Cisco Systems (CSCO -0.27%) was on shaky ground before the novel coronavirus pandemic struck thanks to a cyclical slowdown in cloud infrastructure spending and the U.S.-China trade war that led to a considerable drop in its revenue from Chinese customers last year.
But Cisco management seems confident that its business will start picking up the pace in the wake of the COVID-19 outbreak as organizations ramp up their spending on information technology (IT) infrastructure. This should pique the interest of income-oriented investors as Cisco is one of the top dividend-paying stocks in tech that also trades at an attractive valuation. Will Cisco be able to able to turn crisis into opportunity and put behind its mediocre stock market performance? Let's find out.
Cisco's biggest challenge
Cisco's infrastructure platforms business is its biggest source of revenue and accounts for nearly 54% of the top line. Revenue from this segment was down 15% year over year in the third quarter of fiscal 2020, weighing on Cisco's overall revenue that fell 8% annually during the quarter.
Cisco blamed supply chain disruptions for the weakness in this segment, along with a decline in demand for data center switching products. The situation isn't expected to improve, as Cisco saw a 5% drop in product orders during the quarter. Not surprisingly, the networking giant anticipates a revenue decline of 8.5% to 11.5% during the current quarter.
However, Cisco management tried putting on a brave face. CEO Chuck Robbins believes that network capacity expansion in the wake of the pandemic could spur IT infrastructure investments as organizations shift their employees to a work-from-home model. He said on the latest earnings conference call:
With the world going online practically overnight, the demand on networks has never been greater with users looking for secure connectivity, reliable performance, and consistent experiences. This has led to our customers evaluating how to expand their capacity quickly, how best to protect their teams, and how to keep their data secure while keeping their business productive.
But Cisco's guidance and the drop in orders imply otherwise. The company says that it was performing ahead of expectations in March, but the COVID-19 outbreak disrupted its business momentum as it started witnessing a slowdown from April. The bad news for Cisco is that global IT spending is expected to take a hit this year thanks to the novel coronavirus.
According to Gartner's estimates, overall IT spending could decline by 8% in 2020. The firm forecasts that spending on IT devices could drop by the biggest margin, falling 15.5% from the prior-year period. Meanwhile, data center spending is anticipated to decline close to 10% this year due to the negative impact of COVID-19.
Amid all this uncertainty, a turnaround at Cisco looks farfetched even though there are a few things that make it a stock worth adding to your watchlist.
A few silver linings
Cisco may be going through a bad patch right now, but it looks well-equipped to overcome the near-term challenges thanks to its strong balance sheet. The company's cash position of nearly $28.6 billion easily exceeds the total debt of $17 billion.
The company's margins have moved north over the past year despite the declining revenue while free cash flow generation has been steady -- indicating that its dividend is safe in these uncertain times. The company credits productivity improvements and a decline in memory costs for its margin gains, a trend that may continue thanks to a bump in its subscription-based business.
Cisco's subscription revenue has been rising at a nice clip. Subscriptions accounted for 74% of Cisco's software business last quarter as compared to 65% in the prior-year period. The company doesn't specify how much revenue it gets from selling software, but the shift toward a software-as-a-service (SaaS) model is one of the reasons why its margins have improved in difficult times.
All of this bodes well for Cisco's dividend. The company sports a dividend yield of just over 3% and paid out $1.5 billion in dividends last quarter. It has generated close to $15 billion in free cash flow over the past year, which puts the dividend in safe territory as the company returns at least half of its annual free cash flow to investors through dividends and share repurchases.
And finally, the stock is cheap right now with a price-to-earnings (P/E) ratio of 17, which is lower than its five-year average P/E multiple of nearly 155x and last year's average multiple of over 19.
As such, investors looking for a high-yielding dividend stock at a reasonable valuation should keep an eye on Cisco, though they should keep in mind that the company needs improvement in the IT spending scenario to get back on track.