Description

Overview

Deere & Company (“Deere,” ticker symbol: DE) is a top-notch agricultural (“ag”) and construction equipment manufacturer. Best known for its classic American John Deere brand and its yellow and green logo, the company operates in three equipment segments – Production & Precision Ag, Small Ag & Turf, and Construction & Forestry – as well as a Financial Services segment that provides equipment financing and leasing for both wholesale and retail customers.

Deere provides an opportunity to invest in a global high-quality industry leader operating in an oligopoly industry, overseen by an outstanding management team, with an investment grade balance sheet and a liquid security. The company’s moat grows wider as management plows profits back into R&D to develop innovative technology-led products that provide farmers with much needed yield improvement and cost reduction as they battle challenges like feeding a growing population while managing through a more hostile and dynamic climate. The main knock on Deere is its inherent cyclicality. However, the timing is better than average as the next year is forecast to be below mid-cycle, so the market does not have high imbedded expectations. With this backdrop of a strong and widening moat and secular growth coupled with cyclical normality, Deere’s valuation is attractive. The company also pays a dividend (1.6% dividend yield currently) that contributes to a mid-teens total return potential. 

Note that Deere has an October fiscal yearend. All references to time periods are to the fiscal period unless otherwise noted. References to the latest twelve-month (“LTM”) period are to the 12 months ending April 2024, unless otherwise noted. 

The Business

John Deere is a mainstay in the farming community. Started in 1837 by its namesake founder, the company is nearing its 200th birthday. Deere has been making its world-famous tractors since 1918. The brand is well-known globally for its high-quality and innovative farming equipment products and services, and its broad dealer network. 

Deere operates in two primary businesses – Equipment Operations and Financial Services – that have distinct financial profiles. The company breaks out full financials for each, making financial analysis a bit easier. The Equipment Operations business includes three segments that develop and manufacture equipment. The following chart shows the segment orientation: 

Operationally, Deere organizes around production systems:  

Deere manufactures equipment in its 26 North American and 45 foreign factories and distributes through its 12 North American and 11 international facilities. Overall, Deere owns around 70 million square feet of facilities and leases an additional 13 million square feet. Using its extensive independent dealer network, the company sells many equipment product lines around the globe: 

Production Ag is the major product area, and the biggest equipment types within that category are large tractors, sprayers, and combines. Large tractors, which are workhorses that farmers use most months in the year, retail for around $600k (source: Business Breakdowns podcast).  Farmers use sprayers to apply pesticides and other chemicals. Sprayers can dramatically change crop yield outcomes during the growing season. A new spray truck retails for around $500k (source: WSJ). Combines, which farmers use to harvest crops, can cost over $1 million (source: Business Breakdowns podcast).  According to industry sources, combines are Deere’s main category killer, as their models roughly double a farmer’s speed. Some farmers called their introduction a “tectonic shift” given the huge increase in efficiency that a doubling of speed produced.  

In addition to its major equipment categories, Deere also offers aftermarket solutions and other customer services designed to keep equipment running, such as machine monitoring, remote diagnostics, predictive maintenance alerts, and e-commerce. The company is in the early innings of developing a recurring revenue stream from its software-enabled data services on modern connected equipment.

The financial services segment primarily provides financing (including leases) for retail purchases from dealers of new Deere equipment and for used equipment taken in trade for new Deere equipment. It also finances revolving charge accounts and wholesale loans to Deere dealers to finance equipment inventories. Leases are generally for one- to seven-year terms with an equipment buyout option at the end of the term. Financing terms generally provide Deere with a security interest in the equipment financed, except for smaller items financed with unsecured revolving charge accounts.

As Deere’s biggest business is selling ag equipment, it’s worth taking a moment to understand the farming industry. Farming is an awfully big rabbit hole, so we’ll keep it brief and high level. 

Farmers grow crops as food for both humans and animals. For instance, a large portion of the corn and soy grown in the US (the country’s dominant crops) goes to feed livestock, which in turn becomes meat for human consumption. Some crops are also valuable as fuels (for instance, 40% of US corn is used to produce ethanol and 25% of soybeans are used for biodiesel - source: Goehring & Rozencwajg). 

