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Will this Tech Giant be able to Sustain its Dividend Yield?

Wednesday - 1/16/2013, 1:43pm  ET

Cisco Systems pays a healthy dividend of 2.73%. In a gloomy macro environment, the bears believe that the company may not be able to sustain its dividend yield, let alone a potential capital appreciation in the stock price. Let’s see whether the bears have got a point or not.

My view on Cisco

Cisco Systems is becoming a data center player, not just a networking company, and the shift to more stable and recurring revenue should allow it to return more cash to shareholders. A solid cash story, along with market share gains, the early days of margin improvement benefits, and more predictable earnings through a rising mix of recurring revenue, should support multiple expansion. I expect Cisco's structural changes to outweigh cyclical macro concerns. For a sustainable dividend yield, it is important to predict the company’s expected performance in the future.

The Improving Business Drivers and Dividend Sustainability

Cisco's successful entry into the server market with its Unified Computing System suggests it may be best viewed as a large-cap IT story with diversification into servers and possibly storage and hosted services. Cisco’s dominance in networking makes it well positioned in the data center. Cisco is expected to reach its 5%-7% sales growth target in a modestly growing market through share gains outside of networking and acquisitions. The growth themes behind its efforts to become a leading IT player are cloud, mobility, and video.

The following are some of the points that bulls make which will help the company to grow its revenues and margins.

1)      Cisco is focused on increasing its mix of recurring revenue through its services business.

2)      Cisco’s cost management plan is still young, and there is room for margin improvement across the product family. Its efforts to blunt its gross margin pressure (largely from mix) are expected to help it reach its operating margin target of high-20%.

3)      Finally, Cisco is actively seeking ways to improve return on capital to investors. In August, it announced it will return a minimum of 50% of free cash flow annually through dividends and share repurchases, and doubled its dividend to 3%. Approximately 85% of its cash is held overseas.

Upside Scenario

An improving macro environment, recapturing lost share, and margin improvements could help the company to post an EPS of $2.20 in 2013. This scenario assumes 8% revenue growth in CY13 compared to the company’s long-term 5%-7% target. The bullish price target of $28 embeds a P/E multiple expansion to 13 from the current forward multiple of 10.

Downside Scenario

Ongoing macro pressure, public sector weakness (this sector accounts for about 20% of the company’s sales), market share loss, and the margin pressure could yield a bearish EPS of $1.80. This downside case of $14 embeds a multiple of 8 and 3% revenue growth in 2013, versus the 5%-7% target set by the company.

Valuation Analysis

The $24 price target set by Barclays represents a 12x multiple with a 2013 EPS estimate of $2.00 or a multiple of 9, excluding cash. A 12-times multiple is Cisco’s five-year historical average. The following table compares some of Cisco's valuations with its competitors:

                                      

The table shows that the company's valuations place it between its peers International Business Machines and Hewlett-Packard

Foolish Bottom-Line

Cisco’s capital reallocation plan, modest EPS upside, and more predictable earnings will help the company to close the multiple gap with its large-cap peers. Excluding cash, Cisco’s 7 P/E is below the large-cap IT average of around 10, yet its 8% free cash flow yield and 2.7% dividend yield place Cisco at the mid- to upper half of its peer group. Therefore, it can be concluded that the company has a bright future, which will help it sustain its solid dividend yield. I recommend the stock as a buy.

This article was originally published as Will this Tech Giant be able to Sustain its Dividend Yield?on Fool.com

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