It's hardly a secret for anyone. Since Deere has fallen to about 10 times forward earnings, it has become a darling in the value investors' community. The business generates tremendous returns on shareholder's equity, they boast industry-leading margins, they constantly spit out generous cash flows, the dividend is great, they were in business before John Rockefeller was even born, the brand is everywhere, the stock trades at 9x TTM earnings, and, to top it all off, they buy back their shares massively.
An investor's dream, isn't it?
That's what I also thought at first glance. It's obvious that the stock was beaten down by the poor prospect in the commodities market. Crop yields are at record highs, and farmers need to cut their costs to survive through abnormally low grain prices. But that's just cyclical, as the common rationale says, and over the long term, it will not matter anymore. Deere will keep sailing above its competitors.
What really struck me is how Deere is trading at about the same earning multiple as AGCO. Deere is double the size of AGCO; it has better margins, generates way higher returns on equity, enjoys economies of scale, has a better brand recognition, makes better trucks, etc.
That's when I thought I had spotted a mispricing. My first reasoning was that Deere should be trading a P/E ratio higher than AGCO's, since the two companies face the same poor macroeconomics prospects, but one is better than the other for the reasons I mentioned above.
But I ran into a solid wall.
While trying to asses Deere's earning power, I ended up with a negative number. I went over the metrics all over again to make sure I hadn't made a mistake. Unfortunately, I could adjust every inputs, but earning power would still be worth nothing.
How could that be? Deere definitely has a high reproduction value. A competitor would have a pretty hard time trying to replicate its distribution network and its brand recognition.
But Deere, a value destroyer? I could not believe it.
I should have, because the numbers were right (it's interesting how you never get to trust numbers completely when they tell you something that prove your intuition wrong).
Basic finance theory says that a company that cannot earn enough on its capital to cover the cost of financing is destroying shareholders' value. Sadly, whatever brand power Deere has, it is effectively slowly destroying its value.
Look at the ROIC.
Something should have struck you by now. Deere's return on equity is undeniably appealing for an investor. But the company cannot generate decent returns on the total capital invested in the business. Debt is the main culprit. Deere is highly leveraged when compared to AGCO (precisely 11.3x more leveraged).
Now let's compare Deere's 10 years median ROIC to its cost of capital. Depending on the technique we use, our result would fall between 6% and 10%. I happen to think that the real figure is closer to 10% since the markets tend to be demanding towards cyclical stocks.
So we have a median ROIC of 6.3% and a COIC of about 9 to 10%. Now we know why Deere's earning power is worth nothing to investors. If a typical investor demands at least 9% to invest in the stock market, common sense would tell him to not invest in Deere since the company can only generate about 6 to 7% on an investor's capital.
Unless this investor is an equity investor. Thanks to its massive debt load and since equity represents only a tiny part of Deere's total capital, the company can transform its ROIC of 6.3% into a ROE of 33.5%. If Deere was to repay all of the debt it holds, its return on shareholder's equity would fall pretty much to the same level as the ROIC.
Running a Dupont analysis will confirm our thoughts.
Except for 2009 (which we don't take into account since it was a highly unusual year), the return on equity is purely driven by the equity multiplier (a.k.a. leverage). Both the asset turnover and the profit margins don't seem to have a huge effect on ROE.
It is kind of counterintuitive to think that Deere is an attractive investment because it is highly indebted. If you take off the debt, the investment becomes suddenly way less attractive. (I am certainly not the only one, but my mom always told me that debt was bad).
I am not saying that one should not invest in Deere. But if we do, we need to be aware that the major part of the upside does not stem from the wonderful nature of the business. Leverage is what makes the potential move attractive. If everything goes well for Deere in the upcoming years, an investor could be handsomely rewarded. But the opposite is also true. If the slump in the commodities market turns out even worse than it is right now and Deere runs into more serious trouble, investors could get pinched.
If you are looking for a value generator in the agricultural industry without the volatility of leverage, take a look into AGCO. They may be low profile, but the firm generates better returns on capital than Deere and it outpaces its own cost of capital.
Now we know that a strong brand recognition does not rhyme with value creation.
Note (On October 7th, 2014): After reflexion. I now realize how wrong I was in my analysis. I deeply failed to fundamentally understand Deere & Co. I should have asked myself more questions about what was happening behind the numbers. I should have dug deeper.
A big part of Deere is effectively a financial company. It is impossible to analyze the manufacturing business and the financial business together. They need to be looked at separately because their inner working are completely different.
