It’s time to talk about a few critical topics. One of them is dividend growth. We’re in a market environment where market participants expect that the average dividend investor might be worse off in the years ahead due to outperforming inflation over dividend growth. In this article, I will explain why that is and how I’m planning to solve that for myself and my readers. One part of the solution is buying quality dividend growth at a good valuation. That’s where Deere & Company (NYSE:DE) comes in. The company’s valuation has fallen to a multi-year low, management is expected to build one of the healthiest balance sheets in more than a decade, and shareholders are in a terrific place to benefit from outperforming dividend growth and buybacks. While the stock is volatile, I remain one of the biggest supporters of the stock and believe it will give us dividend growth investors want we need in the years ahead.
So, bear with me!
What’s Going On (The Reason I’m Writing This Article)
There’s some bad news for us dividend investors. According to the market, dividend growth will slow dramatically in the years ahead. When adding inflation, investors will be sitting on lower real dividend growth, as opposed to nominal dividend growth, which will still be positive (but slow). So, what am I talking about?
I’m talking about CME Group’s (CME) S&P 500 Annual Dividend futures. Basically, what these futures tell us is what the market expects in terms of annual dividend payout in the years ahead. The futures are calculated by the S&P 500 value (in points) multiplied by its dividend yield. In other words, if the S&P 500 is trading at 4,000 with a 1.5% yield, the future is trading at 60 points.
Before we continue, my apologies if the graph(s) below look(s) complicated. I try to be as straightforward and uncomplicated as possible. Do not hesitate to ask questions in the comment section or direct contact if you feel you missed something.
What we’re looking at below is the term structure of annual S&P 500 dividend futures. The dates look complicated but just look at the last number of each code/ticker. I.e., SDAZ3 is the dividend future expiring in 2023. If we focus on the light blue line, we see that annual dividends are not expected to rise until 2028 (not a typo). The slightly darker blue line shows the curve on April 11, 2022. Back then, investors were way more positive. Yet, they still expected dividends to remain flat(ish) until 2027.
On April 13, CME published an article that shows the long-term development of S&P 500 dividends as well as forward-looking futures. Note that back then, the most recent data was based on the line in the middle of the graph above.
What the graph below shows is that dividend estimates are pointing to the slowest dividend growth since the Great Financial Crisis. When adding inflation expectations (based on nominal Treasury yields and inflation-protected bonds), we see that real dividend growth is expected to be negative until at least early 2030.
With that said, these are estimates. As I showed in this article, these estimates tend to move around a lot. However, the consensus seems to be that we’re in for at least four years of weak dividend growth.
One reason why the market believes in slow dividend growth is the fact that corporate earnings are now 12.5% of the US GDP, fuelled by strong earnings growth since 2010.
Moreover, since April, dividend expectations have come down as the term structure chart showed. This, of course, is caused by the broader market sell-off. The Federal Reserve is hiking rates while economic growth is weakening, supply chain problems are persistent, and China is locking down major parts of its country, causing further pressure on supply chains and consumption. Add to that high inflation and war in Ukraine that is causing high uncertainty in Europe and food problems across the globe (on top of fertilizer issues and related).
Hence, market participants believe that companies will preserve cash to prioritize balance sheet health (higher rates) and to build a cushion against bad economic times.
Also, a chart I really wanted to show you is the one below. The S&P 500 has outperformed expected nominal dividends because of two reasons: quantitative easing, and (related) long-term declines in rates. Now, both factors are gone.
Again, the dividend expectations I showed you in this article so far are based on expectations. These expectations will improve again when the market rebounds. I’m not at all trying to scare anyone. If you’re diversified, you’ll be fine. Don’t worry. My point here is that quality dividend growth is more important than “ever”. In order to beat slow (expected) dividend growth, we need a stock that:
- Has a great business model and demand tailwinds
- A solid balance sheet to protect against rising rates and whatnot
- High free cash flow in order to be able to distribute dividends
- A solid dividend track record to show that management does care about its shareholders
- A good valuation to put the odds in our favor
Maybe I forgot something, but these are the key points. And guess what, I believe that Deere has all of these things.
