Description

Deere & Co.

DE

$91.10
May 29, 2014

Investment Summary

Deere is the leader in the global agricultural equipment industry with over 50% market share in North America and a strong position in several key international markets. Deere has earned a 25% average operating return on equipment assets over the last 10 years[1]. The company sells agricultural equipment (predominantly tractors and combines) to independent dealers, who then sell the equipment to farm customers. The agricultural industry is a cyclical one tied largely to grain prices. While Deere’s agricultural equipment business is currently overearning relative to normalized mid-cycle demand, the agricultural industry should continue to grow over a 5 year period as older equipment needs to be replaced and farmers purchase more efficient machines. Deere’s stock currently trades at 10.6X 2014 P/E, which is attractive for this high quality, growing business. Deere management has a long record of focusing on shareholder value with ~60% of operating cash flow having been deployed through buybacks and dividends, repurchasing over 1/3 of the company since 2004. We believe an investment in Deere through a combination of stock and in-the-money 3-5 year LEAPs is an excellent risk/reward with low risk of permanent capital loss over a multi-year period.

The Business

Deere is the leading global manufacturer of agricultural and construction machinery. The Deere enterprise is the agricultural industry’s #1 brand and has been manufacturing equipment since 1837. Deere operates in three segments: Agriculture and Turf, Construction and Forestry, and Financial Services which are detailed below.

Agriculture and Turf – 77% of revenue / 79% of EBIT. This group manufactures a full line of agricultural equipment such as tractors, combines, harvesters, and sprayers. Also included is turf equipment such as lawn mowers, golf course equipment and other outdoor power products.

Construction and Forestry – 16% of revenue / 6% of EBIT. This segment manufactures machines and service parts used in construction, earthmoving, material handling and timber harvesting. Products include backhoe loaders; crawler dozers and loaders; four-wheel-drive loaders; excavators; motor graders and articulated dump trucks.

Together, the Agriculture and Turf and Construction and Forestry segments are referred to as Equipment Operations. Deere equipment is sold through its dealer and distributor network. Deere dealers cannot sell competitors’ SKUs although CNH and other small competitors can.

Financial Services – 6% of revenue / 15% of EBIT. This segment finances sales and leases by Deere dealers of new and used agriculture and turf equipment and construction and forestry equipment. Deere’s Financial Services business is quite conservative and recent and historic write-offs are very low (currently near 0 and 0.3% of average owned portfolio since 2005). Across the customer base, Deere on average loans at 70% loan-to-value (at origin) and loans amortize over 5 years.

Approximately 75-80% of equipment operating profit is generated from new equipment sales while the remaining 20-25% is generated from the sale of equipment parts largely associated with replacement and maintenance. Note that Deere only makes money from selling new equipment and parts while Deere’s dealers generate sales from both new and used equipment as well as servicing the equipment for customers.

Agricultural equipment is the primary driver of operating income. Approximately 85% of Deere’s operating income comes from Equipment Operations. Of that total, 93% is derived from the Agriculture & Turf segment (or 79% of consolidated Deere operating income). North America is Deere’s largest market, accounting for 62% of equipment revenues and operating profit. Note that Deere’s construction business is almost entirely North American. The following chart provides an overview of Deere’s geographic operations:

While Deere does not disclose revenue by specific product type, we estimate approximately 45% is from tractors, 20-25% is from combines, 35% is from other equipment (sprayers, loaders, etc). Deere’s new equipment customer base is predominantly large, sophisticated farms (i.e. farms with over 5,000 acres). Smaller farms typically buy used equipment, and over 95% of large agriculture purchases in North America come in the form of trade-ins (i.e. proceeds of a used equipment sale are put toward the purchase of a new piece of equipment).

Competitive Position

Deere is the dominant player in a stable near-duopoly with durable competitive advantages including a hard-to-replicate dealer network, long-term customer relationships, and a premium reputation in a business that requires near-zero downtime during the harvest.  The company enjoys ~50-55% market share in North American tractors and combines with CNH’s Case and New Holland brands following with a combined 30-35% market share. Over the last 10 years, Deere has increased its share in tractors by ~5%. Deere and CNH primarily compete on reliability and technology rather than price. Due to Deere’s premium brand and large market share, the company has strong pricing power and has driven average annual price increases of 3% over the last 10 years.

Deere is a high quality business with excellent returns on capital. The equipment operations’ return on assets (excluding the company’s finance business) averaged 25% over the last 10 years. Because of Deere’s powerful brand and high quality products, Deere equipment retains value in the used market better than competitors’ equipment. Deere equipment lasts anywhere from 10-25 years, although its large customers typically trade-in new machines by year 3 or 4 to buy newer, more efficient models. Large Case dealers noted that they must work harder because Case has less brand cache than Deere.

