Falling crop prices have caused demand to drop sharply for Deere’s tractors and combines, but the best time to buy high quality dividend stocks is usually during periods of distress. Warren Buffett seems to think so and added to his stake in Deere during the fourth quarter of 2015.
Let’s take a closer look at Deere’s business as we consider it for our Top 20 Dividend Stocks portfolio.
Deere was founded in 1837 and has since grown to become one of the largest manufacturers of agricultural and construction equipment in the world. Many of Deere’s products retail for several hundred thousand dollars and are mostly sold through its independent dealer networks.
The company’s Agriculture & Turf segment accounted for about 75% of Deere’s equipment operating profit last fiscal year. Some of its key products include tractors, combines, corn pickers, and mowers.
Deere’s Construction & Forestry segment accounted for the remaining 25% of operating profit and includes products such as backhoe loaders, excavators, crawler dozers, and dump trucks.
The company also has a Financial Services segment that lends money to Deere’s independent dealers and end customers when they purchase equipment on credit or need a lease.
By geography, close to 60% of Deere’s sales are generated in the U.S. and Canada.
With a rich operating history dating back more than 175 years ago, Deere is one of the most iconic American companies of all time.
Many of Deere’s competitive advantages are rooted in its long-standing operations and the conservative culture it has embraced throughout its corporate life.
As a testament to the company’s consistency and steady culture, the Roman Catholic Church has had more popes than Deere has had CEOs since it was started in the 19th century.
One of John Deere’s infamous quotes has continued to guide the company from one generation to the next:
“I will never put my name on a product that doesn’t have in it the best that is in me.” – John Deere
Deere has relentlessly focused on improving the productivity of its customers by listening closely to their needs and heavily investing in product development.
Deere spends over $1.4 billion annually on research and development and has been named as the number one innovator in the heavy industrial equipment industry by the Patent Board. According to a Bloomberg article, some of Deere’s products literally have more lines of software code than a space shuttle!
As a result of Deere’s product innovation, the company has developed a pristine reputation for quality and reliability. Customers know they will achieve a lower total cost of ownership by buying their equipment from Deere.
Deere’s reputation for quality has made it one of the top 100 brands in the world and allowed it to consistently raise its prices at a low-single digit rate virtually every year, including recessions.
Even with U.S. agriculture equipment sales expected to fall by 15-20% in 2016, Deere expects to realize 2% pricing gains across its equipment operations this year.
The company’s pricing power is built on more than just the quality of Deere’s products. In fact, one of Deere’s biggest competitive advantages is intangible in nature – the relationships its independent dealers have with their customers.
Deere has amassed the largest network of independent dealers in the U.S. agricultural industry. These dealers have developed strong, multi-generational relationships with the farmers in their communities.
Many dealers have been passed down from generation to generation and know their customers really well.
Farmers are generally loyal people, too. According to a survey of 2,000 Midwest farmers, about 65% of respondents described themselves as brand loyal, and a whopping 77% of John Deere customers described themselves as brand loyal.
Deere’s existing dealer network has a captivated customer base that helps the company maintain number one market share in agricultural machinery and number two market share in construction equipment in North America.
Besides customer relationships, maintaining extensive distribution networks is a critical piece of Deere’s value proposition. Most of its heavy equipment costs several hundred thousands of dollars and is used for mission-critical, time-sensitive tasks such as planting crops. Minimizing unplanned downtime is essential.
Deere has more dealers than its competitors, which allows it to quickly service customers to keep their gear up and running. Service parts have historically accounted for 15-20% of Deere’s overall equipment revenue, underscoring the importance of having strategically-located and well-equipped dealers on call at all times.
Overall, we believe Deere has a strong economic moat. The company has established an excellent reputation for quality, service, and innovation that allows it to consistently raise prices and hold its dominant market share positions.
New entrants would struggle to break the long-lasting relationships Deere’s dealers have built with brand-loyal customers, and substantial capital would need to be invested to develop and manufacture competitive equipment. Smaller rivals also lack the financing arm Deere has that makes it easier for its customers to fund their large equipment purchases.
Deere’s Key Risks
Despite Deere’s numerous competitive advantages, it has little control over the factors that influence demand for most of its equipment.
With agricultural machinery driving the bulk of Deere’s profits, the company is very sensitive to farmer income.
When crop prices are high and yields are good, farmers are much more willing to open their wallets for Deere’s big-ticket tractors and combines.
However, times are not good right now for farmers.
In fact, farmers have never felt worse about their current situation as measured by The Progressive Farmer Agriculture Confidence Index, which started surveying farmers in 2010.
Demand for crops has continued to gradually increase with the world’s population over time, but excess supply has been an issue. The world has experienced bumper crops for several years, which has driven down the prices of many major crops such as grain and corn.
