Normally a high dividend yielding stock gets investors' attention. However, sometimes the stock that offers a high dividend yield or payout ratio is not a good investment opportunity; especially when the overall industry is going experiencing challenges. Such is the case in the farm and construction machinery industry where I think that a company like Deere & Company (NYSE:DE) might be in trouble and unable to pay or sustain its high dividend yield. The company currently pays a dividend yield of 2.23 percent. Let's analyze the company's future in order to determine whether or not it will be able to continue paying high dividends in the future.
The Future is not Secure
I believe that dividend paying stocks must have few a characteristics. Earnings and cash flows should be stable so that in the future the company's ability to pay dividends will not be hampered. In my opinion, agriculture and turf is the most important segment as it contributes about 78 percent to net sales. The following chart sheds some light on the revenue mix of the company.
SOURCE: SEC Filing
Agriculture & Turf
The company's revenue basically depends upon the demand for the company's products. In Deere's case demand for the company's products is further dependent upon the acres harvested which further depends upon farm commodity prices. Therefore, in order to analyze the impact of revenues on earnings and cash flows one must analyze the acres harvested and prices of farm commodities.
The commodity prices and farm incomes are expected to be lower over the next couple of years compared to fiscal 2013. Therefore I believe that the company's revenues and earnings will be materially affected by lower commodity prices and farm incomes. That is why I think that the company might face difficulty in paying or increasing its dividends. In following table projections regarding farm commodity prices are given.
Note: Data given in dollars per bushel except cotton, which is dollar per pound
As we can see, all of the commodity farm prices are expected to decline over the next two years. Corn prices are expected to decline significantly from $6.89 to $4.40 per bushel in 2013/14and then slightly improve in 2014/15 and reach the level of $4.50. As far as wheat prices are concerned, its price will decline from $7.77 per bushel in 2012/13 to $6.75 in 2014/15. Soybean prices will also follow the same pattern and its prices will decline from $14.40 in 2012/13 to $11.00 in 2014/15. However, the cotton price is expected to improve slightly from $0.73 per pound in 2012/13 to $0.75 in 2013/14; however, it will decrease in 2014/15 to $0.70 per pound. All of the commodity prices are expected to decline in 2014/15 from their levels in 2012/13.
As shown in the following table, acres harvested are expected to decline for all farm commodities in 2013/14. I believe that the main reason behind the decline in acres harvested in 2013/14 will be low commodity farm prices. As discussed above, commodity farm prices will further decline in 2014/15 except for a slight improve in corn prices. Therefore, I believe that the acres harvested will further decrease in 2014/15and result in a lower demand for the company's agricultural and turf products. That is why I believe that the demand for the company's agriculture and turf products will be negatively affected and this will result in lower revenues and earnings. This will eventually have a negative impact on the company's ability to generate cash flows.
SOURCE: Company Presentation
The short term outlook of the company's agriculture and turf segment does not seem attractive. Significant decline in farm commodity prices and acres harvested will become a major reason for the decline in the company's agricultural products. Due to lower commodity prices and acres harvested the industry is expecting a 5 to 10 percent decrease in agricultural machinery in fiscal year 2014. In my opinion, since the conditions are not expected to improve in fiscal year 2015, the demand for agriculture machinery's will fall further by at least 5 percent in fiscal year 2015and this will result in lower earnings and cash flows in the future.
As mentioned earlier, High dividend yielding stocks normally attracts investors but I believe that a high dividend yield does not necessarily mean that the stock is a good investment. The question to consider is whether or not the company will be able to continue its high dividend yield or payout in the future. In order to find out the answer, I believe there are two key metrics that tell us about a dividends' sustainability. The first one is the dividend payment ratio and the second one is the dividend payout ratio. Both of these ratios are calculated using cash flows instead of the accrual earnings of the company. I believe it is easy to manipulate accrual earnings because there is discretion involved and this can manipulate the results. Let's examine both ratios so that we can formulate a conclusion about the company's ability to pay dividends.
The dividend payment ratio is calculated by dividing cash flows from operation on dividends. Therefore, a high ratio indicates the company's ability to sustain its dividends. The following bar chart gives an idea of the company's dividend payment ratio and in comparison to its peers. Over the past three years the company's dividend payment ratio has been lower than its peers in the industry. This indicates the fact that the company has a lowered ability to pay high dividends or even to sustain dividends.
Cash flows are expected to decline over the next couple of years therefore I believe that the company's dividend payment ratio will further decline and that the company would not be able to sustain its dividends in the future.
Now let us analyze the dividend payout ratio. The company managed to keep the dividend payout ratio (Dividends / FCFE) below 30 percent in fiscal years 2011 and 2012 but it was due to the issuance of more debt rather than debt repayments. In fiscal year 2013, the company's net borrowings were negative which indicates the fact that the company paid more debt and issued less in fiscal year 2013. Therefore, the company's dividend payout ratio reached approximately 440 percent.
Another key thing I want to discuss here is the financial leverage (Total Debt/Equity). The company had a financial leverage of 335.85 percent during the most recent quarter which is much higher than the industry average of 20.81 percent. During fiscal year 2012, the company's free cash flows were negative and the company had to issue further debt in order to pay the dividends and debt. Therefore, the company's financial leverage reached a high level. In such a scenario the company does not generate enough free cash flows to pay the dividends and it will face difficulties in raising further debt.
Despite reporting record revenues in fiscal year 2013, I believe that the future of Deere is very vague. Its ability to generate cash flows and sustain dividends is quite low. Key ratios that indicate a company's ability to sustain dividends are not in the company's favor at all. The agriculture and turf segment, the major contributor in net sales for the company, will not be able to support the company in the future. Therefore, I would recommend that investors sell the stock.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.