Routed in the Right Direction
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Sometimes companies surprise me and take suggestions that I make. Never mind that I'm sure they are not even aware that I've made such suggestions. This was the case with Cisco Systems (NASDAQ: CSCO) when I recently suggested the company could significantly increase its dividend yield. Apparently, that's exactly what management was thinking as the company increased its dividend by 75%, giving investors a new yield of nearly 3%. While this has been the most reported information, there were a few things that I noticed in the company's earnings report that should also give investors hope for better results in the future.
It's been widely reported that Cisco improved EPS by a large amount, but I tend to use the lowest growth rate possible when evaluating companies. Though it's true that on a GAAP basis the company's EPS grew by over 60%, on a non-GAAP basis EPS increased 17.5%. While even this lower number of growth is impressive, there are a few factors that should improve the company's top line growth going forward. The first is, the company is slowly but surely moving towards becoming more of a servicing company and less reliant on new product sales. This is good news for investors, as service sales increased 11.7%, while product sales increased just 2.57%.
While service revenue still represents a much smaller portion than products, this type of revenue has increased from just over 20% of revenues last year to nearly 22% this year. In addition, while North American order growth was just 4%, in the Asia-Pacific region order growth jumped 12%. This shows that the company is capturing a portion of the faster growing international market for networking gear. Cisco also mentioned seven different major innovations focused on the areas of mobile networking, cloud enabled routing, social collaboration, and more. While all of this is impressive, what is still the most impressive at Cisco is the company's financials.
In a competitive market such as networking, you would expect that most of the major competitors would have similar gross margins as price competition would keep everyone in line. However, looking at Cisco's major competitors we can clearly see that there are huge differences in the operating costs and relative price points of these networking companies. For instance, Alcatel-Lucent (NYSE: ALU) which has been struggling, has a gross margin of 37.58%. JDS Uniphase (NASDAQ: JDSU) comes in just slightly better with a margin of 41.59%. However, both Cisco and Juniper Networks (NYSE: JNPR) seem to be in a class of their own with both companies sporting a gross margin of over 60%. Where Cisco is the clear leader is in the company's ability to generate free cash flow. The company's cash and cash equivalents increased by over 8%, while at the same time the company repurchased $1.8 billion worth of shares. You can see that the company can not only add to its balance sheet, but also pay out dividends and repurchase shares at the same time.
This is really the crux of the issue with Cisco, the company still foolishly believes that repurchasing shares is more beneficial to investors than paying out the additional cash in dividends. When you compare Cisco to their competition, there doesn't appear to be a better choice in the networking field. With the stock still selling for a P/E ratio very close to its expected growth rate, and with a newly minted almost 3% yield, the company offers the best combination of growth and income. Based on analyst estimates, the only real competitor would seem to be Juniper Networks and the company's 14% expected EPS growth. Though JDS Uniphase is expected to grow at about 12%, as we saw before the company's gross margin is significantly less than Cisco or Juniper and thus puts the company at a competitive disadvantage. The laggard has to be Alcatel-Lucent, which at this point has to be considered more of a turnaround play than a traditional long-term investment. While Cisco is moving in the right direction by significantly increasing their dividend payment, the company has the ability to reward shareholders with a much better yield than even the new payout offers.
In the last 12 months, the company generated over $10 billion in free cash flow and used almost half of that to repurchase shares. In the last year, Cisco issued roughly $1.37 billion in new shares from options and performance awards. The company's new dividend payout equates to about $3 billion in dividends. While it may sound like I'm asking a lot, Cisco could do much more than $3 billion in dividends. Consider for a minute that the company's repurchases in the last 12 months retired 262 million shares. Even if Cisco only repurchased enough shares to avoid dilution from stock options, the company would still have an additional $3.38 billion. This is the amount of money spent in the last 12 months repurchasing shares beyond new shares issued. In the last 12 months, a lower share repurchase amount would have only affected earnings per share by about 3%. Considering the company beat earnings estimates by nearly 6%, the company still would have beaten estimates by about 3% per quarter. To put a number to this, with $3 billion slated to be spent on dividends, and about $3.3 billion in funds not used to buy back shares, the company could even double the new payout. This would represent about $6.3 billion available for common stock dividends. With 5.3 billion shares outstanding, this amount would be equivalent to an annual dividend of $1.20. You can see that what is essentially wasted on share repurchases could further boost Cisco's yield north of 6%.
Long story short, while the new dividend is a step in the right direction, the company has the potential to do tremendously more for their investors. What I'm suggesting does not change the amount of money the company spends each year, it just redirects the funds into dividends versus share repurchases. Using the figures above, the company would've paid out just over half of their free cash flow, which is right in line with management's guidance of returning 50% to shareholders in the form of dividends and share repurchases. The recently announced higher dividend shows the company is beginning to route its free cash in the right direction, but to change the game Cisco can do much more.
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