Despite the Fed’s recent announcement, artificially low interest rates aren’t going away any time soon, and this continues to create very real challenges for income-focused investors (i.e. it’s hard to find attractive yield). As a result, many investors have shifted their focus to dividend stocks (instead of bonds) because they can offer more attractive yields and the potential for price appreciation. And some investors have taken things one step further by attempting to generate even more income by writing covered calls on the stocks they already own. For example, Cisco Systems, Inc. (NASDAQ:CSCO) is a popular stock with a big dividend (3.3%), it has achieved significant price appreciation this year (it’s up 18.4% versus only 7.6% for the S&P500, on a total returns basis), and it may seem like an attractive covered call stock to many income-focused investors. However, we believe now may be a good time to exit Cisco altogether because of the growing commoditization of its main products, the company’s increasing irrelevance with regards to cloud-based data centers and the white box solutions of Amazon.com, Inc. (NASDAQ:AMZN) and Alphabet Inc (NASDAQ:GOOGL), its shifting financial wherewithal, and its recent restructuring. We offer four specific options that we consider more attractive than Cisco covered calls for long-term income-focused investors, including selling put options on the Utilities Select Sector SPDR ETF (XLU) and Vanguard REIT ETF (VNQ).
Generating Income with Covered Calls
Yes, the Fed’s artificially low interest rates have successfully forced many savers to invest more heavily in stocks (this is how the Fed has been trying to stimulate the economy), but what the Fed perhaps did not correctly anticipate is how heavily those investors would skew towards stocks with big dividends. Another perhaps unexpected result has been the increasing use of options by some investors to eke out extra income. For example, covered calls. If you don’t know, writing covered calls is a strategy whereby investors sell a call option on a stock they already own thus giving someone else the right to buy that stock away from them in the future at a predetermined price in exchange for an upfront premium. The premium is a source of income for the call seller, and they get to keep the premium whether or not the call option is ever exercised before it expires. For example, the current premium for selling Cisco call options with a November 18, 2016 expiration date and a $33 strike price is $0.30 (more on this example later).
About Cisco Systems, Inc. (NASDAQ:CSCO)
Cisco is a supplier of data networking equipment and software, and it pays a big dividend (currently 3.3%). And like many other big dividend stocks, it has experienced significant price appreciation this year as shown in the following chart:
For a variety of reasons, we believe the market is overly optimistic about Cisco, and the price has gotten ahead of itself. But before getting into our views on the company, we first review the bull case for Cisco.
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Follow Cisco Systems Inc. (NASDAQ:CSCO)
The Bull Case for Cisco
If you value stocks based only on historical data, Cisco is extremely attractive. Not only does it have a big growing dividend (it yields 3.3%, and the dividend payment has been increasing sharply since 2011), but it also has a mountain of cash ($65.8 billion on its balance sheet), and it generates massive free cash flow ($12.4 billion for their year ended July 31st). It also has a wide operating margin, and its return on capital invested (40.8%) is enormous. And if you factor in a small 2% annual growth rate, a discounted cash flow model (assuming a 9.2% weighted average cost of capital) suggests that Cisco is worth more than $214 billion once you adjust for cash and debt. That’s about 35% upside versus its current stock price. The problem: we believe the 2% growth rate is overly optimistic, and it will be much more challenging than it was in the past for Cisco to grow at all.
Our View on Cisco
We believe Cisco Systems, Inc. (NASDAQ:CSCO) may not achieve the level of growth the market expects for a variety of reasons. For example, competition may put significant pressure on Cisco’s margins. Specifically, HP Inc (NYSE:HPQ) and Dell offer lower cost switching products. Switching is Cisco’s largest source of revenue as shown in the chart below.
Further, Chinese manufacturers (such as Huawei and ZTE) could increasingly detract from Cisco’s Asia-Pacific revenues and margins. For reference, the following table shows Cisco’s revenue breakdown by geography.
Another reason we believe Cisco’s growth may be challenged is because the industry may shift to white box cloud solutions. For example, Amazon.com, Inc. (NASDAQ:AMZN) and Alphabet Inc (NASDAQ:GOOGL) have roughly one million servers installed and connected with white-box solutions (note: a white-box is a server without a well-known brand name). This trend could significantly slow growth in Cisco’s large switching and routing businesses, and it could also cause Cisco to lower prices (thus reducing margins) just to be competitive.
Another reason we believe Cisco’s growth may be challenged is simply because the market may be over-optimistically extrapolating past results. For example, this price-to-earnings chart (below) suggests Cisco may be relatively inexpensive, but the earnings part of the ratio is only backwards looking.
According to Goldman Sachs, three of the key levers that have driven historical earnings-per-share growth for Cisco are now largely exhausted. First, server share gains are now leveling off. Second, operating margins are now at a 10-year peak (i.e. they may get worse in the future). And third, share buybacks may slow now that the dividend has recently been increased again.
Another reason we believe Cisco’s growth may be challenged is because of the current restructuring plan. Cisco recently announced:
“a restructuring enabling us to optimize our cost base in lower growth areas of our portfolio and further invest in key priority areas such as security, IoT, collaboration, next generation data center and cloud. We expect to reinvest substantially all of the cost savings from these actions back into these businesses and will continue to aggressively invest to focus on our areas of future growth.”
First of all, the restructuring plan is an admission that business as usual is not good enough. And second of all, the restructuring introduces new risks, and there is no guarantee that the plan will even work.
Earlier, we valued Cisco using a discounted cash flow model and a 2% growth rate, but if the factors listed above (e.g. competition, industry changes, financial wherewithal, and restructuring) negatively impact growth and margins, and Cisco’s growth slips to, for example, negative 2%, then the company is currently overvalued. And even though Cisco’s dividend is likely safe for many years to come, why invest in a stock with potentially zero (or negative) upside when there are so many better opportunities. Even after factoring in the extra income from selling covered calls, we believe there are better options than Cisco for income-focused investors.
Continued on the next page.