Do Technology stocks make good dividend payers?

I’ve traditionally avoided looking at technology stocks as dividend investment candidates. Generally technology companies haven’t really made a commitment to dividends, but more than that there has always been the risk of inherently volatile demand and players being leapfrogged by improvements in technology. Some recent developments have made me reevaluate this view.

Technology companies don’t pay dividends!

For most of the last decade technology companies have been terrible dividend payers. Surprising really, given the amount of cash that companies like Apple, Amazon, Google and even Facebook have been generating.

The most high profile Tech company that has been flying the dividend flag has been Microsoft. Even there too, up till 2010, Microsoft was a pretty stingy dividend payor, with a sub 2% dividend yield for most of the last decade.

How times have changed.

There are a host of technology companies that have started paying dividends within the last few years. Oracle, Cisco, and probably the biggest surprise of the lot, Apple have all started paying dividends. And not just token amounts either (well, apart from Oracle at least!).

Apple and Cisco are both trading at handsome yields at close to 3%. Thats a very meaningful change and puts them on par with many of the more established industrial payers such as Coca Cola and McDonalds in terms.

Why the change of heart?

If anyone actually followed Steve Jobs thoughts on corporate management, it appeared that Apple would never pay a dividend. Frankly, if Steve Jobs was still alive, I firmly believe that Apple wouldn’t be paying a dividend. I think Steve looked at paying a dividend as a sign of corporate weakness and an acknowledgement that Apple had run out of high quality ideas to grow the business.

While I don’t think that is entirely true, it is certainly my view that the Apple innovation factory is placing more focus on product line extensions rather than bold cutting edge ideas,

You’ll probably see Apple still continue to come out with the odd disruptive product every few years, but not at the breakneck speed of the last 10 years where you had iPod, iPhone and iPAD. Thats a pretty incredible rate of innovation and not something that was ever going to be sustainable in the long term.

If you are doing product line extensions, you need much less cash for R&D and new product introduction. You are leveraging the same marketing, sales channel and manufacturing.

I think you’ll see Apple come out with tweaks of their iPhone, iPAD at different price points and different customizations. In any case, Tim Cook is a very different type of CEO who is more focussed on investor concerns and corporate discipline, and returning some of Apple’s cash mountain was just the prudent thing to be doing.

In Cisco’s case, the stock has really done not much of anything in the last 10 years. In fact, its market value is much the same as it was in 2003. However looking at the revenue growth and financials suggests it is a much stronger business with higher revenues and earnings than it was in 2003. Cisco is now a value stock not getting any love from investors.

While significantly overvalued in 2003, trading at a PE of around 40x earnings, it’s now trading around 12x earnings today.  Moreover, it has a hugh cash pile at close to $30B, or around $8/share. Thats cash that can be returned to shareholders and attract a new class of investors into the stock to breath some life into it.

Worth Buying?

Both Apple and Cisco have very different drivers underpinning their investment cases.

Many hedge funds have been bailing on Apple stock recently, for a variety of  reasons including a lack of an ability to bring new products to market. In my view, the hedge funds exit could be to the benefit of retail investors.

That hedge funds are bailing for the exit shouldn’t necessarily be a concern. Hedge funds typically have high hurdle rates that they need to achieve in order to hit performance fee targets. These hurdle rates typically in excess of 20% returns.

In my view Apple isn’t likely to produce these type of investment returns over the next few years, however it could very handily deliver between 12-15% in total return.

At a 3% initial dividend yield, and dividend growth of close to 10% per year, I’d expect a total return of around 12% p.a for the next few years. That’s not a bad rate of growth, and that’s in the absence of any new disruptive innovation that Apple may deliver, which is just upside.

While Apple clearly doesn’t have the long established history of paying dividends, such as a Coca Cola or a McDonalds, revenue and earnings quality have been fairly good over the last 10 years. Apple has had a continually increasing revenue stream over the last 10 years without any misses in revenue growth, even through 2008-2009. That’s not something that either McDonalds or Coca Cola can claim.

There are a couple of things going against the Apple investment case in my view. Apple serves the notoriously fickle consumer market who are a very faddish, trend following group (just look at facebook). Products are just as likely to go out of fashion as quickly as they were in fashion. The thing that serves Apple well here is that they have created ecosystem lock in.

Consumers have been using Apple apps and Itunes and have their music, videos, books and magazines, essentially all their content, tied into a proprietary Apple system. They will keep moving that around as Apple develops progressively new form factors.

The other thing of concern is Apple is hugely dependent on the current subsidy model for selling mobile devices. Its a mutually beneficial system that suits both the carriers, who benefit from the recurring data plan revenue, and the phone manufacturers like Apple, who can sell devices  to consumers at more appealing price points.

The main risk is that carriers pass on more of this subsidy to consumers over time, which may have the impact of slowing device sales.

In Cisco’s case, the fact that Cisco is selling routers, switching equipment and cloud solutions into enterprise markets creates a far stickier customer with higher switching costs. Enterprise customers aren’t subject to the same fads and trends, so provided solutions offer compelling ROI, that helps assure reasonable ongoing demand.

