its latest earrings update as supply chain hurdles and other headwinds are beginning to fade.

In the fiscal fourth quarter, Cisco's GAAP revenues were broadly flat year-over-year and its GAAP operating income fell by 4% due to its GAAP gross margin falling by ~230 basis points during this period to hit 61.3%. A decline in Cisco's operating expenses offset the decline in its gross margin, to a degree, as its GAAP operating margin fell by ~105 basis points year-over-year last fiscal quarter. Its revenues were supported by 20% growth in sales at its "end-to-end security" offerings, 8% growth at its "optimized application experiences" offerings, and 2% growth at its "collaboration" offerings on a year-over-year basis in the fiscal fourth quarter. However, inflationary pressures and elevated freight and logistics costs are taking a toll on the company’s financial performance.

Cisco remained a stellar cash flow generator in fiscal 2022 and posted $12.7 billion in free cash flow (defined as net operating cash flow less capital expenditures) during this period while spending $6.2 billion covering its dividend obligations along with $7.7 billion buying back its stock. Furthermore, Cisco exited fiscal 2022 with $9.8 billion in net cash on the books (inclusive of short-term debt).

As noted previously, the company is working on growing its recurring revenue streams, which provides for stronger cash flow profiles given the highly visible nature of those future cash flows. During the firm's fiscal fourth quarter earnings call, management noted that Cisco's “total subscription revenue was $22.4 billion, an increase of 2% and total subscription revenue represented 43% of total revenue” last fiscal year. As over 80% of Cisco's software revenue is derived by subscription sales, growing its software sales going forward is a key priority for the company though its software sales were broadly flat in fiscal 2022 over fiscal 2021 levels. Going forward, recent acquisitions should help Cisco resume its software sales growth trajectory in earnest.

We are huge fans of the firm's rock-solid cash flow profile and pristine balance sheet. Average annual free cash flow generation of ~$14.1 billion from fiscal 2020-2022 is more than sufficient in covering annual run rate cash dividend obligations of ~$6.2 billion as of fiscal 2022.

Looking ahead, Cisco expects to grow its revenues by 4%-6% in fiscal 2023 while posting $2.77-$2.88 in GAAP EPS (broadly flat on a year-over-year basis at the midpoint) and $3.49-$3.56 in non-GAAP EPS (up 5% year-over-year at the midpoint). We appreciate that Cisco's business is entering fiscal 2023 on a high note.

Cisco's Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital ["ROIC"] with its weighted average cost of capital ["WACC"]. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Cisco's 3-year historical return on invested capital (without goodwill) is 73.7%, which is above the estimate of its cost of capital of 9.3%.

In the chart down below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Adjusted Return on Invested Capital

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Cisco's Cash Flow Valuation Analysis

Cash Flow Generation

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Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows, net of balance sheet considerations. We think Cisco is worth $56 per share with a fair value range of $45.00 - $67.00, with our fair value estimate (~$56 per share) being significantly higher than where shares of CSCO are trading at as of this writing.

The near-term operating forecasts used in our enterprise cash flow models, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 4.1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -0.2%. Our model reflects a 5-year projected average operating margin of 33.7%, which is above Cisco's trailing 3-year average. Beyond Year 5, we assume free cash flow will grow at an annual rate of 2.4% for the next 15 years and 3% in perpetuity. For Cisco, we use a 9.3% weighted average cost of capital to discount future free cash flows.

Valuation Assumptions

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Valuation Breakdown

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Cisco's Margin of Safety Analysis

Range of Potential Outcomes

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Although we estimate the firm's fair value at about $56 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

In the graph up above, we show this probable range of fair values for Cisco. We think the firm is attractive below $45 per share (the green line), but quite expensive above $67 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Dividend Analysis

Dividend Cushion Ratio Evaluation

Dividend Cushion Ratio Evaluation (Image Source: Valuentum)

The Dividend Cushion Ratio Deconstruction for Cisco, shown in the image above, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Cisco's numerator is larger than its denominator suggesting strong dividend coverage in the future.

The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information. Cisco's dividend health, nonetheless, is strong at the moment.

Concluding Thoughts

We're huge fans of Cisco’s business model, balance sheet health, and free cash flow generation. Cisco has grown its annual dividend over the past 10+ consecutive fiscal years and we are expecting meaningful growth in its payout going forward, aided by its shift to a software and subscription focus. Competing capital allocation options could impact the pace of dividend expansion moving forward, and tuck-in acquisitions should be expected. However, we expect that Cisco's free cash flow generation and fortress-like balance sheet to be able to handle all of its capital allocation needs.

As it concerns Cisco's capital appreciation upside potential, in our view, shares of CSCO are meaningfully undervalued as of this writing. The company's favorable guidance for fiscal 2023 and strong fiscal fourth quarter earnings report, along with Cisco's ability to repurchase sizable amounts of its stock should help shares of CSCO converge towards their intrinsic value going forward. Cisco is a tremendous enterprise.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

Additional disclosure: Callum Turcan owns shares of DIS, META, GOOG, VRTX, and XLE and is long call options on VRTX. Cisco Systems Inc (CSCO) is included as an idea in both Valuentum's simulated Best Ideas Newsletter portfolio and simulated Dividend Growth Newsletter portfolio. This article is for information purposes only and should not be considered a solicitation to buy or sell any security. Neither Valuentum nor any of its affiliates own any securities mentioned in this article. Contact Valuentum for more information about its editorial policies.

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