Dividend Report Card: Deere

All dividends are not created equal.

We learned this lesson the hard way in recent years. In the first quarter of 2009 alone, a record 367 firms cut their dividend payouts only to be followed by another 233 in the next quarter. Because dividends are at the board of directors' discretion, when times get tough, a firm's dividend payout can meet the corporate chopping block.

Avoiding the executioner
Certainly things have gotten better since those dark days, but with many concerns remaining about the global economy, investors would be wise to ask the following three questions of their companies' dividends:

  1. Over time, has this company steadily increased its payouts?
  2. How sustainable is the dividend?
  3. Does the company have room to further increase the dividend?

To help you out, I've created a proprietary dividend report card, which seeks to answer these questions by analyzing a company's financial statements. It's not intended to be a Magic 8-Ball, but it will hopefully get you pointed in the right direction.

Today's pupil is Deere (NYSE: DE  ) , which currently posts a 2% dividend yield.

Dividend history
Income-minded investors prefer a good track record of rising dividend payouts. Not only is it a sign that management is dedicated to returning shareholder value, but also that the board of directors expects future profitability.

Let's see how well Deere has increased its dividend over the past five years, relative to its earnings growth:

Metric

5-Year Annualized Growth Rate

Dividend per share

14.3%

Diluted earnings per share

(5.8%)

Source: Capital IQ, as of July 21, 2010.

You've got to credit Deere for raising its dividend despite declining earnings, but you'd prefer both of those figures to be positive. Making farming and forestry equipment, however, is a highly cyclical business, so five-year runs of poor earnings could very well be followed by five years of abnormally strong earnings.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, Deere scores a 5 out of 5.

Sustainability
Finding companies with solid financial footing, backed by a strong balance sheet, sufficient profitability, and plenty of free cash flow is at the root of successful dividend investing. There's no point buying a stock yielding 5% if you don't believe the dividend is sustainable. For this reason, sustainability gets a 50% weighting in my formula.

To analyze dividend sustainability, I look at three factors:

  1. Interest coverage ratio (EBIT / interest expense)
  2. Earnings dividend payout ratio (dividend per share / earnings per share)
  3. Free cash flow dividend payout ratio (dividends paid / free cash flow to equity)

It's worth noting that in my definition of free cash flow to equity, I also back out any acquisitions the company has made over the past 12 months. Hey, that's cash that could have been paid out as a dividend! Plus, serial acquirers may cut a dividend to help fund a new acquisition, so we want to be sure there's still plenty of cash to go around after all investments have been made.

For Deere, the results are:

 Metric

Trailing 12 Months

Final Grade
Weighting

Report Card Score
(out of 5)

Interest coverage

2.7x

10%

4

EPS payout ratio

36.1%

10%

5

FCFE payout ratio

47.7%

30%

5

Source: Capital IQ, as of July 21, 2010.

These are all encouraging signs that the current dividend level is sustainable. The interest coverage ratio is a little less than ideal, however, so investors should keep an eye on Deere's debt in coming quarters.

Growth
Once you know that a dividend is sustainable, you'll want to see how much room the company has to raise its payout. It may not be quite as important as dividend sustainability, but it's still an essential factor for income-minded investors who want their payouts to increase at rates well above inflation.

For this reason, growth makes up the last 40% of the final grade.

In this section, I once again use the earnings and free cash flow payout ratios. Only this time I'm not just looking to see if there's more than enough profits and cash to sustain the dividend -- I want to see how much the payout can grow, so the lower the payout ratios, the better.

I also consider a firm's implied sustainable growth rate, defined as return on equity times its retention ratio (the percentage of profits it keeps to reinvest in the business). This is the highest achievable growth rate the company can have without changing its capital structure.

Here's how Deere scored on these metrics:

Metric 

Trailing 12 Months

Final Grade
Weighting

Report Card Score
(out of 5)

EPS payout ratio

36.1%

10%

4

FCFE payout ratio

47.7%

20%

4

Sustainable growth rate

10.1%

10%

5

For a cyclical company that's still operating in lean times, those payout ratios are quite good. For example, in 2008, near the peak of foodstuff prices and demand for farming equipment, the EPS payout ratio was only 21.8%. Pared with its good sustainable growth rate, it appears to be able to continue to raise its payout at a good clip for years to come.

Bonus factor
An "ungraded" section of the dividend report card is to see how a stock's current yield stacks up against direct competitors'. If it's too high relative to competitors' yields, the board could be tempted to slow the growth rate, or vice versa, to bring it more in line with the industry average.

Company

Dividend Yield

Caterpillar (NYSE: CAT  )

2.6%

CNH Global NV (NYSE: CNH  )

0%

AGCO Corporation (Nasdaq: AGCO  )

0%

Farming and construction equipment stocks tend to have low dividend yields or simply don't pay a dividend in the first place. The main reason for this is the cyclicality of the industry -- firms don't want to have a huge dividend commitment during downcycles. For instance, CNH Global suspended its modest dividend in 2009 because "the Board believes that in these times of economic turbulence the Company should conserve cash, while maintaining a prudent level of industrial investment." Deere's done a great job balancing its dividend commitments with economic cycles and its 2% yield isn't too aggressive relative to its competitors.

Pencils down!
With all the numbers in, here's how Deere's dividend scored:

Weighting

Category

Final Grade

10%

History

5

 

Sustainability

 

10%

Interest Coverage

4

10%

EPS Payout Ratio

5

30%

FCFE Payout Ratio

5

 

Growth

 

10%

EPS Payout Ratio

4

20%

FCFE Payout Ratio

4

10%

Sustainable growth

5

100%

Total Score (Out of 5)

4.6

 

Final Grade

A

Deere may not be on a high yield investor's watch list, but the current dividend is well covered and has room to grow. The question is how much can it grow during the recession? If the economic recovery is anemic, I wouldn't expect a repeat of the 14.3% annualized growth rate -- more likely it would be in the 5%-7% annualized range.

Fool analyst Todd Wenning does not own shares of any company mentioned. The Fool has a disclosure policy.


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