While Cisco also doesn’t have a long track record of dividend growth, its revenue and earnings over the last 10 years is pretty impressive. Revenue has increased every year in the last 10 years except in 2009. Net income and earnings has shown a similar consistent increase over the last 10 years.

The thing I like most about Cisco is that it is very well positioned in a number of areas that I feel are going to experience strong growth in the medium term.

Cloud services and video delivery solutions in particular should experience robust growth over the medium term as enterprises move more of their storage from on premise solutions into the cloud.

Cisco is cheap on a valuation basis. It is also well positioned in some key markets and has a strong track record of growing revenue and earnings over the last decade. With a 3% yield and a very manageable payout ratio of only 30%, I expect that it should be able to lift dividends at least 10% per year over at least the next 5-7 years, providing total returns of around 13% per year.

In my view, Cisco presents a more compelling and certain case for investment than Apple.

My Takeaway

Technology stocks can be a lucrative area for dividends, more so than at any time previously. I think that you will start to see more tech companies issuing dividends as their cash piles grow, they become more mature , and they transition to more stable rates of growth.

While disruption from the next set of innovators is always a threat, companies such as Apple and Cisco have inherent advantages through consumer lock in to a proprietary system or through providing enterprise customers with a set of sticky services that are difficult to replace, affording both of them with an economic moat.

With yields on offer that are at least at par with some consumer goods and industrial companies, they made compelling opportunities for investment and dividend growth into the future.

I have recently purchased both Apple and Cisco and may look to add to both holdings upon further weakness.

 

Comments

  1. I think apple will be a good company to invest in, just not now. Maybe when it hits 8-10 years of dividend growth, it’s stock price has deflated to a more reasonable level, and it has shown that it can be a profitable business without having to produce an Earth shattering new product every 2-3 years.

  2. Integrator says:

    There is certainly a measure of uncertainty around Apple. Gross margins, sustained revenue growth and new product introduction. I think they will be just fine, not the sustained growth of the last decade, but enough to comfortably grow the dividend at least 10% for the next 5 years.

  3. I like Cisco more than Apple going forward but the potential is there for both to do very well. It was very surprising to see that Cisco has around $8 per share in cash and equivalents. Essentially you’re paying around a 9.1 P/E ratio for a company that is expected to grow eps by over 8% per year. Seems like the growth of the company is being discounted unfairly.

    I never got around to looking it up, but do you happen to know how much of Cisco’s cash and equivalents are essentially useless and stuck overseas to avoid taxes? I’m curious if they could adopt a policy such as Apple did with it’s recent bond sale with the intent to pay a dividend with the cash.

    • Integrator says:

      Cisco has a ton of cash overseas. Close to $46B in fact. I knew they had a lot, didn’t realize it was quite that much. Looks like they are an ideal candidate for bond issue also.

      I feel very comfortable with the Cisco investment thesis. Apple is a little more speculative in my view, but I’m comfortable with my relatively small holding here.

  4. Integrator,

    Great post on a couple of tech heavyweights.

    I like CSCO. I was actually looking up some annual reports and doing some analysis on it at just over $20/share. It then had that big post-earnings pop (like 8% or more if I remember correctly) and it escaped my grasp right in front of me. Couldn’t believe it. Same thing happened with IBM. It dropped 8% and I got interested. I should have just bought, but I wanted to do a little digging. By the time I liked what I saw enough to purchase it popped up again. Tech seems to be a bit more volatile than some of the energy and consumer stocks I usually invest with, so you have to be nimble here.

    If CSCO falls back into the low $20′s I’d be interested!

    Best wishes.

    • Integrator says:

      DM, I’ve missed the odd stock purchase while doing some research, additional diligence before purchase. While I now have a watchlist of things that I’d like to snap up when they are on sale, the way I rationalize missed purchases is that the investing universe is full of a great many opportunities, and I don’t necessarily need to rush out to buy something that is substantially above my assessment of fair value. I’m happy to pay a fair price for quality, but I don’t want to pay materially over this fair price.

  5. Great analysis. These are two companies that I watch closely. You nailed on it on Cisco – Their business is thriving through cloud based offerings and vitalization. They are picking up market share and changing their reputation in the market place.

    I just finished watching the Apple Dev conference from earlier today and I have to say that IOS7 is a difference maker. It’s not groundbreaking innovation but the simplicity and clean feel of that OS has will retain and attract users. It is far beyond any Android OS out there.

    I think the Apple machine is safe for now and the returns you suggest of 12-15% are very likely making it a good value. (I’m long Apple @ 437). If they can revolutionize the TV through integration with their ecosystem and iCloud we can only guess at what happens next for that stock.

    • Integrator says:

      Hi Zach,

      Yeah I agree on Apple, it can keep retweaking its current offerings and be pretty comfortable earnings wise for the next few years. It will be interesting to see how Apple monetize passbook and icloud going forward. I see them as having all the ingredients in place to deliver a B2B2C offering and monetize via partners in the passbook.

      I’m very comfortable on Cisco. I still think its a bargain at these levels. Current pricing will look unbelievable in 10 years time as enterprise cloud really accelerates.

  6. Marvin says:

    I love Microsoft but have the same issues you raised, they have done much better with their dividend but I still believe they can do more going forward. Perhaps they should stop purchasing companies like Nokia and just pay that money out to their shareholders =)

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