These days, the tech industry isn't short of non-profitable, high-growth companies. But if you prefer to invest in solid free-cash-flow machines that should still be able to pay a generous dividend even if a recession materializes, tech giants Cisco Systems and International Business Machines are probably on your radar. But which one should you prioritize?
IBM is facing yet another transformation
Over the last couple of decades, IBM has been selling hardware, software, and services (consultancy and outsourcing) that help enterprises run their computing infrastructure. However, after having survived technology revolutions, major recessions, and world wars, the company -- founded in 1911 -- must adapt its business to cloud computing.
As enterprises move some of their applications from their premises to the cloud, they've needed less hardware and software from IBM, which has also reduced the need for IBM's consultants to implement those solutions.
With the divestiture of some of its low-margin businesses, such as its low-end servers in 2014, IBM has been posting diminishing revenue; that figure dropped from its historical highs of $106.9 billion in 2011 to $77.1 billion over the last 12 months.
However, IBM has been investing in growing markets, such as machine learning and cybersecurity, to offset this decline. And with its $34 billion acquisition of Red Hat in 2019, it has also made a strong push into the cloud market.
As a result, IBM's revenue stayed flat in 2018, and last quarter, revenue declined by only 0.6% after adjusting for divestitures and currency exchange. Besides, as an illustration of the company's shift to new technologies, revenue from its cloud business increased to 27.8% of its total revenue during the last quarter compared to 4.4% in 2013.
Despite these challenges, IBM stabilized its operating margin -- under generally accepted accounting principles (GAAP) -- above 15%. Its trailing-12-month net income reached $7.7 billion, which largely covers its annualized last-quarter dividend of $5.6 billion.
Cisco dominates its market
Cisco is also facing the threat of cloud computing, but in a different way compared to IBM.
Since the end of the last century, Cisco has been selling routers and switches. These network devices connect computers and servers to the same physical network, and they forward network traffic between networks. Cisco dominates this market given its 51% market share during the last quarter of 2018, according to a study from Synergy Research Group.
The giant network vendor then expanded its portfolio with cybersecurity and communication solutions that complement its core business. For instance, enterprises can select Cisco as a single provider for their network and cybersecurity solutions, which simplifies the procurement, implementation, and maintenance of their computing infrastructure.
However, Cisco was slow to adapt its monolithic and proprietary technologies to cloud networking. Web-scale providers such as Amazon with Amazon Web Services and Microsoft with Azure require scalable, flexible, performant, and cost-effective solutions to grow their huge networks. As a result, emerging competitors proposed network solutions that fit the cloud data center model. For example, Arista Networks has made a dent in Cisco's high-speed data center switching market share, which decreased from 78.1% in 2012 to 46.6% during the first half of 2019.
Yet despite its expected single-digit year-over-year revenue decline next quarter due to the challenging macro environment, Cisco should continue dominating its market given its large revenue base of $51.7 billion in fiscal 2019, up 7% year over year. Also, it recently addressed its weakness in the cloud data center with its chip "Silicon One" and its network operating system "IOS XR7" that cloud titans can use to build their own network devices.
Cisco's scale, which contributes to optimizing both its research and development and sales and marketing expenses over its large revenue base, has kept its GAAP operating margin above 25% over the last few years.
As a result, with its trailing-12-month net income of $11 billion and its positive cash position -- net of debt -- of $8.4 billion, Cisco's annualized last-quarter dividend of $5.9 billion seems safe.
Cisco or IBM? Both!
Looking at the valuation metrics listed in the table below, IBM's stock seems cheaper than Cisco's.
|IBM (IBM 0.82%)
|Cisco Systems (CSCO 0.60%)
|Price-to-sales ratio (TTM)
|Enterprise value to EBITDA (TTM)
IBM's stock comes with more risks due to its lower margins and higher debt load -- giving it a lower valuation. But both tech stocks remain compelling for investors looking for a safe dividend with exposure to the tech industry. Thus, there's no clear winner. Prudent investors could diversify their portfolios and buy both stocks.