Company Background (sourced from Yahoo! Finance):
Deere & Company manufactures and distributes agriculture and turf equipment, and construction and forestry equipment worldwide. Its Agriculture and Turf segment provides agriculture and turf equipment, and related service parts, including large, medium, and utility tractors; loaders; combines, corn pickers, cotton and sugarcane harvesters, and related front-end equipment and sugarcane loaders; tillage, seeding, and application equipment comprising sprayers, nutrient management, and soil preparation machinery; and hay and forage equipment consisting of self-propelled forage harvesters and attachments, balers, and mowers. This segment also offers turf and utility equipment, including riding lawn equipment and walk-behind mowers, golf course equipment, utility vehicles, and commercial mowing equipment; integrated agricultural management systems technology; precision agricultural irrigation equipment and supplies; landscape and nursery products; and other outdoor power products. The companys Construction and Forestry segment provides machines and service parts used in construction, earthmoving, material handling, and timber harvesting comprising backhoe and landscape loaders, crawler dozers and loaders, four-wheel-drive loaders, excavators, motor graders, articulated dump trucks, skid-steer loaders, feller bunchers, log skidders and loaders, log forwarders and harvesters, and related attachments. Deere & Companys financial services segment finances sales of and leases new and used agriculture and turf equipment, and construction and forestry equipment. This segment also provides wholesale financing to dealers of the foregoing equipment; finances retail revolving charge accounts and operating loans; and offers crop risk mitigation products and extended equipment warranties. The company markets its products and services primarily through independent retail dealer networks and retail outlets. Deere & Company was founded in 1837 and is headquartered in Moline, Illinois.
Analysts expect Deere to grow earnings 8.00% per year for the next five years and I've assumed they can grow at 2/3 of that, or 5.33%, for the next 3 years and continue to grow at 4.00% per year thereafter. Running these numbers through a three stage DCF analysis with a 12% discount rate yields a fair value price of $111.33. This means the shares are trading at a 24.3% discount to the discounted cash flow analysis.
The Graham Number valuation method was conceived of by Benjamin Graham, the father of value investing, and calculates the maximum price one should pay for a company given the earnings and book value. Deere earned $9.09 per share in the last twelve months and has a current book value per share of $27.46. The Graham Number is calculated to be $74.94, suggesting that DE is overvalued by 12.4%.
Average High Dividend Yield:
Deere's average high dividend yield for the past 5 years is 2.83% and for the past 10 years is 2.57%. This gives target prices of $72.05 and $79.24 respectively based on the current annual dividend of $2.04. I'm more inclined to think the 10 year average is closer to what you'll see over the near future as the 5 year average was increased significantly during FY 2009. For the sake of being conservative, I'll use the average of the two targets giving a target entry yield of 2.70% and target price of $75.64. Deere is trading at a 11.4% premium to this price.
Deere's average low PE ratio for the past 5 years was 10.26 and for the past 10 years was 9.72. This corresponds to a price per share of $85.43 and $80.93 respectively based off the analyst estimate of $8.33 per share for fiscal year 2014. Both PE ratios are relatively close so I'll use the average of the two for my target entry price. This corresponds to a target price of $83.18 with a 9.99 P/E ratio. Deere is trading at a 1.3% premium, suggesting that it's fairly valued.
Average Low P/S Ratio:
Deere's average low PS ratio for the past 5 years is 0.80 and for the past 10 years is 0.75. This corresponds to a price per share of $65.02 and $61.14 respectively based off the analyst estimate for revenue growth from FY 2013 to FY 2014. The price targets don't include effects due to potential share buybacks, rather it's just based off the analyst estimate for revenue and growth, to be a bit conservative. Currently, their current PS ratio is 0.83 on a trailing twelve months basis. Once again I'll use the average of the two ratios in my target entry price calculation, giving a target price of $63.08. Deere is currently trading for a 33.5% premium to this price.
