Image source: Cisco Systems.
While news of significant layoffs at networking giant Cisco Systems (CSCO +1.80%) roiled investors a bit when the company reported its fiscal fourth-quarter results, there are still plenty of reasons to buy the stock. Dominance in its core switching and routing markets, growth opportunities in security and collaboration, a shift to software, a bargain valuation, and an enticing dividend make Cisco an attractive investment.
Complete dominance
About 45% of Cisco's fourth-quarter revenue came from the company's switches and routers. Cisco has been diversifying beyond these businesses, but switching and routing still represent the core of Cisco. In 2015, Cisco enjoyed a 60.7% share of the switching market, according to IDC. Its nearest competitor, HP Enterprise, managed to claim just 9% of the market. A handful of smaller competitors, like Huawei and Arista, are gaining share quickly, but they remain minor players.
This dominance allows Cisco to generate exceptional profitability. During the fourth quarter, the company managed a gross margin of 63.1% and an operating margin of 26.1%. Lower-priced products from competitors haven't been able to make much of a dent in the company's market share, a testament to Cisco's pricing power. Despite new technologies like software-defined networking and cloud computing, Cisco remains the overwhelming leader in the networking hardware market.
Growth businesses
While Cisco's switching and routing businesses tend to grow slowly on average, a few of the company's segments are picking up the slack. Security is already a major business for Cisco, generating nearly $2 billion of revenue in fiscal 2016, but it's growing at a double-digit rate nonetheless. During the fourth quarter, Cisco's security business expanded by 16% year over year, aided by a handful of recent acquisitions. Over the past year or so, Cisco has added CloudLock, Lancope, Portcullis, and OpenDNS to its security portfolio.
Collaboration is another growth area, generating $4.35 billion of revenue in fiscal 2016 and growing by 9%. Again, Cisco is using acquisitions to fuel growth, adding companies like Acano and 1 Mainstream over the past year. Cisco spent a total of $3.16 billion on acquisitions in fiscal 2016, helping to bulk up areas the company hopes will produce growth for years to come.
A shift to software
As part of its fourth-quarter earnings report, Cisco announced that it was eliminating up to 5,500 positions, representing about 7% of its global workforce. This wasn't a cost-cutting measure, but instead a move to shift its workforce toward fast-growing businesses. Cisco plans to reinvest essentially all of the cost savings generated by this plan in areas including security, Internet of Things, collaboration, and cloud computing.
An increasing focus on software will be a theme for Cisco in the coming years. The software business is growing fast, with deferred revenue from software and subscriptions rising by 33% in the fourth quarter. While hardware will remain an important piece of Cisco's business, the company is shifting toward a more integrated approach, selling solutions instead of just hardware. Software will play a major role in the coming years, with the potential to increase margins even further.
A value stock
Shares of Cisco have doubled over the past five years, but the market is still not giving the company the credit it deserves. Cisco generated $12.4 billion of free cash flow in fiscal 2016, compared to a market capitalization of about $153 billion. That's a P/FCF ratio of just about 12.3. Back out the $37.1 billion of net cash on Cisco's balance sheet, and the ratio falls to just 9.3.
This free cash flow gives Cisco plenty of ammunition to buy back its own shares at a discounted price. Cisco spent about $3.9 billion on buybacks in fiscal 2016, and while some of that went to canceling out dilution caused by stock-based compensation, Cisco's share count has been steadily decreasing over the past decade. With a low valuation and a meaningful share buyback program, Cisco's share price doesn't need to grow very fast to produce good results for investors.
A nice dividend
Cisco only began paying a dividend in 2011, but since then it has become one of the best dividend stocks in the technology sector. The stock yields 3.4% at the moment following a 24% dividend hike earlier this year, beating out many of its peers, including Microsoft, Intel, and Hewlett-Packard Enterprise.
Only about 38% of Cisco's free cash flow was eaten up by dividends during fiscal 2016, leaving the company room to grow the dividend at a faster rate than earnings for years to come. An attractive dividend should never be the only reason for buying a stock, but in Cisco's case, it's just icing on the cake.
