Cisco Systems is one of the well established IT stocks on Wall Street, but it has been overhauling its business model in the background. The company has been around for a long, long time and was actually one of the hot-shot stocks back in the dot-com boom when it hit a price of $77.31 (when adjusted for stock splits).

Operations

Now, a lot of people think of Cisco as a hardware provider and that's accurate to an extent, but Cisco do so much more. Cisco provide everything from routers and switches to security and cloud solutions, even certifications. One of their core businesses is networking and that's obvious in the revenue. Their biggest revenue category is Secure Agile Networks which made up 46% of all revenue, followed by Services with 26%, Internet for the Future with 10%, Collaboration with 9%, End-to-End Security with 7% and so on. An important takeaway here is the fact that the management wants to shift more of the core business from hardware to software and towards a subscription-based model. It doesn't mean that Cisco will become a 100% software shop, but they are trying to expand that aspect of their business. Personally, I think that's a very positive switch since software and subscriptions tend to generate a more stable cash flow as opposed to hardware products which you really need to buy once, then just maintain. It also means that Cisco will become less susceptible to the supply chain problems that we have been seeing since 2020.

In terms of geography, the majority of Cisco's revenue in 2022 came from the Americas with 58% whereas Europe, Middle East and Africa accounted for 27% and 16% from China, Japan and the greater Asia Pacific region. The benefit of this spread is that Cisco will be less affected by economic slowdowns in a specific country or geographic region. However, the drawback is that its net income may be affected by the strength of the dollar. The good thing here is that the dollars seems to be trending down slightly which may boost the overall profitability of Cisco's overseas operations.

Profitability

Speaking of profitability, let's look at the actual numbers. Cisco's revenue in its 2022 financial year was $51.6 billion, slightly under the pre-pandemic high of $51.9 billion, but better than the 2020 and 2021 results of $49.3 billion and $49.8 billion respectively. In terms of gross margin, the values have fluctuated between 60.3% and 64.3% over the last 10 years with the latest gross margin sitting at about 62.2% which is slightly under the 5-year average for Cisco of 63.2%, but much higher than the US IT sector's median at 46.6%. In terms of net margins, Cisco is again doing very well with the latest figure being 22% compared to its 5-year average of 17.85% and the US IT sector's median of 14.24%. Finally, its free cash flow margin is 20.23%, slightly under its 5-year average of 22.01%, but above the US IT sector's median of 12.2%. Obviously, it is looking like Cisco is a very profitable business even for the US IT Sector standards and a very consistent one as well, but I really want to hammer that point home so I will show you two of the golden profitability ratios and those are the Return on Equity and Return on Assets. Cisco's ROE is very high and sitting at 27.7%, higher than its 5-year average of 23.1% and higher that the US IT Sector's median of 21.6%. Same goes for its ROA which sits at 12.4%, higher than both its 5-year average of 9.6% and the US IT sector median of 8.5%. Yeah, I know that's a lot of numbers, but the takeaway here is that Cisco is a lean, mean, IT machine. Its operations are strong, consistent and efficient and that's a very, very big green flag in my books.

Financials

The natural follow-up question is: are they managing their financials as well as their operations? Let's take a look. First of all, debt. How much debt do Cisco have? As of their latest report in October last year, Cisco had $7.7 billion in long-term debt and $1.25 billion current portion of long-term debt, totalling $8.95 billion. Given that Cisco has equity of $40.3 billion dollars, this amounts to a very humble debt-to-equity ratio of about 22.2% of Cisco's equity, especially when compared to the US IT Sector's median of 58.16%. Even better though, Cisco has more cash than debt with its total cash and cash equivalents standing at $19.78 billion, almost two and a half times more than its total long-term debt! In fact, Cisco actually makes money on its cash with $153 million in net interest income in the last 12 months! Cisco's credit rating is also double A negative (AA-), which is almost pristine. Basically, Cisco is as good as it gets when it comes to healthy finances, it is simply rock solid.

