How Secure Are Deere's Dividends?

Farm major Deere has had a good track record of paying solid dividends, but it's currently facing two challenges. The long-term concern is that North America, Deere's biggest market, has matured. The near-term worry is that due to a seasonal weakness in the North American ag sector, Deere has forecast a 6% decline in its 2014 sales and profit is expected to be $3.3 billion, down from $3.54 billion last year. Against this backdrop, how sustainable is Deere's future dividend?

Strategy for seasonality
They say that "the key to the future lies in the past." Let's look at Deere's dividend payment trend in the past ag cycles. We will compare annual farm cash receipts compiled by the United States Department of Agriculture, or USDA, which are a good indicator of demand for farm equipment, with Deere's annual sales and dividend payment. Deere's ag segment constitutes two-third of its revenue, and around 75% comes from the U.S. and Canada. This means that there's a positive co-relation between farm equipment demand in the domestic market and the company's overall performance.

As can be seen above, Deere has been increasing its dividend regularly. Even during the crisis period of 2009-2010 when there was a sharp fall in demand and sales, the company was able to sustain its dividend.

Deere has increased its dividends steadily every year. Average dividend growth over the last 10 years works out to nearly 27.5% each year, rising from $0.53 per share in 2004 to $1.99 per share in 2013. For any growth in income to be meaningful, though, it has to outpace the inflation rate. Let's compare Deere's annual dividend growth with the annual inflation rate in the U.S.

Dividend data from Morningstar and U.S. inflation rate from U.S. Bureau of Labor Statistics

It's evident that management has kept dividends well above inflation rates, even during the turbulent 2009-2010. Deere's strategy has been to reward investors handsomely during good years and to ensure they see some increase in real income during bad years. For a cyclical business, this strategy works well without taxing reserves heavily.

Deere has taken a similar stance in the present year as well. In the first quarter of 2014, it has announced a quarterly dividend of $0.51 per share that comes to $2.04 per share annually. This is $0.05 per share or 2.5% more than last year. While a far cry from the big increases that we have seen in the past few years, it still beats the current inflation rate of 1.1%.

Planning for the long term
Deere's biggest challenge is that the North American ag sector, which is its bread and butter, has matured and offers limited growth opportunities. The USDA has forecast that the U.S. farm cash receipts will be approximately $412.5 billion in 2022, a very modest increase from the $392 billion that was recorded in 2013.

Source: USDA Long-term Projections, February 2013

Deere is overcoming this by reducing its dependence on North America. It aims to generate 50% of its targeted $50 billion sales from outside the continent by 2018. There are plenty of growth drivers, too. The company expects a CAGR of 79.5% in the agriculture, hunting, forestry, and fishing sector in BRIC countries. Rising urbanization in developing countries and the mushrooming world population are creating huge opportunities for Deere.

Source: Deere Investor Relations

It's clear that there are plenty of new opportunities to fuel earnings growth, but we need to bear in mind that there would be plenty of operating challenges, too. Each market has to be developed individually and strategies would have to be tailor-made, not to mention the economic uncertainties, political scenarios, and countless farm cycles that would have to be considered. Amid these big changes, can Deere protect its dividend payments?

To answer this, let's look at the company's payout ratio. A Foolish report on fundamentals defines dividend payout ratio as "the percentage of net income a company pays out to shareholders as a dividend." This ratio tells investors the proportion of earnings that a company is paying to its shareholders as dividends and the proportion that it's putting back in business.

Deere should not have a high payout ratio for two reasons. Firstly, it would need the cash to make heavy investments in the new markets. Secondly, the transition might throw up some difficult years wherein earnings might not support a heavy payout.

Fortunately for investors, Deere has kept its payout ratio in the 20%-27% range in the last 10 years, yet its current yield of 2.2% is satisfactory. The only exception was 2010, when earnings had slumped and the company had to pay out half of its profits. Management has a long-term strategy of maintaining 25%-35% payout ratio of mid-cycle earnings. This gives us confidence that Deere's dividend is on safe grounds over the times to come.

Foolish takeaway
Value investors love dividend stocks as they present a steady earnings avenue. However, a decision to cut or suspend dividends can trigger a fall in stock prices. After all, it's nothing short of declaring that the company is no longer confident of earning enough profits -- and nobody wants to back the wrong horse. Deere investors needn't worry, though, as the company has good strategies in place to ensure that its dividends remain steady and offer real growth.

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