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Better Buy: Cisco Systems vs. IBM

Cisco (NASDAQ: CSCO) and IBM (NYSE: IBM) are two tech stalwarts that are usually owned for stable returns and income instead of growth. Cisco is the world’s top maker of networking routers and switches, while IBM owns a sprawling portfolio of IT services, business software, hardware, and cloud services.

I compared these two stocks about a year ago and concluded that Cisco’s superior sales and earnings growth, lower dependency on legacy businesses, stronger cash flows, and repatriated cash made it a better buy than Big Blue. Since that article was published, shares of Cisco have stayed nearly flat as IBM has dipped about 7%.

Image source: Getty Images.

Cisco traded much higher earlier this year, but its gains evaporated last month when it followed up a solid fourth-quarter earnings beat with soft guidance for the first quarter. IBM, however, attracted some bulls with its takeover of Red Hat, which could lift its revenue growth back to positive territory again. Let’s examine both tech stocks again to see if either one is worth buying at these levels.

Comparing Cisco and IBM’s core businesses

Cisco generates most of its revenue from network infrastructure products like routers and switches. The rest of its revenue comes from applications and security software, as well as services for its products, which are usually bundled with its networking hardware.

Cisco faces stiff competition in the commoditized networking hardware market from rivals like Huawei, Arista Networks, Hewlett-Packard Enterprise, and Juniper Networks, but its bundling strategies lock in customers. Cisco usually offsets the slower growth of its infrastructure products with higher sales of its application and software products.

IBM generates most of its revenue from three businesses: cloud and cognitive software, global business services, and global technology services. Each of these units houses a mix of slow-growth legacy products and higher-growth cloud services, and IBM constantly tries to offset the declines in its older businesses with its higher-growth ones.

IBM mainly focuses on private and hybrid cloud deployments, while Amazon‘s AWS (Amazon Web Services) and Microsoft‘s Azure mainly offer public cloud services. IBM believes that its acquisition of Red Hat will strengthen its cloud business and widen its moat against those rivals.

Which company is growing faster?

Cisco’s revenue grew 7% in fiscal 2019 (which ended on July 27) while its adjusted earnings per share grew 20%. It reported robust demand for its networking hardware from enterprise campus customers, its applications and security businesses delivered double-digit sales growth, and it boosted those higher-growth businesses with several acquisitions, including Duo Security and Ensoft.

An IT professional checks a tablet.

Image source: Getty Images.

It’s also in the process of taking over optical equipment maker Acacia Communications to cut costs and upgrade its hardware for hyperscale data center customers. Cisco also applied a large percentage of its repatriated cash toward buybacks, which significantly boosted its EPS growth.

IBM’s revenue and adjusted operating EPS both rose 1% in 2018. The expansion of its cloud services with new applications, partnerships, and acquisitions boosted its total cloud revenues 12% — but barely offset the ongoing declines at its older businesses.

IBM believes that its acquisition of Red Hat will simplify that juggling act. It expects the takeover to add over 200 basis points of revenue growth over the next five years, be accretive to its operating gross profit margin and free cash flow within the first year, and boost its operating EPS by the end of the second year.

The road ahead

Cisco’s growth looks stronger, but it spooked the bulls last quarter with a forecast for 0%-2% sales growth and 7%-9% adjusted EPS growth in the first quarter. Those figures missed analysts’ expectations for 2% revenue growth and 11% earnings growth.

Cisco blamed the slowdown on macro challenges impacting enterprise demand and the rapid deterioration of its business in China, where state-backed firms blocked its bids in response to the escalating trade war. Analysts now expect Cisco’s revenue and earnings to rise 4% and 10%, respectively, this year — which are still solid growth rates for a stock that trades at about 14 times earnings while paying a 3% yield.

IBM’s revenue is expected to decline 2% this year before the inclusion of Red Hat boosts its growth to 4% next year. It also expects its earnings to drop about 7% this year before rebounding 5% next year.

In other words, IBM’s recovery relies heavily on its ability to quickly integrate Red Hat’s operations and generate fresh synergies. If it fails to do so, its growth could continue fading as its $34 billion takeover of Red Hat dilutes its earnings.

IBM’s forward P/E of 10 and forward yield of 4.8% make it look cheaper than Cisco, but it’s cheap for two obvious reasons: Its growth is anemic and its takeover of Red Hat is a risky bet.

The winner: Cisco

Cisco was slammed by the bears last month, but I think it’s still a better bet than IBM. Its growth is stronger, it has fewer moving parts, it dominates its core markets, and it isn’t pinning its entire future on one massive acquisition.

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

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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, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon and Cisco Systems. The Motley Fool owns shares of and recommends Amazon, Arista Networks, and Microsoft. The Motley Fool is short shares of IBM and has the following options: short January 2020 $200 puts on IBM, short September 2019 $145 calls on IBM, long January 2020 $200 calls on IBM, and long January 2021 $85 calls on Microsoft. The Motley Fool has a disclosure policy.

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