Bet the Farm on Deere
John Deere is just too cheap. The company trades at less than 10x earnings on the back of weaker expected agriculture sales, related to a decline in US crop receipts over last year’s record level. While North America remains Deere’s largest and highest-margin market, almost half of Deere’s revenue is earned from its international operations, which continue to grow at double-digit rates. Deere continues to prove itself to be an exceptional brand with a significant moat, as evidenced by its returns on equity, which have averaged more than 30%. Looking out two to three years, the company should earn in excess of $11 per share, which at a 15 multiple gets you to $165 per share, or a double from its current price.
Deere is a leading global manufacturer of agricultural and construction machinery with an operating history of more than 175 years. Consolidations over the past decades have left only three full-line farm equipment companies, of which Deere is the largest. Deere has been the world’s largest producer and seller of farm and industrial equipment for more than 50 years. Deere controls the $24 billion U.S.-Canada market for farm equipment with some 60 percent share. The global market is dominated by three major players that control north of 70% of the market (Deere, CNH, and Agco). Unlike the growth by acquisition strategies of the smaller two, Deere’s growth has been predominately organic. This strategy has provided key benefits to Deere as evidenced by its operating margins and returns on equity shown below.
Deere’s scale in the agriculture business has provided it with an enormous edge against its competitors. Its agriculture sales were almost twice that of CNH (CNH revenue figures above include commercial vehicles) and three times that of AGCO. The company also dedicates a larger percentage of its revenue toward R&D (more than 4% of revenues), which causes the R&D gap between Deere and its competitors to increase even further. Exaggerating these effects, Deere focuses its efforts on a single brand—John Deere. The roll-up strategies of its smaller competitors have left them supporting multiple brands (for example: Agco has Challenger, FENDT, Massey Ferguson, and Valtra). The ability to dedicate a significant amount of spend to a single brand has created a wonderful positive feedback loop (Research spend improves design/fuel efficiency, which ensures market share, which provides for greater research spend creating superior products). Deere’s quality (Nothing Runs Like a Deere) has also allowed it to build significant goodwill in the form customer loyalty, with many farming families using Deere equipment over multiple generations.
The Deere brand is also supported by a robust dealer network that would be very difficult to replicate. Deere dealers typically trade in a single brand, and these dealers are less willing to hold inventory for a manufacturer that has a much smaller customer base. Proximity to a local dealer is critical for the farmer. If a belt breaks or a tire deflates, the farmer needs instant access to replacement parts.
Local dealer networks are critical to the success of a manufacturer, and dealers will only partner with leading suppliers. Given the exclusivity of the brand sold, Deere’s ability to attract the widest geographic spread of dealers is important. Generally, farmers won't consider a brand that doesn't have a dealer location within driving distance. Deere continues to maintain an unparalleled distribution network—another important element to its pricing power.
Deere can be thought of as two businesses: an equipment manufacturing business, which produces a wide range of agricultural and construction equipment, and a financing business, which lends to customers purchasing its products. The financing business primarily finances sales and leases by John Deere dealers of new and used equipment. In addition, the financial services segment 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. Deere’s financing business is exceptionally well run. The company administers a portfolio of more than $30 billion in equipment off of which it makes more than $400 million per annum. While one could argue that write-offs on the portfolio are currently abnormally low at .03%, the ten year average write-off figure for the portfolio is less than .20%.
Deere’s financing business has skewed the optics of what is a pristine balance sheet. The company holds approximately $30 billion of debt, which seems like a relatively large figure for a company like Deere, but the vast majority (80%) of this figure is finance debt and tied to its equipment sales and is fully collateralized. Adjust for the finance debt, and the company’s debt-to-EBIT is less than 2x and net debt is zero, as the company has more than $5 billion in cash and marketable securities on its balance sheet.
