Shares of Cisco Systems (CSCO +0.06%) have had a good run during the past three years, delivering a double to investors. The stock is up about 28% over the previous year on the back of solid operating performance. Cisco continues to invest heavily in capitalizing on the growth opportunities in cloud, security, Internet of Things, and data centers.
While Cisco has found its second wind, IBM (IBM 0.69%) isn't there yet. Big Blue continues to divest legacy, or unprofitable, business lines to focus more on higher-margin, faster-growing areas like the cloud. As a result of the shuffling of assets, revenue is not growing, and that has contributed to a flatlining stock price performance in recent years.
It's tempting to buy IBM stock at these levels, given the cheap valuation and above-average dividend yield. But I believe investors will be better off going with Cisco Systems for three reasons.
Image source: Getty Images.
1. Cisco is financially stronger
Comparing balance sheets is not as exciting as evaluating growth opportunities, but it's essential because a company with more financial resources is in a better position to reward shareholders through accretive acquisitions, share repurchases, and increasing dividends.
Here's how both companies stack up on key financial metrics:
| Metric | Cisco Systems | IBM |
|---|---|---|
| Cash | $40.38 billion | $18.01 billion |
| Debt | $25.63 billion | $49.98 billion |
| Revenue (TTM) | $50.82 billion | $78.7 billion |
| Free cash flow (TTM) | $13.15 billion | $11.82 billion |
Data source: YCharts. TTM = Trailing 12 month.
A few things stand out in Cisco's favor. First, Cisco has more cash than debt, whereas IBM has more debt than cash. Second, Cisco generates more free cash flow despite generating less annual revenue. It's obvious the networking pioneer is in a much stronger financial position than Big Blue.
Both companies have been active in acquisitions. Cisco has purchased several small companies in the past few years to position for long-term growth in areas like cloud and artificial intelligence applications.
IBM is about to swallow Red Hat for $34 billion, financed by a combination of cash and debt. With Red Hat, Big Blue will add about $3.2 billion of revenue to its cloud segment and about $1 billion to its annual free cash flow.
After the Red Hat deal is complete, IBM will have less cash and more debt on its balance sheet, which will only make Cisco Systems that much stronger financially relative to Big Blue.
2. Cisco is growing faster
Cisco is experiencing rising demand for its Catalyst 9000 family of switches. The company introduced Catalyst 9000 in fiscal 2017 to offer organizations integrated security, automation, and better performance. Companies also love that this new product lowers their operating costs. As such, the Catalyst 9000 is the fastest-ramping product in Cisco's history.
Cisco is proving it can still grow its massive $50 billion in annual revenue. In the most recent quarter, the company reported revenue growth of 7% year over year. Analysts expect Cisco to increase revenue 4.8% this year and 3.5% next year. Cisco should be able to maintain steady revenue growth, as global internet traffic is expected to increase threefold over the next five years, which should continue to drive high demand for Cisco's products in data centers and the Internet of Things.
IBM's fastest-growing segment is cloud services, which made up 25% of total revenue during the past year. The cloud segment grew sales by 15% in the most recent quarter, but that is well below the current pace of IBM's cloud competitors, such as Amazon.com and Microsoft.
3. Cisco is growing what counts
Cash is the lifeblood of any business. Both Cisco and IBM generate a lot of free cash flow. However, IBM's free cash flow has decreased by 23% over the past decade, while Cisco has grown its free cash flow by 48%.
Given the faster growth on both the top and bottom lines, it's not surprising that Cisco stock has delivered a total return (including dividends) of 180% in the past five years, while IBM's total return is underwater by 12%.
What's more, Cisco showed the ultimate rewards of rising revenue and free cash flow in the latest quarter, when the company increased its quarterly dividend payout by 6% to $0.35 per share. Cisco also announced a new share repurchase program that brings the current authorized amount to $24 billion, or about 10% of the company's current market value.
On the other side, IBM management announced that it would suspend its share repurchases in 2020 and 2021 to finance the Red Hat acquisition.
Additionally, over the past five years, Cisco has increased its dividend payout 83%, compared with IBM's dividend increase of 59%.
You get what you pay for
Here's a comparison of how both companies measure up on valuation:
| Metric | Cisco Systems | IBM |
|---|---|---|
| Trailing PE | 20.53 | 14.72 |
| Forward PE | 18.43 | 10.07 |
| Dividend payout as a percentage of free cash flow | 46.22% | 48.05% |
| Dividend yield | 2.59% | 4.45% |
Data source: Yahoo Finance! and YCharts. PE=price-to-earnings. PEG=price-to-earnings growth.
IBM stock is cheap, trading around a forward PE ratio of 10, which is much less expensive than Cisco's forward PE of 18.4. But IBM stock has been cheap for a long time because there's no earnings growth.
IBM has rebounded strongly year-to-date, but near-term gains could be limited based on management's guidance for flattish earnings growth for 2019. Analysts currently expect IBM to grow adjusted earnings by 2.7% annually over the next five years.
On the other side, analysts expect Cisco to grow earnings about 10% annually over the next five years, which justifies Cisco's higher valuation.
For all these reasons, Cisco is the better buy for investors today.