Gordon Growth Model:
The Gordon Growth Model is a quick way to calculate the fair value of a company using the current dividend, the expected dividend growth rate, and your required rate of return or discount rate. Assuming a constant 7.50% dividend growth rate and a discount rate of 10.00%, the GGM valuation method yields a fair price of $81.60. Deere is currently trading at a 3.2% premium to this price, suggesting that it's fairly valued.
Dividend Discount Model:
For the DDM, I assumed that Deere will be able to grow dividends for the next 5 years at the lowest of the 1, 3, 5 or 10 year growth rates or 15%. In this case that would be 11.17%. After that I assumed they can continue to raise dividends for 3 years at 75% of 11.17%, or 8.38%, and in perpetuity at 5.00%. The dividend growth rates are based off fiscal year payouts and don't necessarily correspond to quarter over quarter increases. To calculate the value I used a discount rate of 10%. Based on the DDM, Deere is worth $53.88, meaning it's overvalued by 56.4%.
Deere's trailing PE is 9.27 and it's forward PE is 11.10. The PE3 based on the average earnings for the last 3 years is 13.58. I like to see the PE3 be less than 15 which Deere is currently under. Compared to it's industry, DE seems to be undervalued versus CAT (16.13) and KUBTY (76.74). All comparisons are on a TTM basis. Deere's PEG for the next 5 years is currently at 1.26 which has them undervalued versus CAT (1.54) and fairly valued against KUBTY (1.30). A lower PEG ratio is better because it means you're paying less for every dollar of growth the company achieves.
Deere's gross margins for FY 2011 and FY 2012 were 31.2% and 30.5% respectively. They have averaged a 29.9% gross profit margin over the last 10 years. Their net income margin for the same years were 8.8% and 8.5%. Since 2003 their net income margin has averaged 6.9%. I typically like to see gross margins greater than 60% and at least higher than 40% with net income margins being 10% and at least 7%. Deere is behind my typical gross margin targets, but 30% is still a solid level. In the end it's what drops to the bottom line and DE is above my 7% margin target. Since each industry is different and allows for different margins, I feel it's prudent to compare DE to its industry. For FY 2012, DE captured just 97.6% of the gross margin for the industry and 115.4% of the net income margin. On a TTM basis, Deere's gross profit margin was 30% while CAT's was 25% and KUBTY was 28%. Deere's net profit margin was 9.4% with CAT earning just 6.1% and KUBTY earning 8.2%. Against their largest and direct competitors, Deere is doing much better at turning sales into both gross and net profit which can afford them to withstand a downturn better as they have better pricing power.
Deere has been fairly consistent in buying back shares to return capital to current owners. The long-term trend is for shares outstanding to be decreasing but thy have increased twice over the last decade. Since FY 2003 management has decreased the share count by 16.7% for an average annual decrease of 1.81%. By decreasing the share count management can return excess earnings to owners in a tax efficient manner. Buyback programs are generally more flexible compared to a dividend program for investors, so returning excess earnings through buybacks management has more leeway to change the buyback based on company operations.
A negative number for the % change value means shares were bought back by the company and a positive value means the shares outstanding increased.
Deere & Company is a dividend contender recently reaching 10 consecutive years of dividend increases. They have increased the dividend at a 11.17%, 19.71%, 14.08%, and 16.29% rate over the last 1, 3, 5, and 10 year periods respectively. Dividend increases are based off fiscal year payouts and don't necessarily correspond to annual payouts. Their payout ratio based off EPS has averaged 26.3%% over the last 10 years and was only 23.5% for FY 2012. Dividend growth and overall growth of the company ebbs and flows as they are a cyclical company by nature. Management's target is a 25-35% payout ratio of mid-cycle earnings.
Deere's cash flow has been all over the place over the last decade as some years have plenty of excess FCF while others are low due to larger Capex. Over the last 5 years they've been able to turn approximately 33% of their operating cash flow into free cash flow and 12% of their operating cash flow into free cash flow after paying the dividend. Their free cash flow has decreased from $1,226 M in 2003 to -$953 M in 2012. Their free cash flow after dividends has decreased as well from $1,015 M to -$1,651 M over the same time. The free cash flow payout ratio has averaged 55.8% over the last 10 years, but 2012 saw a big decrease as Capex has continued to eat up a larger chunk of their operating cash flow.
