While economist warn of the possibility of an impending recession, investors should focus on putting their money in the stocks of companies with enduring business models that generate significant free cash flow and offer an attractive yield. Cisco Systems, Inc. (CSCO) fits the bill and is this week’s Long Idea.
Cisco’s stock presents quality risk/reward given the:
- company’s large customer network
- long-term demand for networking products and services
- company’s leading networking product market share
- company’s backlog for products and services is at all-time highs
- stock price implies the company’s profits will not significantly improve above TTM levels
Focus on Free Cash Flow in a Stormy Market
While money moves away from profitless growth stories, investors can find safety and value with companies, such as Cisco, that generate strong, consistent free cash flow (FCF). Companies that generate healthy amounts of FCF are better equipped than others to navigate challenging macro environments.
Cisco generated $40.8 billion (19% of market cap) in cumulative FCF over the past five years, and $74.0 billion (35% of market cap) in cumulative FCF over the past ten years, per Figure 1.
Figure 1: Cisco’s Cumulative Free Cash Flow: Fiscal 2012 – 2021
Dividends and Buybacks Provide 6.0% Yield
Cisco’s ability to generate significant amounts of FCF, and its $20.1 billion (9% of current market cap) in excess cash, means it can return a large amount of capital to investors in the form of dividends and share buybacks. Since fiscal 2017, Cisco has paid $29.6 billion (14% of current market cap) in cumulative dividends. Over the trailing twelve months (TTM), the company has paid $6.2 billion in dividends. The company’s current dividend, when annualized, provides a 3.0% yield.
Cisco also returns capital to shareholders through share repurchases. From fiscal 2017 to 2021, the company repurchased $47.5 billion (22% of current market cap) worth of stock. Over the TTM, Cisco has repurchased $6.4 billion worth of stock, and the company has $18 billion remaining on its current share repurchase authorization. Should the company continue to repurchase stock at TTM levels, shareholders would realize a combined yield from dividends and buybacks of 6.0% of Cisco’s current market cap.
Cisco Is a Market Leader in Physical Equipment
Cisco provides the physical infrastructure that powers the internet across the globe. The company estimates that 85% of the world’s web traffic travels across Cisco connections. According to International Data Corporation (IDC), Cisco has the largest market share of routers and ethernet switches worldwide, per Figure 2.
By being the largest provider of networking equipment, Cisco is an established reliable partner with a global reach and offers customers extensive maintenance and support. Additionally, the company’s widespread certification program means customers can more easily find employees with the skills to work with Cisco products and services.
Figure 2: Cisco Vs. Competitors: Routers and Ethernet Switches Market Share – 2021
The Internet Is Still Growing
Per Figure 3, the number of global internet users has increased year-over-year (YoY) in each of the past 16 years and rose from 1.0 billion users in 2005 to 4.9 billion in 2021.
Not only is the number of internet users increasing, but the number of devices and connections per person has grown from 2.3 in 2016 to 3.5 in 2021, while the average monthly traffic per person rose from 12.9 GB to 35.5 GB over the same time. The steady expansion of internet use creates very meaningful long-term demand for providers of the internet’s infrastructure, such as Cisco.
Figure 3: Global Internet Users: 2005 – 2021
Cisco Is Also a Growing Software Company
A key component of Cisco’s future growth strategy is serving customer needs beyond physical equipment. Cisco operates in 115 countries and leverages the customer relationships it has established with its widespread equipment business to grow its software business.
The company’s investment in developing its software business is paying off since the company began its transition to more software subscription revenue in fiscal 2017. Software subscription revenue in fiscal 2021 reached ~$12 billion (24% of fiscal 2021 total revenue), or 3.5x higher than the $3.4 billion of software subscription revenue it generated in fiscal 2015.
Security Concerns Drive Additional Demand
According to Identity Theft Resource Centerthe number of data breaches in 2021 rose 68% YoY and 23% higher than the previous record set in 2017. Companies need to continually invest in network security to protect themselves from the an increasingly hazardous digital environment.