This chart gives a good sense for the major types of crops grown worldwide:

Agriculture is a massive business, generating over $5 trillion in global gross production value in 2022, up nearly 5x over the last thirty years or so (a compound annual growth rate (“CAGR”) of 4.4%):

To achieve this production, farmers must allocate dollars to several important areas, including fertilizer, seed, chemicals, water, labor, fuel, equipment, and farmland (source: AGCO): 

For its part, Deere represents an expense category (equipment), but drives return on that investment by lowering how much a farmer would have to spend (per unit of output) for each of these other costs by using its equipment. 

OECD projects global food consumption, the main driver of ag commodity demand, to increase by 1.3% per year over the next decade.  Over the same period, OECD projects only a 1.1% increase in global ag production (with most of that growth in low- and middle-income countries), indicating the industry will struggle to meet demand. 

Farmers have achieved growth in agricultural production to feed a large and growing population while using much less land per capita in all major regions, a function of improving farming efficiencies: 

About 40% of global arable land is in North America, which is the most mechanized and productive region. Perhaps the biggest variable in terms of driving crop yields is fertilizer, which gives plants energy. Different nutrients, like nitrogen, phosphate, and potash serve different functions, like strength and yield. Farmers are relatively insensitive to fertilizer prices as they need to use them regardless of cost. The good news for farmers is that fertilizer prices are down considerably from their Covid peaks (source: Progressive Farmer): 

This next chart shows prices for chemicals and fuels, two other major ag spend categories, in addition to fertilizers:

A typical US farmer growing soybeans or corn might earn $500-$800 per acre in revenue, with a 50% gross margin and a 5-10% net margin in a normal year (source: Business Breakdowns podcast). Operating expenses tend to be mostly fixed, with land being the biggest single line item, so changes to gross profit largely fall to the bottom line (hence the cyclicality of farm incomes, which will discuss later). On average, about 7% of farmers globally replace their equipment each year, with an average useful life of around 17 years (source: WSJ). 

We have so far avoided a discussion of the construction industry, Deere’s other main business. We discussed the trends affecting that industry in detail in our write-up on United Rentals and refer you to that document for more details.

Deere also has a turf business, selling products into the residential and commercial markets for lawn and golf course maintenance. At 6% of LTM revenues, we have chosen to ignore this product line in our discussion.  

Management

Deere’s CEO is John May, who took the title in 2019 and is only 54 years old and therefore should have many more years at the helm. He became Chairman of the Board in 2020. 

None of the other senior executives are nearing retirement age. Most took their current titles under May’s leadership. We are impressed by what we have seen and heard from this deep bench of senior managers.

Management has been thoughtful in their strategy. For instance, the newly minted CEO introduced Deere’s “Smart Industrial Operating Model” in 2020, with a focus on capturing more value per unit rather than just driving more units. It captures three focus areas (as quoted from the 10K):

1. Production Systems. A strategic alignment of products and solutions around our customers' production systems. Production systems refer to the series of steps our customers take to execute different tasks, operations, and projects to grow an agricultural product or execute a project. 
2. Technology Stack. Investments in technology, as well as research and development, that deliver intelligent solutions to our customers through hardware and devices, embedded software, connectivity, data platforms, and applications. The technology stack leverages the core technologies mentioned in the previous sentence across the enterprise, including digital capabilities, automation, autonomy, and alternative power technologies. The stack has the potential to unlock economic and sustainable value for customers by optimizing jobs, strengthening decision-making, and better connecting the steps of a production system. 
3. Lifecycle Solutions. The enterprise integration of our aftermarket and support capabilities to more effectively manage customer equipment, service, and technology needs across the full lifetime of a John Deere product, and with a specific lifecycle solution focus on the ownership experience. This integrated support seeks to enhance customer value through proactive and reactive support, easy access to parts, value-add services, and precision upgrades, regardless of when a customer purchases our equipment.

Two years later, in 2022, CEO May announced the “Leap Ambitions” framework, an attempt to measure management’s ability to execute the Smart Industrial Operating Model by aligning customers’ production systems to deliver better economic and sustainability outcomes with fewer resources. Per the company, some of their customers’ biggest challenges include doing more with less, labor shortages, volatile input costs, and executing jobs in tight timeframes. The Leap Ambitions framework includes three components (again quoted from the 10K):

1. Size the incremental market opportunity, quantifying the value that can be created.
2. Identify the key actions required to guide investment in digitalization, autonomy, automation, and alternative power technologies.
3. Define the desired financial and sustainable outcomes we hope to achieve to help investors and stakeholders understand the opportunities that can be unlocked in the future through present investments. 