There’s Value In Deere
Deere is my 6th-largest position. It’s also my second-best performing stock since I added it in 2020.
I have often covered the stock because agriculture has been the cornerstone of my research since the pandemic start of 2020 when I did a lot for private clients. Back then we mainly focused on fertilizer companies and related. I bought Deere for my personal dividend growth portfolio because I was impressed by the company’s ability to make money and management’s focus on shareholder distributions.
Basically, the agriculture bull case started in 2020. During the first 2020 lockdowns, agriculture was a total mess – like any other industry. Restaurants were closed, meat processing plants were battling COVID, fuel consumption (ethanol, made from corn) imploded, and global trade slowed.
It was obvious that things would bounce back as soon as economies reopened. Then, in 2021, the bull market started to gain momentum. China accelerated its imports, harvests were bad due to weather, and energy prices started to accelerate. In late 2021, Europe started to suffer from lower energy imports. It hurt fertilizer production, which caused prices to accelerate. Then, in 2022, Russia invaded Ukraine, causing energy prices to fly. Fertilizer exports slumped, and grain supply chains were destroyed in the Black Sea area.
While I absolutely loved the surge in grains and fertilizers in 2020 and early 2021 (when both were below “normal” levels), I’m now anxiously following the development. On Twitter, the food crisis has become my biggest topic as I frequently cover charts like the one below, which shows German agriculture producer prices with crop inflation reaching 40% in March.
Or this one, showing fertilizer (ammonia) since early 2020:
Now, it’s getting worse as the US is hurt by drought in certain areas (mainly impacting wheat). The same goes for Australia, which is forecasted to see a big slump in wheat output.
I could share a million charts but my key point is that agriculture production is key right now. Farmers want to plant, and they have to plant. In the US, Europe, Asia, and everywhere. This weekend, the G7 agriculture ministers are meeting in Germany to discuss this dire situation. I expect more meetings and incentives to somehow boost agriculture production.
Normally, when I discuss long-term investments that I won’t sell for decades I don’t really go into the short-term story as investors will go through many cycles in the future. In the case of Deere, however, the crisis triggered a new “regime” of profitability. It not only increased the need for more production (meaning higher equipment demand), but it also triggered a replacement cycle after commodities were very cheap for many years. Farmers didn’t invest that much in CapEx prior to the pandemic.
This is the longer-term corn chart:
Now, look at the graph below, which shows adjusted EBITDA and free cash flow (“FCF”). In 2021, Deere did $9.1 billion in EBITDA. Yet, it wasn’t a one-off year. It’s expected to gradually rise to $12.8 billion in 2024. In this case, it’s also backed by expectations that EBITDA margins are rising to 23.7% (up from 17.0% in 2020) thanks to strong demand and easing supply chain issues.
After its most recent quarter, the company hiked its full-year outlook as reported by Seeking Alpha:
The company guided for FY 2022 net income of $6.7B-$7.1B, up from its prior forecast of $6.5B-$7B, in line with $6.9B analyst consensus estimate.
In March, Wells Fargo upgraded the stock based on fundamentals, that are providing a good foundation for new machinery sales:
[…] Wells Fargo initiates coverage with an Overweight rating and a $455 price target, even after the stock’s 14% rise over the past two weeks in conjunction with crop prices, in an environment of “healthy farm fundamentals, elevated fleet age and adoption of new tech supporting high-HP equipment demand.”
Wells Fargo’s Seth Weber sees Deere “continuing to distance itself from the rest of our Machinery coverage with respect to embracing secular tailwinds around technology and sustainability,” and the company’s “evolving model… should support higher margins, more recurring revenue and make the model less dependent on machine sales.”
With that said, the graph above also shows free cash flow. In the next fiscal year, Deere is expected to do $7.3 billion in free cash flow. Free cash flow is operating income minus capital expenditures. It’s cash a company can spend on buybacks, dividends, or boost its balance sheet because it’s not needed to keep the company running. This, of course, makes only sense when the balance sheet is healthy. If that is not the case, companies will likely prioritize debt reduction instead of shareholder distributions.
