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Better Buy: Cisco Systems, Inc. vs. IBM

Leo Sun, The Motley Fool

Investors often consider Cisco (NASDAQ: CSCO) and IBM (NYSE: IBM) to be mature tech stocks that are owned more for stability and income than for growth. Yet over the past 12 months, Cisco's stock surged nearly 50% as IBM advanced just 1%. Let's see why investors were excited about Cisco but less thrilled about Big Blue's prospects -- and whether or not that trend will continue.

What do Cisco and IBM do?

Cisco is the world's largest manufacturer of network routers and switches. Those two businesses still generate most of its revenues, but they're also slower growth ones that face tough competition from rivals like Huawei and Arista Networks. However, Cisco has been diversifying away from those businesses by expanding its higher-growth security and applications businesses. Bundling these products together allows Cisco to boost its revenues per customer.

Servers in a data center.

Image source: Getty Images.

IBM owns a wide portfolio of IT services, business software, mainframes, cloud services, and a financing arm. Most of these businesses are slow-growth ones which face plenty of competition. To reduce its dependence on legacy businesses, IBM is diversifying toward higher-growth markets with five "strategic imperatives" -- the cloud, analytics, mobile, security, and social businesses.

How fast are Cisco and IBM growing?

In the past, Cisco usually generated flat to low single-digit growth every quarter, as it offset the softer growth of its infrastructure products (networks, routers, and wireless devices) with its growing portfolio of security and applications products. Meanwhile, IBM only returned to positive growth in early 2018 after 23 straight quarters of sales declines. It accomplished this by aggressively expanding its strategic imperatives with new products, partnerships, and acquisitions.

CSCO Revenue (TTM) Chart

CSCO Revenue (TTM) data by YCharts

Cisco's revenue rose 3% last year, and analysts expect 4% growth this year. Four core tailwinds should support that growth -- strong demand for its infrastructure products among enterprise campus customers, the acquisition and integration of software products (which it can bundle with its hardware products), higher recurring revenues, and the growth of the IoT (Internet of Things) market boosting demand for networking hardware and software. 

The main headwind Cisco faces is competition in routers and switches, especially from generic "white box" rivals which use open-source operating systems instead of Cisco's proprietary software. A growing number of major companies, like AT&T, are switching to these solutions to cut costs and reduce their dependence on Cisco. However, Cisco still has an entrenched position with enterprise campus customers, to which it can cross-sell its newer software products.

Two IT professionals walk through a data center.

Image source: Getty Images.

IBM's revenue slipped 1% last year, but its recent return to growth is expected to lift its sales by almost 2% this year. That rebound is supported by Big Blue's transition from legacy businesses toward its newer strategic imperatives -- which posted 15% annual sales growth over the past 12 months and accounted for nearly half of its top line. Like Cisco, IBM also has an entrenched position in the enterprise campus market -- so it can also cross-sell its newer products (like its Watson AI platform or cloud services) to those customers.

However, IBM faces tougher competition than Cisco in its higher-growth markets, particularly in enterprise cloud services. IBM is a market leader in the private cloud (on-premise) market, but it's a distant underdog in the higher-growth public cloud market which is dominated by Amazon's AWS (Amazon Web Services) and Microsoft's Azure. As Amazon and Microsoft leverage those positions to extend their reach into the private cloud market, IBM could struggle to stay competitive.

Profitability, valuations, and dividends

Cisco and IBM's GAAP earnings were significantly weighed down by tax reform related charges last year:

CSCO Net Income (TTM) Chart

CSCO Net Income (TTM) data by YCharts

But on a non-GAAP basis, which excludes those one-time charges, Cisco's earnings grew 9% last year, while IBM's earnings rose 2%. Wall Street expects Cisco and IBM's non-GAAP earnings to grow 15% and 1% this year, respectively.

Cisco is expected to post stronger earnings growth for two reasons -- its relying more heavily on higher-margin software products and it plans to spend the lion's share of its $67 billion in repatriated cash on buybacks. It also plans to spend some of that cash on dividends and domestic acquisitions.

IBM also repatriated a large portion of its overseas cash, and kept $40.4 billion of its $46.5 billion in cash and equivalents within the United States last quarter. However, IBM will likely spend more of that cash on expanding its strategic imperatives instead of offering bigger buybacks and dividends -- which arguably makes it a less shareholder-friendly company.

Cisco currently trades at 15 times next year's earnings, which is higher than IBM's forward P/E of 10. Cisco's forward dividend yield of 2.8% is also much lower than IBM's 4.3% yield.

The winner: Cisco

IBM might seem like a better stock for value-oriented income investors, but Cisco's superior sales and earnings growth, lower dependence on legacy businesses, stronger competitive position, and shareholder-friendly plans with its repatriated cash make it a better buy at these prices.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Leo Sun owns shares of Amazon, AT&T, and Cisco Systems. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Accenture. The Motley Fool has a disclosure policy.