The framework includes goals to measure results under the Smart Industrial Operating Model, including workforce safety, agriculture customer outcomes, product circularity, environmental footprint, solutions as a service, and equipment operations operating return on sales (another way of saying Equipment Operations’ operating margin). Deere’s R&D investments reflect these priorities. 

In short, management sees a $150 billion incremental market opportunity, with 20% equipment operations operating return on sales by 2030: 

It’s notable that Morningstar confirmed this market framing, calculating $161 billion in value that precision agriculture could create for farmers. Also, research company Brandessence pegged the market for autonomous farm equipment at $155 billion by 2027. Rather than using revenue, Deere defines the “incremental addressable market opportunity” as “The new opportunity for all stakeholders across the applicable acres and job sites that John Deere solutions operate in beyond the value creation already unlocked with solutions in the market today.” As the CEO said, “That figure includes every drop of herbicide or pound of fertilizer that our machines save through precision application. Every extra bushel our customers get from achieving uniform emergence in their crop, and every dollar saved on a job site due to less rework from smart grade technology.”  Management expects to capture 25% of the value add, implying $38 billion of incremental revenue opportunity for Deere when accounting for the company’s market share and split of the value creation opportunity with customers (source: SeekingAlpha). Competitor AGCO, by contrast, hopes to take around 50% of their value add, indicating that Deere should have more competitive pricing.

As thoughtful as they’ve been with strategy, management is equally good when it comes to capital allocation (beyond the internal investments in R&D and production capacity needed to achieve their strategic goals). The main concepts are to maintain a strong balance sheet, use M&A selectively and strategically, and return excess cash to shareholders:

• They manage the balance sheet to an “A” credit rating so they can have “access to low-cost and readily available short- and long-term funding mechanisms (reflects the strategic nature of our financial services operation).”  
• They have used M&A selectively, with the 2017 purchase of Wirtgen for $5.2 billion (a 9.5x EBITDA multiple) being the most important acquisition in recent years. Wirtgen significantly enhanced Deere’s roadbuilding and mineral equipment businesses, especially in Europe and emerging markets, while complementing its existing business in earthmoving equipment. The deal moved Deere’s construction equipment business from #10 to #3 globally.
• They return cash to shareholders through a combination of dividends and buybacks. They target a 25-35% payout ratio of mid-cycle earnings for the dividend and use any excess cash to buy back stock, provided returns on the stock are attractive. They have grown the dividend for many years, other than a pause during the downcycle periods of 2009-2010 and 2014-2018: 

This slide captures the sources and uses of cash since 2004, shortly after Deere management embraced the use of “shareholder value added” concepts in 2002 (an offshoot of economic value added, or EVA, introduced by Stern Value Management in 1983):  

Management compensation is tied to their strategy, with the short-term incentive based on operating return on assets and sales, and the long-term incentive based on shareholder value added. 

Business Quality

Deere is an exceptional business, with many strong characteristics contributing to a wide and growing moat. 

Deere benefits from its massive scale. The company is the big gorilla in an oligopoly ag industry, with the biggest competition coming from CNH Industrial and AGCO (though neither comes close to Deere’s size). Deere has 25% market share globally, with over 40% of the North American market (source: MarketBeat). Within North America, they have 60% of the market for combines (source:Avant Marketing) and about two-thirds of the market for new high-horsepower tractors (source: WSJ). The competition in construction and forestry is a bit broader, where Deere is third behind Caterpillar and Komatsu. 

