3 Reasons Cisco Systems Is a Better Value Stock Than IBM

Big Blue has a lower valuation and a higher dividend than Cisco, but its growth prospects are much murkier.

Leo Sun
Leo Sun
Jun 27, 2017 at 3:31PM
Technology and Telecom

Cisco (NASDAQ:CSCO) and IBM (NYSE:IBM) are both mature tech stocks that are often considered cheap income plays. On the surface, Big Blue looks like the better value play. Its forward yield of 3.9% is higher than Cisco's 3.6% yield, it has a longer streak of dividend hikes, and it trades at just 13 times earnings -- compared to Cisco's P/E of 16. But if we dig deeper, we'll notice that Cisco is actually a better value play for three simple reasons.

1. Better growth prospects

IBM's biggest flaw is that its revenue has fallen annually for 20 straight quarters, and Wall Street anticipates annual declines for the next two years. Its higher growth "strategic imperatives" businesses (cloud, analytics, mobile, social, and security) simply aren't growing fast enough to offset the ongoing slowdowns at its older IT services, hardware, and software businesses.

A visual representation of the global stock market.

Source: Getty.

That turnaround is painful, because IBM must divest weaker businesses, invest in higher-growth ones, and match the features and prices of leading cloud rivals like Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT). IBM bulls believe that those efforts will eventually boost its top line growth again, but many investors -- including Warren Buffett -- are losing their patience.

Cisco hasn't posted a quarter of positive year-over-year revenue growth for six straight quarters, but those declines can mostly be attributed to the sale of its set-top box business to Technicolor in late 2015. Excluding the impact of that deal, Cisco's revenue only fell annually for two straight quarters.

Analysts still expect Cisco's revenue to fall 3% this year, due to waning demand for its core routers and switches, but rebound next year with 1% growth. That's because Cisco's higher-growth businesses are expected to gradually offset the soft demand for its networking hardware.

2. Less complicated turnaround plans

IBM's turnaround plan is complicated. It requires its legacy customers to shift toward its hybrid and public cloud services, the increased adoption of its AI platform Watson for analytics and blockchain for securing enterprise networks, and new quantum computing systems helping it stay ahead of the tech curve in high-end computing.

That turnaround relies on older customers, particularly large businesses, sticking with IBM as they migrate their data to the cloud -- which could be tough considering how competitive Amazon's AWS (Amazon Web Services) and Microsoft's Azure have become in terms of pricing and features.

Servers in a data center.

Source: Getty.

Cisco's turnaround strategy is easier to understand. The company predicts that between 2015 and 2020, the number of connected devices worldwide will double from 25 billion to 50 billion. As one of the world's biggest networking hardware vendors, it should benefit from that growth.

The market for routers and switches might be saturated, but Cisco can keep expanding its higher-growth units, like wireless and cybersecurity, via acquisitions. It can then bundle those services with its routers, switches, and UCS (unified computing system) servers to maintain its lead in the networking market.

Bundling cheaper hardware into that ecosystem can also widen its moat against disruptive challengers like Arista Networks, which sell cheap, specialized switches for networks running on generic hardware.

3. Better free cash flow growth

Over the past five years, Cisco has steadily grown its free cash flow. IBM, which followed up a period of excessive buybacks with aggressive acquisitions, has posted steep declines.

IBM Free Cash Flow (TTM) Chart

Source: YCharts

This trend will likely continue, since IBM's revenue growth should stagnate as it increasingly relies on acquisitions to boost its strategic imperatives growth. IBM can probably divest some more businesses to increase its cash flows, but it already parted with some its biggest businesses (PCs, x86 servers, and its chipmaking unit) over the past few years.

IBM and Cisco are both relying on big layoffs to boost its earnings growth. Both companies are expected to grow their earnings by about 1% this year.

The key takeaways

I believe that IBM's low valuation and high yield should set a floor under the stock, so the near-term downside potential seems limited. But over the long term, IBM could struggle to grow its revenue and earnings, which could make its stock look more like dead money than a value play.

Cisco also faces tough headwinds, but its road to recovery seems more clearly defined than IBM's. Therefore, I think both stocks are low-risk plays, but investors looking for an undervalued turnaround play should consider buying Cisco instead of IBM.