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.

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.

4 Better Income Generating Options

For your consideration, here are four opportunities that we consider better options for generating income than writing covered calls on Cisco.

1.    Verizon Communications Inc. (NYSE:VZ): Writing Covered Call Options
We consider Verizon covered call options more attractive than Cisco covered call options for a variety of reasons. For starters, we’d rather own Verizon Communications Inc. (NYSE:VZ) instead of Cisco. Not only is Verizon’s dividend bigger (4.4% dividend yield), but its business is more stable, predictable, and less likely to deliver negative surprises. Yes, Cisco has wider margins and high returns on capital, but we believe those may shrink causing the stock to potentially lose more value than you’d make by writing the calls. And even though the premium on Verizon calls is smaller than the premium on Cisco covered calls, we believe the combination of dividend, plus call premium, plus price safety makes Verizon Communications Inc. (NYSE:VZ) a more attractive covered call stock than Cisco. We like the November 18, 2016 calls with a $55 strike price because even if the shares get called you’ve still picked up 5.4% gains (premium plus price appreciation) in less than two months, and that doesn’t even included the $0.5775 dividend to be paid on November 1st.

2.   Welltower Inc (NYSE:HCN): Selling Put Options
We consider selling Welltower Inc (NYSE:HCN) put options more attractive than selling Cisco call options. Selling put options gives someone else the right to sell a stock to you at a predetermined price. Welltower Inc (NYSE:HCN) is a stock we’d like to own (because of the relative safety of its big dividend), but we’re not anxious to buy at the current price (it’s significantly outperformed the S&P 500 on a total returns basis this year). The puts allow us to collect a premium now and it may result in us buying the stock later at a more attractive price. And not only are many put price premiums significantly larger than similarly out-of-the money call premiums, but we particularly like the November 18th, 2016 puts as shown in the following table because the put premium is nearly double the call premium for options that are a similar (but more conservative) number of standard deviations out of the money.

3.   Utilities Select Sector SPDR ETF (XLU): Selling Put Options
The Utilities Select Sector SPDR ETF (XLU) has been on a tear this year, and now is a good time to consider selling puts on it. There is some concern that (because of the recent run) utilities are due for a pullback, and for this reason put buyers are willing to pay a healthy premium. For example, the following table shows you can collect an attractive premium for selling puts on safe boring utility stocks.

And if the shares do get put to you then you own a big dividend paying (4.0%), lower risk ETF, at a more attractive price. We consider selling Utilities Select Sector SPDR ETF (XLU) puts more attractive than writing CSCO calls.

4.    Vanguard REIT ETF (VNQ): Selling Put Options
The Vanguard REIT ETF (VNQ) is an attractive way to pick up some extra income (it yields 3.8%) but we’re uncomfortable buying it after its very strong one-year rally. However, by writing puts on this ETF we can pick up some attractive income now, and we may end up owning it in the future at a more attractive price. The following table shows VNQ’s premium relative to volatility compared to CSCO covered call options, and we believe selling Vanguard REIT ETF (VNQ) puts is the more attractive option for income investors.

Conclusion

Writing covered calls on stocks you already own can be an attractive way to pick up extra income. However, we don’t recommend the strategy on stocks you wouldn’t want to own in the first place. For example, we believe Cisco Systems is a relatively unattractive dividend stock, and we are not interested in owning Cisco just so we can write covered calls on it. We believe there are more attractive options for increasing income, and we’ve described four of them in this article. More research on the stocks mentioned in this article is available in our recent report titled 12 Attractive Equity Options for Income Investors. And if you are frustrated with the Federal Reserve’s artificially low interest rates, you are not alone.