Deere’s scale provides numerous benefits, including purchasing leverage, fixed cost absorption at the factory level, overhead leverage, and the resources to invest heavily in R&D. Deere also benefits from breadth of customers and geographies, allowing it to level-load manufacturing facilities more easily. The relative margin comparison between Deere and its main competitors supports the notion of scale advantages:

The dealership footprint is another area of scale advantage. Dealers have deep relationships with the farmers and undoubtedly play a big role in equipment purchase decisions. Deere’s dealer network is unmatched, with 2,050 independent dealer locations in North America, including 1,600 selling agriculture equipment, 450 selling construction and/or forestry equipment, 90 selling roadbuilding equipment, and 280 selling turf-only products (as well as Lowe’s and Home Depot, which sells some of Deere’s lawn and garden product lines). Outside of North America, Deere sells through approximately 1,700 dealers and distributors in over 100 countries (source: Morningstar). Deere’s competitors generally sell through non-exclusive dealerships, as they do not have the breadth of product lines that dealers require to justify an exclusive relationship.

The extensive dealer network provides another important scale advantage – customer downtime avoidance. Farmers work on thin margins and short windows to accomplish key tasks like field prep, sowing, and harvesting. Having proximate and dependable access to dealer assistance for service and parts is important. Deere’s network in North America is around twice as big as its nearest competitor, which means that on average a Deere dealer is roughly half as far away (or closer) from the average farmer as its competitors. Same-day service on broken machinery is critical as unplanned downtime can ruin a farmer’s profit for the year.

Another advantage of scale is the accumulation of data, enhanced by Deere’s leading technological innovation. With sensors all over their equipment, Deere arguably has more farming data than anyone. Consider the following: “I want you to think about Ted Johnson, who farms about 6,500 acres of corn and soybeans here in Iowa. Ted has 80 fields spread out over 30 miles, has a fleet of 15 pieces of equipment, a team of 7 that support him. In one season, Ted's team will operate equipment for over 2,000 hours, working ground equivalent of 40,000 football fields. He'll plant 500 million seeds. He'll apply 3,300 tons of fertilizer and harvest a million bushels of grain, which is almost a 1,000 semi-trucks. Our aim is to help farmers like Ted, manage the operations of his farm like a well-oiled machine. Now, in addition to these operational challenges, Ted's ultimate goal is to optimize the profitability of those 6,500 acres, which are highly variable. He has nine soil types, plants 16 seed varieties and will apply 12 different fertilizer and crop protection products this year. And what makes the challenge of farming unique is that each season's weather can be different and so many of these key variables will change each year. Realistically, Ted has 40 chances in his lifetime to optimize the economics of his farm and to pass a profitable and sustainable operation to the next generation. Our aim is to help farmers like Ted accelerate their learning through the power of data and multiply their chances for success. What if Ted could learn from 40,000 other lifetimes through powerful insights gleaned through the digitalization of the farm?”  

In today’s age of artificial intelligence and machine learning, Deere should be able to leverage that data to create significant value. For instance, in addition to some of the technology applications we discuss below, the company can (anonymously) share data from nearby farms growing certain crops to a customer that is similarly placed, providing valuable benchmarking data (not to mention a great sales pitch to switch to Deere if the company’s customers outperform the prospect farm). All those sensors also provide excellent feedback for Deere’s own internal product development research.

Deere’s well-known brand is another huge advantage. The brand’s reputation has been built over nearly two centuries on the backs of high-quality, durable products with excellent aftermarket service and a track record of industry-leading innovation. In developed markets, Deere is also known for its ability to lower the total cost of ownership, despite selling premium priced equipment on a unit-for-unit basis. Deere accomplishes this by reducing customer input costs, limiting machine maintenance (for instance, they can plan maintenance through telematic data rather than having to service machinery when it fails) and repair costs, and contributing to a strong used equipment market that allows for high resale values. Deere’s well-earned reputation has led to significant customer loyalty, with many farmers happily donning their yellow and green hats and allocating the bulk of their capital equipment budgets to Deere year in and year out. As one farmer said, “It’s almost territorial or religious” (source: Business Breakdowns podcast).  

On a dollar revenue basis, here is how the major players stack up (total market calculated on assumed 25% share for Deere): 

However, that doesn’t even tell the whole story, as Deere goes to market essentially under one brand while AGCO and CNH have multiple brands (like Fendt and Massey Ferguson for AGCO and Case and New Holland for CNH). On a brand basis, Deere is way ahead.

