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Better Buy: Cisco Systems vs. IBM

By Will Healy - May 17, 2020 at 3:08PM

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Which company can offer more shareholder value in the new tech economy?

Cisco Systems (CSCO 1.74%) and International Business Machines (IBM 0.33%) have one big thing in common. Both are formerly-hot tech stocks that fell out of favor amid changing technologies. Now, they seek to return to prominence by adapting to the current tech environment.

Though networking remains a large part of Cisco's business, it has worked to redefine itself as a 5G and security-oriented company. IBM appears to have staked its future as primarily a cloud play. Success in their chosen niches will determine whether these companies reemerge as venerable tech giants or if they get permanently left behind by more dynamic enterprises.

Why investors should consider Cisco

Twenty years ago, Cisco briefly had the largest market cap of any company in the world. This happened as Cisco products built the infrastructure of a then-burgeoning internet.

Over the years, Cisco evolved from a high-flying tech growth stock into a more conservative, dividend-paying Dow 30 stock. Unfortunately for long-term investors, Cisco stock still trades about 50% below that dot-com-era high. Even though the company remains profitable and continues to innovate, it has not attracted as much attention as it garnered in the 1990s and early 2000s.

CSCO Chart

Cisco Stock Performance, data by YCharts.

Cisco still derives just over half of its revenue from infrastructure platforms, a capability that could bolster Cisco as 5G increases in importance. It has also ventured into security, the Internet of Things, and data centers in recent years.

However, in the most recent quarter, falling product sales led to an overall revenue decline of 8%. Moreover, although Cisco's quarterly adjusted earnings per share of $0.79 beat estimates, that represented only a $0.01 per share increase from the year-ago quarter. The company also warned investors that it expects revenue and earnings to fall from year-ago levels in the current quarter.

Cisco stock trades for about 14.5 times the company's projected earnings for fiscal 2020, well below the S&P 500 average of around 20. Its annual payout of $1.44 per share yields approximately 3.3%. The company began paying dividends in 2011 and has hiked its dividend every year since that time. At a payout ratio of 56% (based on GAAP EPS), Cisco is spending a slight majority of its profit on the dividend. Still, this level does not put the dividend in any immediate danger.

Although Cisco has faded from the headlines, it remains a profitable company that generates income for its shareholders. If the company returns to revenue growth once 5G becomes more widely adopted, perhaps Cisco can again become more of a growth stock.

Hands typing on laptop on white table with a smartphone and cup of coffee

Image source: Getty Images.

The case for IBM

IBM appears to be following in the footsteps of Microsoft. Like the maker of Windows before it, IBM elevated the head of its cloud division to the CEO job.

Since Arvind Krishna has only run IBM for a few weeks, it is too early to tell whether the company can repeat Microsoft's success in the cloud. However, the previous CEO, Ginni Rometty, had held the job since 2012. During that time, IBM stock fell. Hence, Krishna will face some pressure to turn things around.

IBM Chart

IBM Stock Performance, data by YCharts.

However, the cloud has become a bright spot even as the company has declined in an overall sense. In the most recent quarter, revenue in the cloud and cognitive software division increased by almost 5.5%, even as total revenue fell by just under 3.4%.

The $34 billion acquisition of Red Hat last year represented a massive bet on the cloud business. Gartner Research expects double-digit growth rates for the cloud industry over the next few years, and this division should share in some of that prosperity.

IBM withdrew its annual guidance in April and stated that it will reassess that decision at the end of the second quarter. Despite a bleak outlook, IBM bulls have good reason to take a chance on this company. The current P/E stands at around 11.5, well below its five-year average valuation of just under 14.7 times earnings.

Moreover, the dividend of $6.52 per share annually yields approximately 5.6%. The company also just increased its payout for the 25th straight year, making IBM the newest Dividend Aristocrat. Although IBM's payout ratio of about 64% is a significant burden, the company will probably not want to walk away from Dividend Aristocrat status, which it built over the last 25 years.

Furthermore, if Krishna can orchestrate a turnaround, IBM could not only maintain the dividend growth streak, the P/E ratio could also climb out of the low double digits. These possibilities might make IBM a worthwhile investment.

Cisco or IBM?

Cisco and IBM are older tech companies trying to find a way to stay relevant in today's market. Amid the struggles, they have remained profitable and consistently raised their dividends.

Both have the potential to make a comeback. However, in this case, I give the edge to IBM. From a financial standpoint, it trades at a lower P/E ratio than Cisco. With a newly-minted Dividend Aristocrat status, it is also more likely to maintain payout hikes despite a slightly higher dividend payout ratio.

Moreover, the acquisition of Red Hat last year increases the likelihood of IBM becoming a prominent cloud company. While Cisco could also become a player in 5G or one of its other niches, how the company might perform in its new industries remains an unknown.

Given the more attractive valuation and a clearer path forward, IBM appears to offer more potential for investors.

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Stocks Mentioned

International Business Machines Corporation Stock Quote
International Business Machines Corporation
IBM
$138.08 (0.33%) $0.46
Cisco Systems, Inc. Stock Quote
Cisco Systems, Inc.
CSCO
$42.69 (1.74%) $0.73

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