As seen below, net farm income skyrocketed from 2010 through 2013 thanks to strong commodity prices and healthy agricultural exports.
However, after peaking out at $123.3 billion in 2013, U.S. net farm income plunged over 50% to hit $56.4 billion in 2015.
Source: Congressional Research Service
While the USDA’s Economic Research Service expects U.S. net farm income to fall just 3% in 2016 (much less than the 27% drop in 2015), the decrease would bring farm income to its lowest level since 2002.
The ups and downs of the agricultural market are to be expected, but some investors can’t help but be reminded of the 1980s farm crisis which saw an economic crisis “more severe than any since the Great Depression.”
The farm crisis of the 1980s caused Deere to cut its dividend from 32.9 cents per share in 1981 to 12.5 cents in 1983. Annual dividend payments didn’t recover back to 33 cents per share until 1990.
Leading up to the crisis, farmers took on substantial amounts of debt to finance their land, crop inputs, and equipment.
Interest rates began to surge leading up to the farm crisis with the prime lending rate tripling to exceed 20% in 1981, an all-time high.
At the same time, unfavorable economic environments and geopolitical factors combined to cause crop prices to collapse.
Farmers’ debt-to-income ratios became unsustainable, and many farmers were unable to repay their loans. Just making interest payments was hard enough.
As a result, there were widespread bankruptcies, land values plummeted, and demand for Deere’s equipment virtually dried up.
Trying to forecast commodity markets is a fool’s errand, but it’s important to realize just how unpredictable they can be.
We don’t believe there will be another farm crisis today because farmers maintain a lower debt-to-assets ratio and interest rates are literally a fraction of what they were in the early 1980s.
On a somewhat related note, Deere also faces indirect risks from government policies that materially impact net farm income.
The 2014 Farm Bill is a government subsidy program meant to help farmers during periods of difficult market conditions. The bill is set to pay farmers close to $14 billion in 2016 (up over 30% from 2015), which amounts to about 25% of total net farm income.
Without this legislation, which is updated every five years, it’s safe to say that Deere would be experiencing even more difficult times.
Monetary policy also impacts Deere. With U.S. agricultural exports accounting for around 30% of U.S. farm income, the strength of the U.S. dollar impacts demand for U.S. crops. The export business is currently weak due to the strong dollar and weakening macro outlook in several key foreign countries.
What does all of this mean for Deere’s equipment?
Since peaking in 2013, industry sales of large agricultural equipment in America have fallen by more than 60%, and the U.S. and Canadian agricultural industry is projected to be down another 15-20% in 2016.
Deere has fared better than the overall market. The company’s sales have declined by roughly 25% from their all-time high. However, last year’s sales decline was the company’s largest percentage drop since the 1930s.
The company’s sales have rarely dropped more than two years in a row, and according to Deere’s annual report, its sales have never dropped for more than three straight years.
Deere’s markets are cyclical, but they have rarely experienced a prolonged down cycle like they seem to be facing today.
The good news is that farm cycles come and go. Demand for crops should continue rising over time as the world’s population continues growing, just as it has in the past. World demand for grain and oilseeds has increased in all but two of the past 40 years while more than doubling over that period.
Unexpected events such as a drought could also suppress industry supply to quickly lift commodity prices again. Importantly, Deere is still generating cash and making its business even stronger for the next upturn.
Investors considering Deere should remain aware of the commodity risk the business faces. However, they might also find some comfort knowing that the worst of the current downturn could be close to over (barring another low probability, high severity farm crisis type of event).
Dividend Analysis: Deere
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Deere’s long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Deere scores close to average for dividend safety. One of the factors helping the company’s score is its healthy dividend payout ratios. Despite the downturn in agricultural markets, Deere’s earnings and free cash flow payout ratios have remained solid at 44% and 21%, respectively.
Even if Deere’s profits were cut in half, it would still have enough financial strength to continue paying its dividend. Management also targets a 25-35% dividend payout ratio of mid-cycle earnings to ensure the company remains reasonably safe during unexpected industry downturns.
We also evaluate how a company performed during the last recession to assess the safety of its dividend. Deere’s sales fell by 19% during fiscal year 2009, and its reported earnings per share plunged by more than 50%. Deere’s stock also dropped by almost 60% in 2008 and trailed the S&P 500 by over 20%. Deere’s business is clearly sensitive to the economy and needs to be managed more conservatively than some other types of businesses that are less cyclical.
While Deere’s business must always be ready for the ups and downs of its markets, the company’s free cash flow generation has been nothing short of excellent. As seen below, Deere has generated free cash flow in each of the last 10 years.
The company has consistently improved the profitability and flexibility of its manufacturing plants to quickly respond to industry downturns as well – Deere’s free cash flow increased over the last few years despite the steep drop in demand for its agricultural equipment.