Return on Equity and Return on Capital Invested:
Deere's ROE has averaged a very solid 27.3% over the last 10 years and 33.1% over the last 5 years. DE's ROCI has averaged 8.3% over the last 10 years and 8.9% over the last 5 years. It's great to see that the continue to earn higher returns on both equity and invested capital. I'd like to see the ROCI creep up to the 10% level, although if you back out FY 2009 the new 4 year average would be 10.1%. Things are on the right track here. Their debt levels leave a bit to be desired, although like Caterpillar, they have their own financing arm to allow customers to purchase their product. A more thorough analysis of the true debt that DE is exposed to for their operations versus the customers would be needed. Their debt to equity ratio has averaged 3.5 over the last 10 years and 4.2 over the last 5 years. Despite the increase in debt, their debt to capitalization has been relatively flat averaging 68.9% since FY 2003 and 73.4% since FY 2008. Like I said earlier, the debt position is a bit worrisome and further analysis would be needed to determine the risk due to such a high debt load as well as the breakdown of debt for operations and debt for customers that is on Deere's financing arm's books.
Revenue and Net Income:
Since the basis of dividend growth is revenue and net income growth, we'll now look at how Deere & Company has done on that front. Their revenue growth since the end of FY 2002 has been excellent with a 11.4% annual increase growing their revenue from $12,338 M to $36,157 M in FY 2012. Their net income growth has far outpaced revenue growth with a 25.4% annual growth rate increasing net income from $319 M to $3,072 M. This has led to the net profit margin increasing from 2.6% in FY 2002 all the way up to 8.5% in FY 2012.
The average of all the valuation models gives a target entry price of $77.67 which means that Deere is currently trading at a 8.5% premium to the target entry price. I've also calculated it with the highest and lowest valuation methods thrown out. In this case, the DCF and DDM valuations are removed and the new average is $75.69. Deere & Company is trading at a 11.3% premium to this price as well.
Assuming that Deere & Company can grow their earnings and dividends at the rates that I assumed, you're looking at solid returns over the next 5 years. In 2018, EPS would be $9.56 and slapping an average PE of 12.97 gives a price of $123.98. Over the next 5 years you'd also receive $14.17 in dividends for a total return of 64.0% which is good for a 10.4% annualized rate if you purchase at the current price. If you purchase at my target entry price of $77.67, your projected 5 year total return jumps to 77.87% for an annualized return of 12.2%.
According to Yahoo! Finance the 1 year target estimate is at $86.16 suggesting about 2.3% upside from Friday's closing price. Followers at The Motley Fool have Deere rated as a 4 out of 5 stock, meaning they're bullish on the company. Morningstar has Deere & Company rated as a 4 star stock suggesting that it's trading below their fair value estimate.
I really like the company and their long term prospects but going into an investment with Deere you need to catch it at the right time as they are a highly cyclical stock. Operational results will wax and wane with the outlook for the farming industry which leads to a bumpier ride for investors in both share price and dividend growth. For just a quick example, look at the FY's 2008 through 2011. Year over year growth of the dividend was 19.8%, 8.7%, 3.6% and 31.0%. Not exactly the smoothest run, but the overall trend is higher.
Given that Deere provides products that will continue to be needed as the population continues to grow and demand more food there is a growth thesis for their farming equipment. They've built up a solid brand loyalty among their customers and everyone can recognize their logo. Sometimes brand recognition is enough to entice potential customers to purchase your product over another. I think the shares represent decent value here as they are trading at around a 9% discount to my average valuation price and around 8.5% premium to the target entry price. I wouldn't be opposed to initiating a position around current levels. The one major concern for me is that Deere is projecting declines over the next 2 fiscal years in revenues. Of course as a cyclical company you have to be willing to buy during the darker hours.
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What do you think about Deere & Company as a DG investment? How do you think the long-term dividend growth prospects are?