Despite all these advantages of scale, Deere management has not been comfortable resting on its laurels. Instead, they have made concerted efforts to expand Deere’s moat and business quality by focusing heavily on technological innovation. The following chart shows how these efforts have evolved: 

For decades prior, farmers and manufacturers emphasized planting more acres, increasing horsepower, and applying more nutrients. In the last 30 years, Deere’s focus shifted to precision ag and the efficiencies it brings – doing more with less. Deere also determined to do produce its technologies in-house, rather than outsource them the way competitors did. This allowed for seamless integration, an intuitive user experience, and strong customization capabilities. Areas of advantage include software, highly accurate signal correction GPS hardware, powerful but low-heat graphics processing units (“GPUs”) for edge computing, proprietary guidance technology, and proprietary cameras that can see plants in both sunlight and shadows from the same image. Deere runs its entire digital experience through the John Deere Operations Center, from which customers can organize their agronomic data and use analytics to make better decisions. Management calls it the “digital twin” of the farm, as they “create a digital representation of each farmer's equipment, fields, the products that are planted and applied, the field operations that are performed, and the yield outcomes that are achieved.”  Here is an example of the digital twin in action, which describes the company’s AutoPath guidance solution: “We take the high resolution planting data from the planter. We send it to the Operations Center and we create a digital representation of where each seed was planted in the field. And this knowledge of the planting lines is then sent back down to sprayer and back down to the combine, so that when they enter the field, our equipment can navigate the field using the precise location of each plant that was recorded in a prior step.” 

The Operations Center also enables connected support and financial tracking through Deere’s farm profitability software, Harvest Profit, and is the hub for third party developers to interact with the Deere system. As of 2022, Deere had over 250 connected software companies linked through its API platform.

Deere’s earlier work targeted telematics and guidance. These systems remotely connect equipment owners, business managers, and dealers to equipment in the field. This provides real-time alerts and information about equipment location, utilization, performance, and maintenance to improve productivity and efficiency, as well as to monitor agronomic job execution. Among other things, telematics and guidance systems allowed farmers to automatically steer equipment perfectly straight through a field and then turn around with no variation to the path. This was a huge deal, as prior to telematics, a driver would have to expend a lot of effort and concentration to pull this task off with even less precision. Cellular communication is an important piece of the telematics puzzle as it allows farmers to monitor and steer equipment remotely, troubleshoot problems without hauling tractors to repair shops, and receive real-time data on soil, seeds, and planting. The introduction of satellite communication (Deere recently inked a deal with SpaceX’s Starlink) will expand the addressable market for connected machinery. For instance, nearly 70% of the current ag productive area in Brazil does not have access to cellular connectivity, while even in the US it is around 30%.  Customers can retrofit existing equipment by adding SpaceX-made antennas to the top of vehicle cabs. 

Building off telematics and guidance, Deere has also introduced autonomous driving capabilities on certain equipment, allowing farmers to farm 24 hours a day uninhibited by labor constraints. As management said, “Autonomy runs 24/7. It never calls in sick. It never migrates to urban areas. And most importantly, autonomy scales perfectly at the exact time you need it, turn it on in a second and you can triple your head count and turn it off when you don't need it. The payoff is dramatic. Sure, farmers no longer need to pay for surge labor, but that's only the floor of its value. Most importantly, they'll be able to get the jobs done in the optimal window to get them done. That economic return is enormous. It's moving from a constraints and time to limitless labor.”  They are working on introducing autonomous capabilities across the broader product line. For instance, they plan to have a fully autonomous corn and soy production system by 2030, including spring tillage, planting, spraying, harvest, and fall tillage.

Another recent innovation is the introduction of electric drivetrains for its equipment, helping to reduce fuel costs and address carbon emissions. In addition to helping with global warming, emissions control is a major source of regulatory pressure for farmers. The use of electric drivetrains often comes with government subsidies, and many farmers have onsite renewables (wind and solar) that could help power their vehicles. Deere has its own battery technology and battery buffered charging infrastructure offering.

