Bondholders are giving Cisco Systems Inc. a free pass on itsplan to reward shareholders with half its free cash flow this yearas the biggest maker of computer-networking equipment cuts pricesand jobs to increase profit.

Cisco's bonds are trading at levels that imply it should berated Aa2, according to Moody's Corp.'s capital markets researchgroup, two levels above its actual rating of A1. Cisco'sfourth-quarter results beat analysts' estimates, and executivessaid this week that the company will raise its dividend 75 percentas part of a plan to reward shareholders with at least half thecash generated from operations.

The firm's stock reversed a 4 percent 2012 decline to a 5.2percent gain on the news. Bondholders of San Jose, California-based Cisco may not mind the shareholder largesse because of thefirm's “relatively strong balance sheet,” according to moneymanager Bonnie Baha of Los Angeles-based DoubleLine Capital LP.

“It seems they can walk the fine line between keepingstockholders happy and debt holders happy at the same time,” Baha,head of global developed credit at the firm, which oversees $40billion and doesn't own Cisco bonds, said in a telephone interview.“As long as they don't get out over their skis in terms of makingbig acquisitions and keep interest aligned between shareholders andbondholder and management, it should be fine.”

Cisco's bonds have fallen 0.9 percent in the past two days,about in line with the 0.7 percent decline for all the bonds in theBank of America Merrill Lynch U.S. Industrial Corporates index. Thecompany's $3 billion of 5.5 percent notes due 2016 fell to 115.9cents on the dollar, down 0.2 cent, to yield 0.89 percent on Aug.15.

The company is raising its dividend to 14 cents a share,starting this quarter, from 8 cents, for a yield of 3.2percent.

Cisco won't have to issue debt to fund the dividend increase,according to Kristin Carvell, a company spokeswoman. Its sharessurged more than 9 percent after the announcement to close at$19.02 in New York trading yesterday.

The dividend doesn't affect the rating for Moody's analystsRichard Lane and Robert Jankowitz because the payouts as apercentage of discretionary cash flow is forecast to remain as lowas 20 percent, compared with 40 percent for non-technologycompanies, they wrote in an Aug. 15 note. Discretionary cash flowis cash from operations minus capital expenditures.

Chief Executive Officer John Chambers has cut 7,800 jobs, shutbusinesses and reduced prices to win business lost to JuniperNetworks Inc. and Hewlett-Packard Co. and combat a slowdown inEurope.

Domestic Cash

Cisco, a beneficiary of the growth in data that needs to beshuttled among servers, mobile phones, search engines and videowebsites, reported profit Aug. 15, excluding some costs, of 47cents a share. That compared with the average estimate of 46 centsin a Bloomberg survey for the fourth quarter, which ended July28.

The company, which has been an advocate for a tax break onoverseas profits, doesn't need the “repatriation” holiday to fundthe dividend, Chambers said during an Aug. 15 conference call todiscuss fourth-quarter results with analysts and investors. OfCisco's $48.7 billion in cash and investments, only $6.2 billionwas available in the U.S. at the end of the last quarter, withabout $42.5 billion parked overseas.

Demand for networking equipment has been weak in Europe, inIndia, and from government agencies, Chambers said on the call.

Europe, which makes up about 20 percent of sales, is “going toget worse before it gets better, and federal government spending isnot going to improve in the short term here in the U.S.,” he said.Orders from Europe, the Middle East and Africa fell 6 percent fromlast year, the only region to experience a decline.

Chief Financial Officer Frank Calderoni said on the call thatthe company would return at least half of annual free cash flow toshareholders as dividends or buybacks.

The dividend change does “raise an eyebrow” for Joel Levington,managing director for corporate credit at Brookfield InvestmentManagement Inc. in New York.

Cisco's cash flow and cash balances are “largely tilted outsidethe U.S.,” which “limits financial flexibility, something uniquefor such a highly rated entity,” he said in an e-mail. Cisco canget away with it if it “will stop pursuing moderate-to-largeacquisitions,” he said.

Including last month's acquisition of NDS Group Ltd., whichmakes software that powers cable set-top boxes and delivers video,Cisco forecast profit of 45 cents to 47 cents a share this quarter,compared with the average estimate of 46 cents.Sales will rise 4percent to 6 percent from a year earlier.

The company spent $375 million on business acquisitions in itslatest fiscal year, up from $266 million the year before, accordingto an earnings statement.

With its free cash flow of $2.8 billion last quarter, Cisco canafford the dividend, and “this is part of the transition to a moremature company,” according to Jon Duensing, the Boulder,Colorado-based head of corporate credit at money manager SmithBreeden Associates, which oversees $6.3 billion and doesn't revealits positions.

“From a debtholder's perspective, they currently have plenty ofbalance-sheet cushion,” he said in a telephone interview. “Whileit's currently regarded as manageable, it's likely this type ofactivity will continue to be a theme.”

For more on corporate dividends, see Slideshow: Spotlight on Dividends and Tax Hike Could Discourage Dividend Revival.

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