Deere & Co. (NYSE:DE) is one of the stocks that I've been most bearish on over the past couple of years. I continue to think that the epic bear market in commodities that started almost two years ago is going to continue as the dollar strengthens and by extension, Deere's revenue base is still very much at risk. Last month I profiled why I think the stock is an unequivocal sell and although I mentioned the company's dividend as the only reason one would own the stock, I'll use this space to go in depth into the company's capital returns as they pertain to the investment case.
I pulled all data from Morningstar and use the data to create the charts below.
We'll begin by taking a look at the company's dividend per share over the past decade to get a sense of where the payout has come from.
We see strong, steady growth in the payout as DE has always made capital returns a priority, surely a significant reason why many investors own this stock. Companies that place so much emphasis on returning capital to shareholders are few and far between and I certainly find that attractive. However, I also believe a company cannot blindly increase its capital returns every year without consideration for how to pay for it and I'm afraid DE is rapidly approaching that situation.
After some token increases following the financial crisis, DE has stepped its game up since 2011 in terms of boosting the payout.
Last year's bump represented the smallest increase since 2010 as DE was still reeling from the commodity down cycle of the global recession; the decreasing size of the dividend bumps may indicate that DE is indeed structurally weakening, as I've laid out in my articles on the company's fundamentals.
How is DE continuing to pay for those dividend increases? Any company that pays a dividend should fund it via free cash flow because if it is funding it some other way, funding will eventually dry up. The only source of recurring cash generation is FCF so that is how I view a company's dividend sustainability; DE's dividend cost against its FCF for the last ten years is depicted below.
DE's FCF generation has been all over the place in the past decade as its very cyclical business produces very cyclical results. This is part of the problem with DE; it necessarily goes through boom and bust cycles because its revenue base is so heavily dependent upon commodity prices. However, to its credit, its FCF mostly exceeds dividend commitments.
Seen another way, this chart shows the amount of FCF that is consumed by dividend payments, referred to as FCF coverage.
DE's dividend was only about half of its FCF in 2010 but after significant increases in the payout and relatively little movement in FCF, its FCF coverage numbers have skyrocketed. The last three full years have consumed an average of 89% of FCF just to pay the dividend, well in excess of the 80% max target a company should have. The culprits are obvious; flat FCF and a rising payout are a bad combination.
Part of DE's problem is that it continues to invest heavily while its revenue base is shrinking, crimping FCF generation. This chart shows DE's capex for the last decade and one thing is painfully obvious; DE is investing at a time when it can't really afford to do so.
Capex increases like that will crush FCF generation because capex is subtracted directly from FCF. A dollar spent here is a dollar that cannot be spent on the dividend or anything else for that matter.
So going forward, what does all of this mean? First, it means that DE's ability to finance anything via FCF is heavily constrained. The company is continuing to produce stable FCF levels but its stubborn desire to constantly raise the dividend has impaired its ability to finance anything else. That includes the company's buyback, something it has been using a lot in the past few years, as we can see below.
The interesting thing about DE's buybacks is that they are funded entirely from other sources. Those other sources can include debt, asset sales or anything else that can be used to raise cash but as I said earlier, any source besides FCF is necessarily finite. No company can borrow or sell assets indefinitely and that means DE's capital return binge needs to slow down.
DE has been spending roughly four times as much on buybacks as dividends in recent years and since it is using almost 100% of its FCF to pay the dividend, it doesn't take a math major to realize that DE is overspending on its capital returns. This cannot continue forever and I think it has some pretty bearish implications for the stock.
DE won't cut its dividend because doing so would be disastrous; the company's FCF can still support the current payout indefinitely and I don't think that will change anytime soon. However, DE simply cannot afford to continue to prop up its falling earnings by buying back lots of stock each year as its cash position continues to deteriorate. The only reason DE's EPS numbers haven't fallen off a cliff in the past couple of years is because it has been reducing the float so aggressively but I'm theorizing this level of spending simply cannot continue to occur. And since that is the only source of stability or growth in EPS as the company's fundamentals continue to deteriorate, it is yet another reason not to own this stock.
For investors that hold DE for the dividend, it is important to recognize that the company's FCF is unable to support further increases. That doesn't mean DE won't do it - because it can temporarily fund increases from other sources - but it does mean that DE shouldn't do it. In addition, its huge buyback program has propped up EPS but that cannot last forever either. In short, with only small dividend increases likely for the foreseeable future and a cash position that cannot support further capital returns, I don't see any reason to own this stock. I'm still very bearish on DE's fundamentals and that includes its capital returns; I think the party is over and it is time for holders to move onto a company with better fundamentals.
Disclosure: I am/we are short DE.
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.