Before I get to the balance sheet, let me say that $7.3 billion in next year’s expected free cash flow is 6.6% of the company’s $110 billion market cap. This is very high and it means there is a lot of room for dividend growth and buybacks. Technically, the company could return 6.6% of its market cap to shareholders in 2023. Either via dividends or buybacks. That’s truly a stunning number.
It also helps that the balance sheet is healthy. This year, the company is expected to lower its net debt to $34.4 billion. That’s 3.2x EBITDA. However, because free cash flow is so high, the company will lower net debt to $28.2 billion next year (unless it boosts buybacks or misses big on these estimates). This would mean the lowest number since the Great Financial crisis and a net leverage ratio of 2.3x EBITDA. In 2024, it could be even better.
So, this opens the door to higher shareholder distributions.
The Dividend Is Fantastic
In the past 10 years, Deere mainly focused on positioning its company for success based on acquisitions in an environment of low commodity prices. Between 2012 and 2020, dividend growth was rather slow as it averaged roughly 6.8% per year including three years without hikes. That’s still a decent average.
Then, after the pandemic, the company hiked more aggressively resulting in a 10-year average annual dividend growth rate of 9.1% according to Seeking Alpha data. The scorecard below is also from Seeking Alpha, which shows that compared to the industrial sector, Deere scores very high on dividend growth, safety, and consistency. It all makes sense based on high free cash flow and sustainable debt on its balance sheet.
Below, I’m listing the most “recent” dividend hikes that show how management is adapting to a better environment and its own ability to distribute cash:
- August 2021: +16.7% (2 hikes in 2021)
- February 2021: +18.4%
- December 2018: +10.1%
The only problem is that the yield isn’t that high. Deere is currently paying $1.05 per quarter per share. That’s $4.20 per year per share or 1.15% of its current stock price.
This means that the stock is not a good investment for older investors depending on cash flow. Other than that, it’s great for every investor – even the ones looking for high yield. Why? Because I expect that Deere will continue long-term outperformance, which means high expected capital gains. If that happens, investors can sell Deere in the future to buy high-yield investments.
The graph below shows the 10-year total returns of Deere and the S&P 500. Both have done very well, yet Deere returned close to 220 points more than the S&P 500. Even prior to the pandemic, Deere was able to follow the index quite well despite being in a somewhat unfavorable situation as commodity prices were suppressed most of the time. This is important because unless a margin-focused fertilizer company, Deere makes good money when the economy isn’t booming. Even if agriculture prices come down (I hope that happens to avoid a crisis), the company will do very well when it comes to long-term cash flow.
In this case, it helps that Deere is aggressively buying back shares. In the past, total distributions were close to or higher than free cash flow.
Also, bear in mind that the market is currently pricing in a lot of weakness already. Deere is trading close to $365 after making it to $440 this year, which brings me to the valuation.
Using Deere’s $110 billion market cap, $28.2 billion in estimated 2023 net debt, and $3.3 billion in pension-related liabilities give us an enterprise value of $141.5 billion. That’s roughly 11.6x next year’s EBITDA estimate of $12.2 billion.
This valuation offers a great risk/reward given that it’s one of the best valuations since early 2016. The same goes for the implied free cash flow yield of 6.6%, which means investors are not overpaying to get access to free cash flow.
So, with that said, here are my final remarks.
In this article, I explained why I care so much about dividend growth instead of buying a high yield. While estimates are subject to change, it is likely that average S&P 500 dividend growth will be subdued in the years ahead. Add above-average inflation and we get a situation where purchasing power from dividends comes under fire.
While Deere’s 1.15% yield isn’t high, it will more than likely protect investors against inflation. The company is benefiting from an accelerating demand cycle after years of subdued commodity prices. This is causing free cash flow to accelerate, which means higher expected dividends and buybacks as the balance sheet does not require special attention.
Moreover, thanks to the recent sell-off, the stock is trading at a very favorable price and a strong implied free cash flow yield.
Investors who are looking for quality dividend growth in the industrial sector should consider adding this agriculture giant.
(Dis)agree? Let me know in the comments!