Dividend

How about the dividend though? Are we getting that nice divvy with Cisco? Cisco's current dividend yield stands at 3.13% which is above the median for the US IT sector of 1.35%. It is not a massive dividend by any stretch, but there are only 5 companies with a higher dividend yield than Cisco and, let's just say there is a reason for that. One of these is Western Union, another is Intel, businesses facing massive challenges, you get the picture. Now, Cisco's yield is above its 5-year average of 2.98% which is good to see. Plus, it has a 5-year annualized growth rate of 5.55% which is a decent, sustainable pace. It is below the US IT sector median of 10.99%, but I am not too worried about that given that the majority of the other companies pay a much lower dividend. Cisco's payout ratio is also very manageable, sitting at 44.4% which is essentially the same as its 5-year average of 44.7% and below the 50% recommended by credit rating agencies. Cisco's annual dividend is $1.52 per share while their free-cash-flow per share stands $3.19 so its dividend is covered twice over by its free cash flow. Basically, we can draw the conclusion that Cisco's dividend is probably one of the best in the US IT sector. Plus, Cisco have been very active when it comes to share buybacks. Since 2013, Cisco have been extremely active in repurchasing shares, reducing the total outstanding shares count from 5361.5 million in 2013 to the latest figure of 4108.1 million. That's a reduction of 23.3%! Just in 2022, Cisco repurchased 146 million of shares and they have another $15.2 billion left in their stock repurchase program which, at current prices, amounts to another 313 million shares. Basically, the management does not shy away from returning capital to shareholders which is really good to see in my opinion.

Valuation

So, the profits are good, the financials are healthy, the dividend is extremely solid… What is the price tag? How much are we paying for Cisco right now and are we getting a bargain? Let's look at the basics. Again, I will use the adjusted PE ratio because it is simply a more accurate representation of the underlying business. Generally speaking, if you are looking at a tech business, you simply need to use adjusted PE. So, the values here are an adjusted PE ratio of 14.3 and adjusted forward PE of 13.7, both cheaper than the 5-year average for Cisco which stand at 15.8 and 15.2 respectively. They are also cheaper than the US IT sector medians standing at 24.54 and 17.66 respectively. When it comes to asset valuation, Cisco's price-to-book is 4.94 compared to the 5-year historical average of 5.2 and the US IT sector's 5.25 so Cisco is looking discounted on another ratio. However, Cisco does have a higher price when it comes to earnings growth. Now, analysts expect Cisco's earnings to grow by about 6% annually over the next 5 years which gives the stock a PEG ratio of 2.7 which is unfortunately higher than the 1.9 median for the US IT sector. When it comes to analyst price targets, the average for the next 12 months is about $53.88 dollars which gives us about a 10% upside. According to SimplyWallstreet, the intrinsic value of Cisco based on its discounted free cash flows is about $68.35 dollars although that's a longer-term price target. Personally, I think there is some upside to Cisco. It looks like the latest support is at around $45 dollars, followed by $40 and finally by $35.7 dollars. There is a bit of resistance at about $50 dollars, followed by more resistance at $54 dollars, then $60 and finally the spike at $64 dollars. Judging by the levels of support and resistance, we have a potential maximum 33% upside on a potential maximum downside of 25% which is not the best risk-reward ratio, but it is decent overall. Cisco is also currently trading above its 10, 20 and 50-day moving averages, but under the 200-day average so it is picking up some momentum, but it has not really set up a trend yet.

Final Conclusion

So, that's a lot of information, but what does it tell us? Well, fundamentally speaking, Cisco is undervalued relative to its historical averages and its competitors in the US. However, the discount is not that big. The technical indicators are also telling us that while Cisco offers some upside, it is currently not that significant. My personal opinion? If you are looking to make a short-term trade with Cisco, you should probably pass as it's not offering the best risk/reward ratio and you should instead wait until it drops to $45 or even lower. However, if you are looking to build a long-term position in Cisco for its dividend and general stock price appreciation, now is a good time to start. I personally will start a position in Cisco. In fact, today I bought $120 dollars worth of the stock and I will look for more opportunities to add to it. I think that Cisco can help stabilise your portfolio during 2023 while giving you a stable and growing dividend.

What do you think? Are you bullish, bearish or neutral on Cisco? I'd love to hear your comments 🙂