Dividend Safety Analysis: Cisco (CSCO)

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This week, I will be taking a look at the dividend safety of technology giant Cisco (CSCO).

My full thesis on Cisco can be seen here, but I will focus primarily on its Dividend Safety Score in this article.

Before analyzing the company’s dividend, let’s quickly recap how Cisco makes money. After all, one of the best pieces of investing advice is to only invest in simple, easy-to-understand businesses.

Cisco has been in business for more than 30 years and is one of the biggest tech companies in the world.

The company’s products (77% of sales) and services (23%) are primarily sold to businesses to help them connect computing devices to networks or computer networks with each other.

Switches and routers are Cisco’s largest product segments and help connect communications devices and manage the flow of data between networks.

Cisco’s reach is global in nature with approximately 40% of revenue generated outside of the Americas.

Cisco’s Dividend Safety

As I noted in my recent analysis of Caterpillar’s dividend, my intention is to never own a company that reduces its dividend payment.

The three dividend portfolios in our newsletter have been successful so far. These portfolios have collectively enjoyed over 60 dividend increases and avoided any dividend cuts since they were started.

Companies usually give off a number of warning signs before they actually cut their dividends.

The companies most likely to cut their dividends usually have some combination of high payout ratios, weak free cash flow generation, declining sales and earnings, weak balance sheets, and no proven commitment to paying and growing dividends over time.

Tracking these key metrics is time-consuming, which is why I created Dividend Safety Scores to help me keep tabs on all of these factors for companies I am interested in.

Our Dividend Safety Score analyzes 25+ years of dividend data and 10+ years of fundamental data to answer the question, “Is the current dividend payment safe?”

We look at factors such as current and historical EPS and free cash flow payout ratios, debt levels, free cash flow generation, industry cyclicality, profitability trends, and more. Cisco’s most important dividend and fundamental data can be seen by clicking here.

A Dividend Safety Score of 50 is average, 75 or higher is considered excellent, and 25 or lower is considered weak.

Most companies that end up cutting their dividends score below 25 for Dividend Safety prior to announcing their dividend reduction.

Kinder Morgan, Potash, BHP Billiton, and ConocoPhillips all scored below 20 for Dividend Safety before announcing their dividend cuts.

Fortunately, dividend investors who own shares of Cisco for income can sleep well at night.

Cisco’s Dividend Safety Score of 87 indicates that the company has one of the safest dividend payments in the market.

Unlike more proven dividend growth stocks, Cisco only started paying dividends in 2011. How can the company score so well for Dividend Safety with such a limited track record?

I’m glad you asked.

Cisco’s strong Dividend Safety Score begins with its healthy payout ratios. Over the last 12 months, Cisco’s dividend has consumed 46% of reported earnings and 38% of free cash flow.

While the company’s payout ratios have meaningfully increased since Cisco began paying dividends (see below), their current level is very safe. Even if Cisco’s earnings were unexpectedly cut in half, the company’s payout ratio would still be below 100%.

Source: Simply Safe Dividends

Source: Simply Safe Dividends

And Cisco’s earnings are at very little risk of being chopped in half. The company performed relatively well during the last recession, which also impacts its Dividend Safety Score.

Cisco’s sales fell by 9% in fiscal year 2009, and its free cash flow per share dropped by 14%. Technology spending is certainly correlated with GDP growth, but many of Cisco’s solutions are mission-critical for businesses to continue operating.

In future years, Cisco’s performance during economic downturns could be even stronger. The company is shifting more into recurring software and services revenue, which improves Cisco’s cash flow stability and business forecasting.

To put some perspective behind Cisco’s ongoing mix shift, an analyst from Oppenheimer estimates that Cisco’s recurring revenue has doubled since fiscal year 2008.

Source: Simply Safe Dividends

Sales growth doesn’t do a company much good if it fails to generate free cash flow. Free cash flow is the money that is leftover after a company has reinvested back into the business to keep it competitive.

Without free cash flow, a company cannot sustainably pay dividends over the long term. As seen below, Cisco’s free cash flow generation has been outstanding.

The company has generated free cash flow each year for more than a decade, and its free cash flow per share has more than doubled since fiscal year 2005. Consistent cash flow generation adds further strength to Cisco’s dividend payment.

Source: Simply Safe Dividends

So far, we have seen that Cisco’s strong Dividend Safety Score is backed up by the company’s healthy payout ratios, relatively strong performance during the last recession, and consistent free cash flow generation.

Another major factor influencing dividend safety is financial leverage. Companies will always make their debt and interest payments before declaring dividends.

Businesses with high debt levels can be at greater risk of cutting their dividend if they unexpectedly fall on hard times. During such periods, earnings can be significantly reduced and existing cash must be preserved.

Cisco’s balance sheet is in excellent shape. As seen below, the company has more cash ($63.5 billion) than debt ($24.9 billion) on hand.

If the company paid off all of its debt and only used its remaining cash on hand to pay dividends, it could continue making its dividend payments for more than nine years before needing other funds! It’s hard to find a better balance sheet than Cisco’s.

Finally, it’s always worth reviewing a company’s recent sales and earnings trends to make sure no nasty surprises are brewing.

Cisco’s last quarterly earnings report showed adjusted revenue growth of 3% and a 6% increase in non-GAAP diluted earnings per share.

The company also commented that it was pleased with the progress it was making on its continued transition to more software and subscription revenue.

Unlike some old technology giants (see IBM), Cisco continues to hold its own in an ever-changing world.

By now, it is quite evident that Cisco’s dividend payment is very safe. Management last raised the company’s dividend by 24% earlier this year.

Cisco’s quarterly dividend payout has more than quadrupled since 2011 and continues to have double-digit growth potential.

With a healthy dividend yield of 3.4%, Cisco offers a unique blend of safety and growth.

Closing Thoughts on Cisco’s Dividend Safety

The technology sector is generally not a great hunting ground for dividends because of its fast pace of change and numerous opportunities for growth, which makes companies less willing to pay out dividends.

However, Cisco is a clear exception because of its large size and mature rate of growth. The company is generating more cash flow than it can profitably reinvest, which allows management to shower higher dividends on shareholders.

Cisco’s dividend payment is extremely safe. While the company’s track record of paying and growing dividends isn’t as long as some of my other favorite dividend stocks, Cisco’s dividend scores very well for safety and growth.

The company’s low payout ratios, consistent free cash flow generation, hoard of cash, mission-critical products, and stable sales and earnings growth all make Cisco a safe bet for dividend growth investors.

What other stocks would you like me to review for Dividend Safety? Leave a comment below with the ticker.