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With a Yield Approaching 4%, Is Cisco an Undervalued Dividend Stock?

By Leo Sun - Mar 11, 2020 at 11:10AM

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The networking giant faces significant headwinds, but its high yield and low multiple are tough to ignore.

Cisco's (CSCO -0.52%) stock has tumbled about 20% over the past 12 months amid concerns about its slowing growth, the U.S.-China trade war, and the novel coronavirus crisis. A dismal second-quarter report in February, which featured the company's slowest revenue growth in two years, exacerbated the pain.

However, that decline also boosted Cisco's forward dividend yield to a multi-year high of 3.6% and reduced its forward P/E ratio to 12. Those numbers, along with Cisco's unbroken streak of annual dividend hikes since it started paying dividends in 2011, suggest it's an undervalued income stock.

A network of cloud computing connections.

Image source: Getty Images.

Reviewing Cisco's challenges

Cisco's revenue and earnings growth decelerated over the past year as campus and data center customers ordered fewer routers and service providers bought fewer switches. It was also barred from state-backed contracts in China as the trade war escalated.

Cisco's weak hardware sales offset the stronger growth of its security software business, which expanded significantly in recent years with its acquisitions of smaller companies like Sourcefire, Umbrella (OpenDNS), and Duo Security.

Year-over-year growth

Q2 2019

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Revenue

7%

6%

6%

2%

(4%)

Non-GAAP EPS

16%

18%

19%

12%

5%

Note: EPS growth is calculated on a non-GAAP basis. Source: Cisco quarterly reports.

Yet those headwinds are mostly cyclical, and don't indicate that Cisco is losing ground to rivals like Arista Networks (ANET -0.92%) and Juniper Networks (JNPR -1.05%). In fact, Cisco's gross and operating margins expanded sequentially and annually last quarter on a non-GAAP (generally accepted accounting principles) basis -- which suggests it still wields considerable pricing power.

Metric

Q2 2019

Q1 2020

Q2 2020

Gross margin

64.1%

65.9%

66.4%

Operating margin

32.1%

33.6%

33.7%

Non-GAAP basis. Source: Cisco quarterly reports.

The COVID-19 crisis could exacerbate Cisco's slowdown and temporarily dent its margins, but its growth should stabilize over the long term. Analysts currently expect Cisco's revenue to dip 2% this year before rebounding 3% next year.

Why is Cisco undervalued?

Cisco's earnings, which are buoyed by consistent buybacks, are expected to rise 5% this year and 4% next year. Here's how Cisco's earnings growth and forward valuation compare to Arista and Juniper's numbers:

Estimated EPS growth

Current year

Next year

Forward P/E

Cisco Systems

5%

4%

12

Arista Networks

(10%)

16%

23

Juniper Networks

2%

9%

12

Source: Yahoo Finance, March 11.

Arista usually generates stronger revenue growth than Cisco and Juniper, but it doesn't pay a dividend. Juniper's earnings growth is consistent and it pays a higher forward yield of 3.8%, but it generated weaker revenue growth than Cisco over the past two years as demand from its cloud and service provider customers dried up.

Why is Cisco a good income investment?

In a recent article, I noted that ideal dividend stocks generally have long operating histories, wide moats, and consistent free cash flow (FCF) growth. Cisco checks all three boxes: It was founded 35 years ago, leads the switch and router markets, and significantly grew its FCF over the past decade:

CSCO Free Cash Flow Chart

Source: YCharts

Cisco spent just 40% of its FCF on its dividend over the past 12 months, which gives it plenty of room for future hikes. Juniper spent 62% of its FCF on dividends during the same period. Cisco was still sitting on $27.1 billion in cash, cash equivalents, and investments last quarter, which provides a comfortable cash cushion for dividends, buybacks, and future acquisitions to boost shareholder value through the cyclical downturn.

The bottom line

The bears will likely claim that Cisco faces significant near-term headwinds with few catalysts on the horizon. Those criticisms are valid, but I believe Cisco's long-term tailwinds -- which include network upgrades for growing companies, data centers, and service providers -- should eventually spark a cyclical rebound.

Cisco's stock could certainly head lower in this wobbly market, but I believe its high yield and low valuation should limit its downside potential -- and reward patient investors for sticking around for the eventual recovery of this tech stock.

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Stocks Mentioned

Cisco Systems, Inc. Stock Quote
Cisco Systems, Inc.
CSCO
$42.42 (-0.52%) $0.22
Juniper Networks, Inc. Stock Quote
Juniper Networks, Inc.
JNPR
$28.20 (-1.05%) $0.30
Arista Networks, Inc. Stock Quote
Arista Networks, Inc.
ANET
$92.88 (-0.92%) $0.86

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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