Deere’s extensive dealer network in North America is a huge barrier to entry as well as a sustainable competitive advantage. The short duration of the harvest (usually a couple months or less) requires dependable, close serviceability of machines so the reliability of dealers and the strength of the dealer-farmer relationship are vital. This dynamic favors the large incumbent OEMs and minimizes the threat of new entrants. Both Deere and Case have strong dealer networks, although Deere’s is larger. CNH has generally allowed its dealers to grow more aggressively through buying other CNH dealers whereas Deere has historically been restrictive, limiting the power of any individual dealer. Unlike its competitors, Deere requires its dealers to be brand exclusive. As noted previously, the independence of Deere’s dealer network means Deere does not enjoy significant aftermarket business.

Note that Caterpillar made an effort in the 1990s to create an agricultural equipment competitor to Deere in North America with its Challenger line. The business line struggled largely due to construction dealers’ poor understanding (and the urgency) of farmers’ service requirements along with no reputation in the agricultural industry and no superiority in technology or equipment capabilities. In 2002, Cat sold the Challenger line to Agco, although Cat shopped the line to Deere initially.

Furthermore, the punitive costs of downtime during the harvest cause farmers to demand high quality machinery. Equipment purchases are only a small fraction (~4%) of expenditures on a farm, but broken equipment can wipe out an entire year’s crop during the vital months of the harvest. Thus, under-spending on farm equipment is a high-risk, low-reward trade-off. (See Appendix Figure 1).

Deere’s competitive advantages have allowed it to take share in international markets as well. Although Deere entered Brazil later than some competitors, the company has been taking share and now has 20-25% of the market vs. 30-35% for CNH and 40% for Brazilian leader Agco. In Europe, Deere equipment is underpenetrated with only 15-20% share. Deere’s European market share is likely to increase as it continues to roll out its full product line over time. Deere also has a presence in Russia and China. Russia could eventually be a meaningful business for Deere although there are obvious challenges there now.. China seems unlikely to represent a large growth opportunity any time soon due to a lack of large mechanized farms. 

Deere’s competitive position is not as strong in the construction business as in the agricultural industry.  However, this segment has been under-earning due to the recent investments in international expansion and a weak U.S. economy. A cyclical recovery should lead to meaningful improvements in profitability.

Industry

The agricultural equipment industry should benefit from several strong, long-term secular tailwinds. Globally, demographic changes are increasing the need for efficient farming. In North America, an increased use of biofuels will likely support healthy crop prices. Technological advancements and an old agricultural fleet further support long-term replacement demand for farm equipment. While the North American agricultural industry is cyclical and has enjoyed a very favorable past few years, these secular tailwinds should mitigate the impact of a sustained, cyclical downturn.

Worldwide agricultural output needs to double by 2050 in order to support projected population growth. Little additional arable land is available. Therefore grain yields, which have improved at a ~2% CAGR over the past 50 years, will need to continue to improve. Rising incomes and changing diets in emerging economies are also increasing the demand for protein. This increased demand for livestock means a further increase in demand for grain as feed.

In North America, several factors have created a recent boom for U.S. farmers. Grain prices have been at high levels, driven in part by ethanol demand. We are burning up a meaningful percentage of our food. Favorable depreciation policies on new equipment have encouraged farmers to trade in used equipment and buy new machinery in order to capture the tax benefits. Additionally, interest rates have been at historically low levels, and approximately 50-60% of Deere’s customers finance part of their equipment purchase with debt. Note that U.S. farmer balance sheets are very strong with historically low debt to equity and debt to assets ratios.

While this booming agricultural environment has caused Deere and its competitors to earn excess profits, a significant, sustained decline in Deere’s profits seems unlikely. First, demand for biofuels and livestock is rising while the supply of arable land is limited, which should continue to support grain prices over the long-term. The EPA requires that 10% of all gasoline be comprised of ethanol and any move to undo that mandate would require a massive change in infrastructure. Second, while the tax policies that have encouraged equipment purchases are set to expire, advancements in technology and healthy farm incomes continue to give the purchase of new equipment a compelling return on investment.

Innovation is an important part of the health of Deere’s sales and margins. Over the last 10 years, Deere has notably increased the size and power of its equipment, especially combines. Currently Deere is continuing to make advancements in precision farming, such as enabling tractors and combines with GPS systems and data analytics. Farmers have thin profit margins and even a slight improvement in yields from these technologies can have a large impact on their bottom-line. Lastly, it is important to note that while the North American farm equipment fleet is now younger than in the recent past, it is still reasonably old. By most estimates, 75% of North American combines are over 10 years old. The average aggregate age of both tractors and combines is above their useful economic lives.