The quality Deere is expressed through the quality of its leadership. For nearly 175 years, John Deere has benefitted by strong, decisive leaders at its helm. Most recent management has proven no exception. Over the past ten years, Deere had grown revenue from $13 billion to more than $34 billion. Over the same time period, return on operating assets have improved from 10% to more than 30%, leaving its competitors in the dust. The company has also dramatically improved asset intensity by significantly reducing receivables as a percentage of sales—a key component to avoiding the additional working capital requirements of such a fast growing business. These efforts have led Deere to become a cash generation machine. Over the past ten years, the company has repurchased more than 179 million shares compared to a current base of 369 million. These moves have helped allow Deere’s earnings to grow from $1.32 in 2013 to more than $9 per share last year.
Deere CEO Samuel Allen aims to continue this impressive run with a goal to increase total sales to $50 billion by 2018, with half from outside the U.S. and Canada (up from 39 percent today). He expects to do this while continuing to improve the company’s operating margins. In the last few years the company has finally begun to make significant gains in Brazil and other countries where its rivals—mainly Agco and CNH—have deeper roots. Twenty years ago, Deere had two tractor factories outside the United States. Today it has nine, in Germany, India, China, Mexico, and Brazil. Its sales in Central & South America have compounded at 18% per annum over the last six years, while Asia, Africa, & Middle East sales have compounded at 17%. Currently, half of Deere’s 61,300 full-time employees work outside the U.S.
As with many companies in the agricultural space, Deere’s business is cyclical. Farmers typically upgrade or purchase new equipment on the back of strong crop season. Given that equipment upgrades are one of the few variable costs in the farming process, a weak farm season can result in an even weaker spend for new equipment orders. Crop cyclicality can be seen in the recent corn futures data which shows a fall in corn futures by almost 50% from last year as the record season caused more crop planting, which has led to a large expected crop forecast (the second-highest ever). While there are no absolutes in investing, one thing you can be pretty sure about is that the farming cycle hasn’t suddenly ended. Just as the record season brought more planting, this year’s weak receipt figures will induce lower planting and rotation into other crops (and higher prices). The chart below demonstrates the dips and rebounds in corn production.
Deere's historical financials demonstrate that its business quickly recovers after temporary weakness in the corn cycle. There have been two disruptions in farm income in the past ten years—once in 2005 and again in 2009 after the global recession. In each case, Deere quickly recovered after several weak quarters. In both cases, Deere went on to post record earnings the following year. In fact, Deere has posted record earnings in eight of the last ten years. As an investor, this is exactly the type of cyclicality one should look for when examining potential investment candidates. As noted in the chart below, while tractor expenditures occasionally decline, a bet against a subsequent rebound has never proven correct.
Deere should trade at least a market multiple. The company is growing more rapidly than the market, it sells into an under-penetrated market that benefits from the secular trends of emerging market farmers getting increased access to credit to buy equipment, it grows organically and requires little in terms of capital investment, and returns significant capital to shareholders. Over the last ten years, the company has traded at an average multiple of around 16x. As the company rebounds from a weak crop season, revenues will approach $40 billion in one to two years. At the company’s mid-cycle operating margin expectations of 12% and a normalized charge-off rate of 20 basis points for the financial services portfolio, earnings should rebound to more than $10 per share in one to two years. If the company can maintain similar margins and get half-way to its 2018 target of $50 billion in sales, earnings will be in excess of $11 per share. Choose your multiple on these earnings, but any reasonable assumption will result in a valuation significantly above the current stock price.
Looking longer term, to feed a population expected to hit 9 billion by 2050, food production must increase by 60 percent, according to the United Nations’ Food and Agriculture Organization. John Deere is uniquely positioned to capitalize on these economic tailwinds. Global macro-trends – population and income growth in developing nations – will continue to drive increased demand for agricultural output and infrastructure investment, as caloric intake increases (see chart below). Technology advances and continued shift toward credit availability in emerging markets will expand Deere’s markets, as many of these areas currently sit much lower on the technology curve. With the increasingly urban population wishing to enjoy higher living foods such as meat, which are much more grain intensive, Deere is positioned to greatly benefit from offering of products and services needed to help meet this demand.