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Will Other Tech Companies Follow Cisco's Lead by Paying Out Dividends?

By , Contributing Writer, Money Morning •

When Cisco Systems Inc. (Nasdaq: CSCO) last week announced that it would institute the first dividend in company history, it raised hopes among investors that hi-tech companies would finally begin to loosen the strings on their hefty cash holdings.

But will other tech giants really follow suit and institute dividends of their own?

Cisco Chief Executive Officer John Chambers announced the payout last Tuesday, saying the networking giant would reward shareholders with a dividend likely to yield between 1% and 2%. The exact amount will be determined in the coming months while the company considers developments on the tax front and broader market conditions.

The move offers a small glimmer of hope for technology investors. Hi-tech investors have been plagued by meager returns, since the dot-com bubble burst at the turn of the century.

For Cisco investors, this small dividend would provide some semblance of a return on their investment, which has been mostly flat since 2002.

The tech sector is more unpopular than it's been in years. So unpopular, in fact, that tech shares have dropped to their lowest valuation relative to the Standard & Poor's 500 Index in nearly 20 years, Bernstein Research analyst Toni Sacconaghi wrote in a research report.

Tech stocks now trade at 1.0 times the S&P on a forward P/E basis, a valuation last seen in March 1991 and dramatically below the historical average since 1977 of 1.31 times.

The lack of favor toward the sector doesn't exactly jibe with reality, though. Tech companies have mountains of cash, technology continues to account for more corporate capital spending, and consolidation seems to be accelerating.

So what gives?

Tech Companies Hold Back on Dividends

Shareholders like dividends because they provide a steady, reliable source of returns that help smooth out the stock market's ups and downs. Since 1926, they have provided almost 43% of the return from the S&P 500.

But companies slashed dividends during the latest financial meltdown, as the number of companies declaring an initial dividend in 2009 dropped by 6.3% from 2008. During the same period, companies announcing dividend increases dropped by a whopping 46.6%.

Fortunately for income investors, it appears that dividend stocks payout policies are once again moving in the right direction.

Thanks to greatly improved corporate cash flow and profits, 2010 has seen a healthy upswing in dividend policies. As of August 31, 2010, total dividends declared, extra dividends, and dividend increases were all up year-to-date, and companies already offering dividends upped their payouts by 58%.

While telecoms and utilities boast the highest average dividend yields, technology companies are notorious for compulsively hoarding cash, refusing to pay shareholders more than a token dividend or, in most cases, any dividend at all.

Only 10 of the top 20 technology companies by market cap pay a dividend, and just two - Intel Corp. (Nasdaq: INTC) and Automatic Data Processing (Nasdaq: ADP)- yield more than the S&P 500.

Rather than return it to shareholders, tech companies usually use their cash to buy back their own stock or reinvest in research and development. Many analysts say this is because tech companies are subject to rapid technology obsolescence, which causes them to re-invest most of their earnings back into the business just so they can maintain their market share.

Through 2010, Cisco has returned $65 billion to shareholders through buybacks. And Chief Financial Officer Frank Calderoni told the Associated Press that his company is committed to continue doing buybacks.

Meanwhile, Intel reduced the number of its shares outstanding to 5.52 billion in 2009 from 6.73 billion in 2000. International Business Machines Corp. (NYSE: IBM) has reduced the number of shares outstanding to 1.31 billion in 2009 from 1.75 billion in 2000. And Microsoft Corp. (Nasdaq: MSFT) has reduced the number of shares outstanding to 8.76 billion in 2010 from 10.76 billion in 2001.

The issue with buybacks is that they generally tend to be initiated and maintained as a result of higher earnings when stock prices are high. Worse, companies tend to eliminate their stock buyback programs during recessions to conserve cash.

That means the companies wind up spending shareholders' money at overvalued stock prices, and stopping their buyback programs when prices are low.

Cash is King

Most large cap tech stocks have hoarded billions of dollars in cash on the balance sheets, which sits idle or is used in bidding wars to pay for companies with strategic patents for tech dominance.

Cisco has nearly $40 billion in cash and short-term investments, more than any other nonfinancial company in America, according to Standard & Poor's Howard Silverblatt. That stash represents about 32% of Cisco's market value, and about half of it is in government securities.

Semiconductor giant Intel Corp. has $16 billion in cash. Google has $30 billion. And Dell has a net cash pile of $8 billion.

In February, Apple Inc. (Nasdaq: AAPL) CEO Steve Jobs told shareholders that he wanted to keep the company's $25 billion cash balance, which he said provides "tremendous security and flexibility."

For its part, Intel has recently been on an acquisition binge, spending almost $10 billion in the past month on Texas Instrument Inc.'s (NYSE: TNX) cable modem division, security software maker McAfee, and Infineon's Wireless Solutions business.

But Intel's track record on acquisitions has actually turned out to be a disaster.

Between 1999-2003, Intel spent over $11 billion buying about 40 companies, the vast majority of which failed. In fact, of the 15 largest acquisitions in its history, Intel has shut down or sold off the acquired products in every single case.

No wonder some investors argue that the money tech companies are holding is better spent on them than chasing further growth.

Dividends Used as Political Ploy?

Policies in Washington on repatriating foreign profits and the fate of the tax cuts instituted under the Bush administration also are playing a part in the dividend conundrum facing tech companies.

Cisco CEO John Chambers said the exact amount of the company's dividend would be influenced in part by what Congress does with the personal tax rate on dividend income and the corporate tax on repatriated earnings.

Today, most corporate dividends are taxed at a top rate of 15%. If Congress does nothing, dividends next year will be taxed as ordinary income, at rates up to 39.6%.

Chambers has lobbied the federal government to loosen taxation rules that require U.S. companies to pay a tax to the U.S. government, on top of taxes paid to foreign governments, when the cash is brought back to the U.S.

Cisco said it would fund its dividend with cash from U.S. and North American operations to avoid having to pay a tax on funds repatriated from overseas. Calderoni said more than $30 billion of Cisco's cash is located overseas.

"It would be a tremendous opportunity lost not to bring back the cash," Chambers said Tuesday.

In 2005, companies were given a one-time chance to repatriate earnings at a low effective tax rate of 5.25%. Tech CEOs including Chambers have been lobbying Congress for another break.

Companies were supposed to use their repatriated cash to create jobs and make investments - not for share buybacks or dividends.

Effect of Payouts on Stock Prices

While cash balances at tech companies remain extraordinarily high, they've returned little of that money to shareholders and that may be hurting their stocks.

Compared to the S&P 500, tech stocks have outperformed over the last three years, but underperformed over the last one and five years.

Investors continue to argue that tech companies should initiate dividends to boost their stock prices. But if recent history is any guide, tech stocks shouldn't expect to see much impact on their stock just because they issue dividends, according to Bespoke Investment Group.

Over the last one, three, and five years, the 32 tech sector stocks that pay dividends have collectively underperformed the average return of the 44 tech sector stocks that have no payouts.

Even worse, it appears as though the higher the yield the worse the performance.

The nine stocks that have payouts that are greater than the 10-year U.S. treasury yield have an average return of minus 3.29%, compared with the S&P's return of plus 9.29%.

And analysts blame the slump on-you guessed it-tech companies' continued romance with building huge cash holdings.

"With companies seemingly hoarding cash, we believe investors may not be giving full credit to tech stocks for their high cash balances, especially for those that have historically been acquisitive or shown no interest in returning cash," Bernstein's Sacconaghi wrote.

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