Another factor we look at when it comes to dividend safety is the return on invested capital a company earns. Higher quality, more reliable businesses tend to healthy and stable returns on capital.
Deere has earned good returns in the high-single to low-double digits throughout most of the last decade. Despite the capital intensity of its operations and the volatility of its end markets, Deere’s pricing power and efficient operations have helped it create economic value consistently.
Whenever we analyze a cyclical dividend stock, we pay very close attention to its balance sheet. If a company has taken on too much debt right before demand unexpectedly falls, its dividend could be jeopardized.
Looking at Deere’s balance sheet is a bit complicated because of its Financial Services segment, which provides financing to dealers. This segment financed the purchase of half of the new equipment sold by Deere last year, so it’s very important to the company’s business.
Practically all of Deere’s debt is related to its Financial Services segment. The loans are backed up by the company’s equipment. If a customer defaulted on their payments, Deere would reclaim its equipment and could presumably resell it somewhat easily given its high quality.
Importantly, Deere has run this segment very conservatively over the years. Despite the tough agriculture markets today, credit losses amounted to about $1 per $1,000 of loans in 2015, highlighting the good credit quality of Deere’s end customers. While we will keep an eye on this metric going forward, we aren’t too concerned about the company’s loans because of Deere’s long-term track record of conservatism.
Deere’s dividend has a lot of strengths going for it. The company maintains healthy payout ratios, generates consistent free cash flow, and is conservatively financed. Despite the prolonged downturn in agricultural markets, Deere appears to be reasonably well positioned to keep paying its dividend.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Deere’s Dividend Growth Score of 46 suggests that the company’s dividend growth potential is close to average. The company’s reasonable payout ratios and excellent cash flow generation are being offset by deteriorating near-term business trends.
Looking longer term, Deere has increased its dividend for 12 consecutive years and paid uninterrupted dividends since 1988. We are not sure if Deere will eventually qualify to join the dividend aristocrats list, but its dividend growth has certainly been impressive.
The company’s quarterly dividend has about quadrupled over the last decade from 16 cents per share in 2005 to 60 cents today.
However, as seen in the table below, Deere’s dividend growth rate has decelerated from 15% per year over the last five years to a high-single digit rate more recently.
The company has also held its dividend flat at 60 cents per share for eight straight quarters as it deals with the numerous macro headwinds that are reducing its profits.
Deere’s dividend growth rate will likely remain low until agriculture fundamentals improve. However, once the macro environment is more favorable, the company’s dividend has nice potential to continue growing at a mid- to high-single digit rate.
Deere trades at a forward price-to-earnings multiple of 20.2 and has a dividend yield of 2.9%, which is somewhat higher than its five-year average dividend yield of 2.4%.
While the company’s earnings multiple doesn’t look cheap at first glance, cyclical companies usually look expensive near the bottom of their cycles and cheap near the top.
Deere’s earnings have contracted significantly in recent years as the agricultural cycle turned down. Investors are anticipating better profits in future years.
Even despite the macro headwinds faced by Deere, the company has still compounded its diluted earnings per share by 5.8% over the last five years.
While trends could get worse before they get better, we ultimately believe Deere’s earnings can continue to compound at a mid- to high-single digit rate over the long term. Agriculture demand should continue rising over time, and Deere seems likely to continue dominating the market and steadily repurchasing its shares each year.
Under these assumptions, Deere’s stock appears to offer annual total return potential of 9-12%.
Management also issued a target for 2018 to generate $50 billion revenue and earn a 12% operating margin. Assuming the company continues repurchasing its shares each year and pays taxes at a 35% rate, Deere’s earnings seem likely to exceed $12 per share under management’s goals.
If this played out and Deere traded at 13x earnings in 2018, the stock would fetch a price of about $150 per share – nearly double where Deere’s stock is trading at today.
Macro weakness makes Deere’s 2018 sales goal look increasingly unlikely, but the company’s long-term earnings power is still strong once the agriculture cycle begins recovering sometime in the future.
Barring a 1980s type of farm crisis, which seems very unlikely in our view, Deere’s stock appears to be reasonably priced for long-term investors.
Deere is a wonderful business that is sensitive to a number of factors outside of its control. Weak crop prices, the strong dollar, declining farm economics, and sluggish global growth are all hurting demand for the company’s large equipment.
However, Deere’s economic moat and long-term earnings power remain largely intact. Like Warren Buffett, we enjoy buying blue chip dividend stocks when they are on sale and holding onto them indefinitely. Buffett actually increased his stake in Deere during the fourth quarter of 2015, which suggests he sees value in Deere at its current stock price.
Several of the companies we already own in our Top 20 Dividend Stocks portfolio overlap with Deere, but this is a remarkable business that we will certainly keep our eyes on.