The industrial sector is up 14% over the last year -- slightly lagging the performance of the S&P 500, but still a solid gain. Despite being an industry leader in heavy equipment for agriculture, construction, and forestry, Deere(NYSE: DE) stock is down 20% over the last year and hovering around a three-year low.
Here's why the dividend stock has sold off far enough and why it is worth buying and holding for the next five years.
Image source: Getty Images.
A textbook cyclical business
When you think of Deere, residential landscaping, lawn, and garden equipment may come to mind. But the business is actually far more complex, spanning tractors with varying degrees of horsepower, highly sophisticated software and hardware for commercial agriculture, industrial engines, natural gas engines, equipment for forestry, construction, turf and utility equipment, and more.
Deere operates a global network of corporate offices, manufacturing, service centers, and partnerships with dealers. In 2023, 45% of sales were production and precision agriculture, 24% were construction and forestry, and 23% were small agriculture and turf. The majority of sales are business-to-business.
There are many moving parts to Deere's business, making it very difficult to pivot to changes in the capital spending cycle. When interest rates are low, commodity prices are higher, and business is booming, Deere's customers may expand operations or make capital investments in new equipment. But when borrowing costs are higher, commodity prices are down, and business is slowing, customers may delay buying big-ticket items.
Changes in input costs like fuel, chemicals, fertilizer, and more also affect Deere's business. Profitability in the construction segment can fluctuate based on commercial and residential real estate trends.
The factors that affect a given end market vary, but in general, all of Deere's segments are vulnerable based on the capital spending cycle. Many variables outside of Deere's control can heavily affect its performance.
To its credit, Deere has made efforts to reduce the cyclicality of its business through software offerings, like its cloud-based farm management system -- John Deere Operations Center -- which lets customers monitor, organize, analyze, and share data. Its precision agriculture segment offers upgrade kits for existing equipment that can help boost crop yield, lower costs, and more. These offerings can help drive sales without depending solely on new equipment purchases.
But Deere's performance will still ebb and flow based on industry trends -- at least in the short term. In the long term, Deere can separate itself from its peers through innovation, competitive advantages such as its global supply chain and sales network, product improvements, acquisitions, pricing power, and more.
Deere is a great value
Deere's valuation is low, given its leading position across multiple industries on the global stage. The stock price has languished for multiple years while earnings have gone up -- which has pushed the price-to-earnings (P/E) ratio down to just 10.4. Even if Deere's earnings fall 50% from its record year, the stock would still have a P/E ratio of around 20.
Aside from its reasonable valuation, Deere consistently returns capital to shareholders through dividends and stock buybacks. Over the last decade, Deere's dividend has increased 145%, while its share count is down over 20% thanks to buybacks. Deere only yields 1.7%, but the payout ratio is just 16% -- meaning Deere is only spending 16 cents for every dollar in earnings on dividends.
A low payout ratio indicates Deere can raise the dividend at a faster rate than earnings without making the expense unmanageable. More importantly, it shows that dividends are affordable even if earnings slow. A 50% to 75% payout ratio is generally considered healthy, and Deere would still have under a 50 payout ratio if earnings were just a third of what they are today.
Take a leap with Deere stock
Deere checks all the boxes when looking for a top stock to buy and hold for years to come. It is a well-run, industry-leading business that invests capital well, benefits from economic growth and population expansion. It operates in proven industries that are hard to disrupt, is investing in technological improvements like automation and artificial intelligence, returns capital to shareholders through dividends and buybacks, and has an inexpensive valuation.
Since Deere's earnings are expected to fall this fiscal year and could even decline further next fiscal year, short-term-minded investors may choose to bail on the stock in pursuit of a hotter opportunity. However, lasting gains in the stock market are made by investing in a company at a good price and watching it compound in value over time.
I could see Deere stock continue to languish or even fall further until there's more certainty regarding the extent of its slowdown and how long it could last. But trying to perfectly time the market could lead to missing out on this compelling opportunity to buy Deere at a great value.
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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool recommends Deere & Company. The Motley Fool has a disclosure policy.
