4 Reasons This Run Is Not Done

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I know I should be happy with what's happened to Cisco Systems (NASDAQ: CSCO) stock over the last several months. I wrote about the company in August of last year, and suggested that they were generating enough cash to significantly increase their dividend. Since their dividend was $0.32 at the time and has been raised to $0.56 today, apparently management had similar thoughts. Previously the stock was at $16, and today shares trade for more than $21. So why am I frustrated? Honestly, it's because I didn't follow my own advice. I saw the potential in Cisco, wrote about it, and did nothing. I'm also here to tell you, this company's not done.

The 800 lb gorilla still rules the industry
Cisco faces serious competition from companies within its field like Juniper Networks (NYSE: JNPR). However, Cisco also faces the likes of companies like Hewlett-Packard (NYSE: HPQ) and Dell (NASDAQ: DELL). The latter two, hope that networking sales can generate growth. While Juniper is on much stronger footing than Dell or HP, each of these companies struggles to match the scope and size of Cisco's portfolio of products and services. Dell and HP also have the additional challenge because a large portion of their business is tied to the slower growing PC industry. Dell is said to be in talks to go private, but even if this occurs, Dell would still attempt to steal networking sales from the 800 lb gorilla in the industry.

Better margins lead to better cash flow
If you are looking for a stock to hold over the long-term, it helps to search for a category leader. One way to find these category leaders is, by looking at their gross margin. Generally speaking, a company with a higher gross margin is either more efficient, or has pricing power. Either way, investors should benefit and a higher gross margin gives the company a safety net against price competition.

Cisco carries a gross margin of 60.95%. Juniper Networks comes close to Cisco with a gross margin of 60.25%. Unfortunately Dell does not break out their margins for each product segment, but even in the usually high margin services segment, they managed a gross margin of just 35.49% at the end of last year. Hewlett-Packard on the other hand, managed a services margin of just 22.40%, which was actually lower than their overall gross margin of 24.19%. With such a huge lead in gross margin, Cisco in theory should generate more cash flow. 

What makes sense in theory also happens in reality. Cisco generates significantly more free cash flow than its competition. I use free cash flow per dollar of sales to compare companies of different sizes. In the current quarter, Cisco generated $0.20 of free cash flow using this measure. None of their competition is even in the same ballpark. Hewlett-Packard generated $0.11 per dollar of sales, Dell generated $0.09, and Juniper only made $0.08. This proves that Cisco management is paying attention to detail, by cutting costs where possible to push more money through to spendable cash.

Spending money where it counts
Cisco management knows when they spend money, what needs to take priority. First, the company showed the market how to repurchase shares the right way, by continually retiring shares while the stock was floundering. Cisco repurchased shares at an average price of $16.44 in the last quarter, and bought at an average of $20.44 over the last year. These share repurchases were no flash in the pan either. The company spent at least $3 billion in share repurchases in each of the last few years. 

Maybe more important than share repurchases is, the way Cisco spends its money on research and development. With any technology company, investors should watch the spending pattern in this area. I would actually argue that investors can pick out potential future winners, based on if they spend enough on research and development today. I don't think it's a coincidence that Dell and Hewlett-Packard only spend 2% and 3% of their current quarter sales on R&D and both have struggled to stay relevant. By contrast, Cisco spends more than 12% of their sales on R&D, and Juniper actually spends even more at over 25%. It should be no surprise then, that Cisco and Juniper are both expected to grow their earnings faster in the future.

What's the encore?
Looking at these four companies, the choice of which one to buy seems pretty clear. Though Dell has run up recently on privatization talks, the company was struggling because of their large PC division. Today, Dell is more of an arbitrage play than a long-term investment. Hewlett-Packard is still struggling, and even their 3% yield and forward P/E of 5 don't make me take a second look. The company is expected to post flat growth in the next few years, and without a massive increase in the dividend, there just isn't a lot to get excited about. 

Juniper Networks is a decent alternative to Cisco. The company spends plenty on R&D to keep itself ahead of the curve, and analysts expect 14% EPS growth in the next few years, but the stock sells for over 19 times forward earnings and pays no dividend. For growth and income investors, Cisco is the best choice. The company is expected to grow earnings by 8.4%, and their 2.6% yield should easily increase in the future. The company's free cash flow payout ratio is just 30% so management should be able to increase the dividend in the future. Now if only I had listened to my own advice. Don't make my mistake, add CSCO to your personalized Watchlist today.

MHenage has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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