Bumping Up Your Deere & Co. Cash Flow

| About: Deere & (DE)

Summary

Deere & Co. is an interesting security to review in that it has a cyclical but routinely profitable business.

This article looks at a way to “bump up” your cash flow from the security.

In the end it’s about being aware of your possibilities.

When I look at a company like Deere & Co. (NYSE:DE) I reminded of a few investing lessons. The first thing that I note is that the business tends to be cyclical. In fiscal year 2000 Deere was earning around $1 per share. The very next year this number had decreased to $0.30 per share. By fiscal year 2008 the company was earning $4.70 per share. In 2009 this figure dropped to $2.80. And even recently, earnings-per-share of $9 in 2013 have turned into something in the $4 to $6 range as a trailing and expected figure more recently.

Deere & Co.'s earnings history is not reminiscent of your "steady eddy" Johnson & Johnson (NYSE:JNJ) type holding. Yet this doesn't mean that it can't be a solid investment. During both the last two decades and during the last 10 years, investors would have experienced roughly 8% annual gains prior to thinking about reinvestment. That's the sort of thing that can turn a starting $10,000 investment into nearly $50,000 after 20 years.

But it's not going to be linear. You have to keep in mind that some industries are inherently cyclical and so it can pay, quite literally, to expect to take the ebbs and flows as they naturally come along.

The second thing that I think about is whether or not a long-term thesis exists. Deere & Co. has been straightforward with this thesis, putting it as the opening page - "Why Invest?" - on its investor relations page. Essentially the world's population (and specifically middle class) is growing, and more people are moving to urbanized areas. As such you have a need for more food (and specifically grain-based food demand) to go along with required infrastructure build out. Both of these things are items where Deere can provide solutions. So the long-term thesis for Deere is that more food and infrastructure demand will propel the company for decades to come.

Obviously you could have a different take (demand shifts, better competitors, etc.) but I find a long-term thesis useful to deal with the natural cyclicality of a business. If you're thinking in the short-term, a 70% price decline or lower earnings are going to shake you. If you're thinking about what the company will be able to produce in 10 or 20 years, it's a lot easier to deal with this sort of thing.

Once you have those things in mind, you can start to consider the current value proposition. Based on a $2.40 annual dividend, the "current" yield for the security is about 3.2%. Not that this is indicative of what must happen, but the last few times that Deere traded with a dividend yield above 3% it has worked out well for investors. Even more so than the company's long-term compound rate, as the price tends to be lower and income component higher in these instances.

So let's imagine that you'd be happy to own shares of Deere and have a long-term mindset in doing so. Naturally there's more work involved in getting familiar with the security, but the idea is to be comfortable with both the business and the valuation. Without this component the price offered probably won't be of interest.

With a reasonably lower price as of late, you could think about partnering with the business in a number of ways. You could buy shares outright, buy shares and think about selling a covered call or make an agreement to buy shares by selling a cash-secured put.

The first option is what most dividend investors are accustomed to doing. You buy shares of Deere, collect the quarterly dividend and watch as the company progresses through the years. As we all know, this strategy can work quite well.

Of course that's not to suggest that it's the only option (in this case literally) that is available to you. While you may be happy to hold shares at today's price, this doesn't mean that the security automatically meshes with your overall ambitions. Perhaps you'd like to withdraw 4% or 5% from this holding this year, but you don't necessarily want to sell shares at today's price. This is where making an agreement can be useful.

For illustration, let's suppose you own (or are about to own) 100 shares of Deere at a cost of $7,600. Your expected dividend income from those shares would be about $240 on an annual basis (or more if you anticipate a dividend increase). Yet instead of $240, perhaps you'd like to generate at least $400 (a 5.3% yield) in annual income from this holding. Let's see how you could go about doing that.

As I write this the January 20th 2017 call option with an $87.50 strike price for Deere has a bid of $1.96. (Note that I have no affinity for this expiration, but it makes comparisons easier.) This means that if you were to agree to sell your 100 shares at a price of $87.50 anytime between now and January, you'd receive ~$185 (after fees and fluctuations) for doing so. Let's look at the two basic outcomes.

If the share price of Deere & Co. stays below $87.50, the option is unlikely to be exercised. In this scenario you keep holding your shares, continue to collect the dividend and you also received the upfront option premium (which may be taxed differently than dividends). Your cash flow from this scenario would be ~$425, reaching your goal of generating at least $400 for holding shares of Deere.

Your total return could be positive or negative, depending on the share price of Deere. However, it's clear that if the option is not exercised your cash flow and return would be higher than simply owning shares.

If the option were exercised, you would receive $8,750 for your shares and keep the ~$185 in upfront option premium. The risk here is that shares jump to $100 and you're left "stuck" selling at $87.50. Yet I'd contend that this isn't a great tragedy. You would collect total proceeds between $8,935 and perhaps $9,120, depending on when the option is exercised and if you also collected dividend payments. At a minimum your total return would be 17.5% (prior to frictional costs) in less than 10 months. You could take $400 of that to satisfy your withdraw requirement, and still have ~$8,500 to redeploy into other income opportunities.

This is the sort of thing that can help expand your investing possibilities. The first step is to be comfortable with the business and valuation being offered. Thereafter, you can see what types of agreements are available to help you work toward your goals. It's not going to be for everyone as it's a personal endeavor. Yet it can be useful to learn about new areas. If you require or desire a 5% yield, you're not stuck with the AT&T's (NYSE:T) of the world. Instead, you could think about owning Deere or even lower yielding securities and make agreements that you'd be happy with to supplement your income.

Disclosure: I am/we are long JNJ, T.

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.

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