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Bet the Farm on Deere

August 01, 2014 | About:
ValueStalker

ValueStalker

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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.

Company History

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.

Financial Strength

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.

Management

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.

Valuation/Risks

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.

Outlook

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.


Rating: 4.6/5 (20 votes)

Voters:

Comments

Dan Dellegrotti
Dan Dellegrotti premium member - 3 months ago

I will take the other side of that bet.

pravchaw
Pravchaw premium member - 3 months ago

Nice article. However have you compared DE with AGCO? AGCO while clearly far behind DE in market share etc. may be a better buy because of its low share price. DE carries a lot of leverage (due to its finance business) while AGCO does not. AGCO's cash return seems to better. However it may make sense to buy both as this industry looks like a very profitable oligopoly.

batbeer2
Batbeer2 premium member - 3 months ago

Hi Dan Dellegrotti

You say: I will take the other side of that bet.

Why?

ValueStalker
ValueStalker - 3 months ago

Dan-

I would love to hear some constructive thoughts, as opposed "your bet".

ValueStalker
ValueStalker - 3 months ago

Pravchaw-

AGCO's cash return is NOT better. The company's strategy has essentially been to make acquisitions, then delever. Over the last three years, the company has spent $1 billion on acquisitions, while creating slightly more than $1 billion in free cash (before those acquisitions). Dividends and share repurchases are approaching zero. Furthermore, Deere's margins and returns on capital are more than twice that of AGOC--the margin piece will be especially critical in a potential downturn. Also, you have to make the distinction between the Finance operations and the Equipment operations. Deere's finance piece is the equivalent the the company owning one of the most well run banks in the country, with charge-offs that are almost non-existent. It is completely collaterialized by finance receivables and made money throughout the financial crisis. This is nothing like the debt of most companies--Deere could sell the Finance operations for a profit of several billion dollars and be debt free tomorrow.

jayb718
Jayb718 - 3 months ago

What's the profit breakdown? How much does the equipment business bring in compared to the finance business?

ecotycoon
Ecotycoon premium member - 3 months ago

I also look at it, at first look it was looking like a great investment. Berkshire bought it, but Warren laugh at it when he was ask about it in an interview, he is not the one who took the decision, he would not have bought it....

You have to care, story does not always repeat itself in the same way but it does rhyme... In the 70s same cyclical phenomenon’s happen there was shortages , price of corn, wheat… went up, farm equipment sales went up than everything turn around fast in two steps….shortages stop and... sales of farm equipment company drop 50%, everybody tough it was over…. than it fall another 50%. One of the only survivors was Deere.

It might be better to invest in that kind of business when they lose money rather than making it, while investing in the best in the overall group... that might sound odd but it's what i believe is the best way to invest in cyclical business.

ValueStalker
ValueStalker - 3 months ago

Jayb- Last year, Equipment earned $3 billion and Financial Services earned $550 million.

ValueStalker
ValueStalker - 3 months ago

Tycoon-

This is actually the exact type of business Buffett looks for--high returns on capital, leader in an industry with dupoloy-like characteristics, strong brand with a history of organic growth, etc. While it might not be at the top of his radar in terms of open market purchases (due to its size), I can assure you that Buffett would take the call, if Deere were for sale. As for cyclical companies, it does usually work out better to purchase when P/Es are at highs as opposed to the lows seen at the top of the cycle, but we are no longer at the top of the cycle. DE is off from $95 during a period in which the stock market increased more than 30% and drifted toward record highs. The relative underperformance has been huge. As for waiting to buy until the company is losing money, good luck with that. The business is completely different from that of the 70s or even late 90s--its easier to see a 50% drop in earnings when your margins are only 3% (vs the current 14%). I cant imagine what AGCO and CNH will look like if Deere is losing money--it wont be pretty. Also, with the international piece of the business approaching 50% of the equation, the relative impact of the over-investment in equipment will be much less pronounced. The economic trend for emerging market farmers is clear and will result in Deere becoming more profitable over the longer term.

braber12
Braber12 - 3 months ago
Value Stalker,

How do you figure capital return such that DE is better than AGCO? From the Joel Greenblatt (Trades, Portfolio) ROC statistics, it looks like AGCO is averaging around 25% over the past 10 years, while DE is only averaging around 12.5%, basically half of AGCO?

Both look very cheap, and the industry does have great defensive characteristics with favorable long-term tailwinds. It does appear that AGCO ability to grow in developing countries outweighs Deere's brand and buyback strategy.

ValueStalker
ValueStalker - 3 months ago

Braber- Check your 10-ks. AGCO has not earned an ROE in excess of 20% in any of the last ten years. Deere's ROE was 34% last year. Also, Deere is growing just as quickly overseas, and does so organically--anyone can pay for growth.

pvsk77
Pvsk77 - 3 months ago

Value Stalker,

Great article, I have done some research in the past few weeks after the results. One reservation I have with DE is the disparity between Earnings and Free Cash Flow. It is great to see that DE is able to sustain ROE inspite investing heavily each year on capital expenditure but do you think the Capex will come down in the future so that investors can enjoy more of earnings? I am not sure the Capex requirements of DE for the long term.

JeffreyRen
JeffreyRen premium member - 2 months ago

DE's market is limited. It is hard to expand its sales volume by double or tripple in a few years.

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