Cisco Systems (NASDAQ:CSCO) is buying back a ton of its own shares these days. Is that a smart capital management strategy, or would Cisco be better off investing this $7.5 billion cash package elsewhere?
First, let's look at the numbers. The networking giant's cash flows have increased by 40% over the last 5 years, while buybacks skyrocketed more than 130% higher:
Cisco hasn't spent this much on share buybacks since 2005. Back in the day, Cisco was notorious for making large buybacks without reducing the share count much. The repurchases were effectively a tax-efficient part of Cisco's employee compensation strategy, a counterbalance to dilutive share and option grants.
Things are different now. Cisco has retired 4.6% of its shares outstanding over the last 4 quarters. During this period, Cisco shares were available at historically attractive prices, as low as 11 times trailing earnings.
Against this backdrop, Cisco isn't just throwing its cash flows away. Buying back cheap shares can be a sensible investment, and may in fact be the most shareholder-friendly capital strategy of all.
However, it's rarely a company's only reasonable cash use. Would Cisco serve its shareholders better by raising its dividends, pouring more money into developing its own business, or perhaps pouncing on plug-in or game-changing acquisitions?
Better off doing buyouts?
Let's start with the acquisition angle.
It's been more than three years since Cisco CEO John Chambers promised to trim his company down. "It's time for focus," he said in an official blog post addressed to Cisco's own employees. "Plain and simple -- we need to roll up our sleeves and work it out, together."
Part of the problem was that Cisco had become bloated and inefficient. A long series of questionable buyouts wound up adding more to costs than profits. Chambers got to work, selling or shutting down several of these recently acquired business lines. More than 4,000 Cisco employees lost their jobs.
At the same time, Cisco never stopped making new acquisitions. Last year's $2.7 billion Sourcefire buyout was simply one more in a long line of strategic additions. Payrolls soon ballooned again, and Cisco has 3,000 more full-time employees today than it did in 2011.
Chambers takes an active interest in buyouts, and is not afraid to pull the trigger on tempting deals. Sourcefire, for example, expands Cisco's presence in the data security industry. Other recent deals have dipped into familiar businesses like cloud computing, online communications, and wireless networking. As long as Cisco sticks to deals firmly within its field of expertise, buyouts can add plenty of shareholder value.
Back to the lab again?
How about accelerating Cisco's in-house research and development efforts?
The company actually pulls its weight in the R&D department -- and then some. Would you believe that Cisco spends more on product development than mighty Apple (NASDAQ:AAPL) and patent leader IBM (NYSE:IBM)?
It's true, albeit with a couple of caveats:
IBM's R&D budget is declining, allowing Cisco to jump ahead only in the last 6 months. Big Blue is going through its own slim-down makeover right now, much like Cisco's in 2011.
As for Apple, Cupertino's R&D spending has accelerated in recent years. The company's famous shoestring budgets and minimal product catalogs have given way to looser R&D purse strings. The Apple Watch is one result from this strategy change, and I can't wait to see what else might come out of Apple's rising research efforts.
So Cisco may not rule this trio of big-ticket research budgets for long, but John Chambers still earns applause for making the effort. R&D spending nearly matches the temporary buyback spike, and should remain at these high levels for years to come.
No complaints here.
Time for bigger dividends?
Finally, let's consider Cisco diverting some of the buyback funds into larger dividend checks.
Once again, Cisco is actually doing well on this alternative cash use. Since kicking off its first-ever quarterly dividend policy in 2011, at $0.06 per share, Cisco has raised its payouts four times. The annual dividend budget has more than tripled.
And even as Cisco put the pedal to the share-buyback metal, the company still raised its dividend payout by 12% in 2014. Over the last 2 years, Cisco has boosted its dividends faster than either IBM or Apple:
The final verdict
In August's fourth-quarter earnings call, Chambers underscored his commitment to the current capital allocation strategy.
"I feel very good about our cash flow," Chambers said. "We are committed to the dividend and the share repurchase. We see no indication of changing our direction. We have a minimum of 50% free cash flow return to our shareholder and as [CFO Frank Calderone] said, it was 120% of last year."
Is the strategy absolutely perfect? Well, nothing ever is. But Cisco has given itself an admirable platform to work from. The company is investing more than $6 billion in R&D, which still lets $11 billion fall down to the free cash flow line. There, management has committed to returning 50% or more of this cash to shareholders -- and over-delivered on the promise. And the door is always open to sensible acquisitions.
Buybacks aren't always a great idea, but Cisco appears to be using them as a shareholder-friendly tool for all the right reasons.
Anders Bylund has no position in any stocks mentioned. The Motley Fool recommends Apple and Cisco Systems. The Motley Fool owns shares of Apple and IBM. Try any of our Foolish newsletter services free for 30 days.