A Close Look at Cisco Systems' Dividend Potential

Image source: Cisco.

In the five years since Cisco Systems began paying a quarterly dividend, the stock has quickly become one of the best dividend stocks in the technology sector. Cisco has made a habit of routinely increasing the payout, never going more than four quarters without a dividend hike. Since its first dividend payment was announced in March 2011, Cisco has raised its dividend a total of six times.

Data source: Cisco.

The latest dividend increase from Cisco was substantial, bringing the quarterly dividend up to $0.26 per share and the yield up to 3.7%. The question that dividend investors should be asking is: How fast can Cisco raise its dividend going forward? Let's dive in and find out.

Cisco's dividend potentialLike many large technology companies, Cisco is sitting on a mountain of cash. At the end of the company's second fiscal quarter, Cisco had $60.4 billion of cash and investments on the balance sheet, along with $24.6 billion of debt. Unfortunately, much of this cash is currently overseas, meaning that Cisco would have to pay taxes in order to bring it stateside. Still, the massive cash hoard makes a dividend cut very unlikely, even if Cisco goes through a prolonged rough patch.

Ultimately, Cisco's dividend payments come out of its free cash flow. Over the past 12 months, Cisco has generated $12.6 billion of free cash flow. Based on paying a $0.26-per-share quarterly dividend, and using Cisco's current share count, the company will pay out roughly $5.3 billion in dividends over the next year, putting the payout ratio relative to free cash flow at 42%.

The payout ratio is a much higher 51.5% relative to net income, and stock-based compensation is the reason. Stock-based compensation is treated as a cost when calculating net income but added back when calculating free cash flow. Over the past 12 months, Cisco took a $1.47 billion stock-based compensation charge, boosting free cash flow relative to net income.

Cisco actively buys back shares, and part of this goes toward balancing out the dilution caused by stock-based compensation. Because of this, I think it's reasonable to back out this charge from the free cash flow, bringing the payout ratio relative to this adjusted free cash flow up to 47.6%. Cisco is likely to always buy back enough shares to balance out dilution, meaning that that cash isn't truly available for dividends.

This payout ratio isn't the highest among Cisco's peers, so there is still room for Cisco to boost its dividend faster than it grows earnings. Microsoft, for example, pays out 54% of its trailing-12-month adjusted free cash flow in dividends, based on its most recent quarterly dividend, while Intel pays out 49.4%. Buybacks will also help bring down Cisco's share count, allowing the total amount paid out in dividends to rise more slowly than the per-share dividend.

Over the next three to five years, Cisco expects to be able to grow revenue by 3% to 6% annually, with non-GAAP EPS growing at a faster 5% to 7% rate. The dividend should be able to grow slightly faster than this earnings growth rate, given that the payout ratio has some room to expand, so I would expect high-single-digit annual dividend growth from Cisco going forward. The big 24% increase announced in February is very unlikely to be repeated anytime soon, but with a 3.7% dividend yield, Cisco's dividend growth rate doesn't need to be that fast in order for it to be an attractive dividend stock.

The article A Close Look at Cisco Systems' Dividend Potential originally appeared on Fool.com.

Timothy Green owns shares of Cisco Systems. The Motley Fool recommends Cisco Systems, Intel, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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