Importantly, Deere only profits from the sale of new equipment, mainly to large corporate farms. As long as there is a healthy used equipment market to absorb the trade-ins (which is grounded in the high average age of the fleet) and buying a new, advanced machine has a compelling ROI, sophisticated farmers should continue to buy new equipment. The problem for Deere comes when farming conditions are so bad that farmers are not making enough money to invest in equipment, even if that investment has a good ROI. Combines are the primary product line that has seen a material acceleration of trade-ins and a build-up of used inventory. This product comprises only ~12% of Deere sales, so even a 20% correction in North America combines won’t have a dramatic impact to Deere’s business. Reported Deere dealer inventory levels show that on the whole, inventory is not materially elevated as compared to the past few years. Overall trade-in values, the measure of used vs. new equipment prices, are slightly below although reasonably in-line with historical levels.

It is also worth noting that Deere’s North American construction business (8% of Equipment Operations operating income) is under-earning and earnings normalization in this segment should mitigate an agricultural cyclical downturn to some degree. Investments in emerging markets and compliance with new emissions standards are impacting margins in the near-term. As these investments mature, profitability should improve. A recovery in the housing market and broader U.S. economy will also drive improvement. Note that in 1999, construction was Deere’s most profitable business and management believes the segment can return to a 13-14% operating margin from its current 7.5%.

Although taking a view on global grain prices is not an integral part of our investment thesis, having an understanding of the key agricultural importers and exporters is important.  The U.S. is the leading exporter of Corn, Soybeans and Wheat. China is by far the leading importer of soybeans (~65% of global imports), although no country has a greater than 15% share of either corn or wheat imports. (See Appendix Figure 2.)

Management

Deere’s management team is excellent with respect to operations and strategy and maintains a strong focus on shareholder returns. Management has allocated capital wisely with ~60% of operating cash flow going to stock buybacks and dividends, repurchasing approximately one-third of the company’s shares since 2004.

CEO Sam Allen is thoughtful and focused on metrics such as total shareholder return, return on equity and Shareholder Value Added (SVA). Executives as well as many employees outside of the senior management team are compensated based on SVA, which measures in dollar terms the excess of operating profit over Deere’s cost of assets. The company also pays bonuses to salaried employees based on divisional operating return on assets. Since being introduced by former Deere CEO Bob Lane in 2000, SVA has shaped Deere’s culture down through almost every level and the company has generated a ~14% annualized return to shareholders.

Price

Deere currently trades at 10.6X 2014 P/E with near zero net debt (excluding the finance business). (Note that excluding the cash on the balance sheet, Deere trades at 9.2X 2014 P/E.) This represents an attractive valuation (a near all-time low multiple) for this well-managed, dominant franchise in a cyclical yet growing industry. Note that Deere’s 5 and 10-year average forward P/E is 13-13.5X and CNH’s is ~14X.

We believe the current depressed multiple is due to fears about a near-term cyclical drop in North American agricultural equipment sales. While we do not dispute this view, we believe the likelihood of a sustained, multi-year downturn is very unlikely yet that is what is discounted in the price.

Risks

Material decline in grain prices cause farmers’ profitability to decline meaningfully. Crop prices drive farmer cash receipts, which have historically been the best indicator of farm equipment sales. Crop prices drive acres planted (units of equipment needed) and farmer cash receipts (which impacts farmers’ ability to buy new equipment).

Unfavorable foreign government intervention. Several foreign governments require a certain percentage of agricultural machines sold in the country to be locally sourced and manufactured, which is less profitable for Deere than to manufacture the equipment domestically and then ship it overseas. Russia has instituted a 32.5% import tax on combines, although Russian combines represent less than 2% of Deere sales. Brazil and Argentina currently have a ~100% tax on non-locally manufactured foreign imports, so Deere manufactures locally for the South American market.

Developing countries slowdown. Emerging economies, especially China, have been marginal buyers of grains. However, an increased slowdown in China would most likely be in fixed investment rather than grain consumption.

Mechanization of China’s agriculture industry and eventual competition from Chinese equipment makers. China represents the lion’s share of global soybean imports. If the Chinese government decides to import less over time and/or promote Chinese equipment makers, there is a risk of lowered import demand and increased equipment competition. That said, any competition from Chinese firms would be unlikely to impact regions where Deere and other equipment makers have existing extensive dealer networks.

Decline in cash receipts causes used buyers to hold equipment longer. If the number of medium sized farms decreases, then the market for trade-ins would be disrupted and sales of new equipment would be hampered. There has been no evidence of a material impact so far.

Appendix

Figure 1: Farm equipment is a small part of typical farm expenditures.

Source: USDA

Figure 2: Trade flows of major crops.

Source: USDA

Catalyst