Perhaps not surprisingly – given the backdrop – Cisco’s security segment is the company’s fastest growing by revenue. Revenue from Cisco’s security segment grew 20% from fiscal 2019 to 2021. Figure 4 shows Cisco’s revenue from its security group rose from $2.0 billion in fiscal 2016 to $3.4 billion in fiscal 2021, or 11% compounded annually.
While competitors are also growing their security businesses, Cisco is growing fast enough to take market share. Cisco’s share of the calendar 4Q21 worldwide security appliance vendor market rose from 14.6% in calendar 4Q20 to 15.3% in calendar 4Q21. This improvement displaced Palo Alto Networks (PANW) (15.2% share in calendar 4Q21) for the market’s top spot.
Figure 4: Cisco’s Security Group Revenue: Fiscal 2016 – 2021
China’s Loss Is Cisco’s Gain
Concerns over security not only boost Cisco’s security segment but will likely drive more demand for its trusted physical networking equipment. While Chinese competitors Huawei and New H3C Technologies may offer lower-cost products, rising global tensions with China make companies and entire countries reluctant to use products and services from Chinese companies to handle sensitive information. Given China’s history of exploiting Huawei’s equipment to collect intelligence, concerns over using equipment made by Chinese firms are likely to grow in the current political environment.
US-based Cisco is positioned to benefit from these increased concerns as the company offers a more creditable commitment to security than its Chinese competitors. The Chinese system of production has just as much trouble as the Soviet system when forced to compete directly with the West and is ultimately incapable of meeting customer needs of various complexity.
Should tensions between US-friendly and China-friendly countries give rise to two separate internets, Cisco would likely gain more than it would lose as it did in fiscal 2021. While the company doesn’t disclose country-specific revenue, its Asia Pacific, Japan, and China (APJC) region reveals the strength of the company’s business outside of China. Though revenue declined 4% YoY in China in fiscal 2021, revenue in the APJC region rose 4% YoY as growth in the rest of the region more than offset the decline from China.
Core Earnings Are Moving Higher
Cisco’s strong equipment business and growing software segment generate consistent profits. Cisco has generated positive Core Earnings in each of the past twenty years. More recently, Cisco’s Core Earnings rose from $8.5 billion in fiscal 2012 to $11.5 billion over the TTM, per Figure 5.
Cisco still faces supply challenges which have affected its business since the COVID-19 pandemic began. These challenges have resulted in lower revenue and Core Earnings. However, the company’s Core Earnings are back on an upward trend. Cisco’s fiscal 2Q22 TTM Core Earnings were up 2% YoY.
Figure 5: Cisco’s Revenue & Core Earnings Since Fiscal 2012
Cisco Delivers Profitable Scale
Though Cisco’s return on invested capital (ROIC) fell from 18% in fiscal 2019 to 15% over the TTM as it faced pandemic-related challenges, the company’s economic earnings have trended higher over the past five years. Economic earnings improved from $6.4 billion in fiscal 2017 to $7.3 billion TTM.
Cisco’s economic earnings are superior to the economic earnings of 20 out of 22 peers which include the publicly traded competitors listed in the company’s fiscal 2022 10-K. Only Microsoft and Amazon, which are among the largest companies in the world, have higher economic earnings over the TTM.
Figure 6: Cisco’s Economic Earnings Vs. Peers: TTM
Historically High Backlog Will Deliver the Goods
The decline in Cisco’s revenue during the pandemic doesn’t mean demand for the company’s products and services has declined. As the company continues to navigate supply constraints, its backlog of orders has been growing. Cisco ended fiscal 2Q22 with an all-time high backlog valued at more than $14 billion (27% of TTM revenue).
As supply constraints unwind, Cisco will likely realize a large boost to its top and bottom lines from the orders in its inflated backlog. Of course, the risk is that the global economy suffers a sharp decline before the backlog is worked off and orders are canceled. Nevertheless, given the essential nature of internet usage for so many people and companies, demand for…
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