The next set of advancements required the advent of machine learning and computer vision, as well as advanced compute technologies like Nvidia’s GPUs. This enabled the concept of plant level management, rather than the historical method of decisioning at the field level. This next innovation phase for Deere focuses on reducing input costs like seeds, fertilizer, and pesticides. For instance, they can ensure the optimal number of seeds are distributed per acre by using precision planting and by allocating more product to the most productive acreage. Decisions like seed depth, variety, population, started fertilizer, soil health (including various concentrations of each nutrient across a map of the entire field), etc., are all possible to optimize with the advanced information from Deere’s technology. Another initiative is to use machine-mounted cameras and precision applicators to spray only the specific plants that show disease or insects, or only weeds and not the crops, rather than spraying indiscriminately. The custom GPU and camera technology Deere uses for See & Spray covers 2,100 square feet through its 120-foot-wide boom and captures about 3 billion pixels each second with rapid edge processing while the sprayer moves through the field at 12 miles per hour.  This is quite a feat! Deere claims the technology can reduce the usage of contact herbicide by up to 67%. One farmer who treats 3,000 acres a year for weeds, said he used 80% less herbicide with the new sprayer technology than he had in prior years, and had better weed control (source: AgWeb). A crop consultant who has seen farmers reduce herbicide use by 60% with the Deere technology puts the herbicide savings alone at $25-$35 per acre assuming 50-75% reductions in use. The technology is applicable to herbicides, fungicides, pesticides, and fertilizer.

As per Morningstar, “Tillage equipment used in field preparation can utilize guidance systems to reduce overlap in each machine pass, collect data on field conditions (satellite mapping), and be flexible enough to adjust depth and down pressure maneuvers. In planting, Deere's machines can precisely place and space seeds in the field, all while moving up to 10 miles per hour faster than previous models (without losing accuracy). Farmers can also apply chemicals (herbicides, pesticides, and fungicides) to weeds through customized spray solutions (machines can control individual nozzles to dispense a spray). When plants are ready to be picked, Deere's products can harvest more capacity, without reducing crop quality or losing crops, in addition to saving on fuel costs.”  In this way, Deere is a key enabler of low-cost food around the globe. 

Prior to the digital era, farmers would be loyal to a brand like Deere, but might also buy some competitive equipment for non-essential areas. With the advent of digital technology and the cloud, that is becoming a lot less common, much like Apple or Android phone owners will frequently buy computers, tablets, and other devices that use the same operating system. Deere makes sure to integrate its technological innovations across its offerings so that customer employees are familiar with the user interface and can run every piece of equipment. Integration also allows for data analysis across seasons – for instance to see how seeding changes impact harvest performance. Integration will prove even more important as the industry furthers development of fully autonomous equipment (where all the seeding, spraying, and harvesting decisioning and execution is automated), as flowing data through the whole farm will be important and customers will not want to train their employees on different operating systems. An ecosystem approach should prevail in the farm equipment market, and Deere is in the best position to own that space. Such a dynamic will increase switching costs as farms and their employees become used to running a certain operating system.

Deere’s innovation separates it from its competitive set. Both CNH and AGCO have been trying to play catch-up but are well behind. CNH acquired Raven for $2.1 billion in 2021, which some industry sources say amounts to an admission that Deere is crushing them (source: Business Breakdowns podcast). Raven itself was a bit of a roll-up story. Raven makes guidance systems, crop spraying gear, and driverless navigation systems that CNH sells on new machines and as retrofits. AGCO, for its part, paid $2 billion in 2023 for an 85% stake in Trimble’s agriculture technology business. Trimble’s business provides software and components for self-steering, precision spraying, data management, and equipment monitoring. AGCO pairs those products with software and components for retrofitting seed planters that it makes through Precision Planting, a business it acquired in 2017. AGCO forecast $1 billion in Precision Planting sales by 2025 (the business was expected to do $535 million with $185 million in EBITDA (35% margin) in 2023 at the time of the deal). As is evident from these strategic moves, the competitive focus is on retrofitting existing equipment (Deere also has retrofit capabilities), though they offer new equipment too. For farmers that are short on cash or reluctant to make the leap into automation, AI, and software, retrofits are a good way to put a toe into the water as they cost 20-40% as much as buying new equipment. Of course, retrofits are more limited in their capabilities than new equipment. 

Deere’s focus on innovation should pay dividends as well when Deere’s software business becomes more apparent in the financials. The company recently shifted to a lower upfront cost of technology coupled with a pay-as-you-go data model. Management has a goal to make recurring subscription-as-a-service (“SaaS”) revenues around 10% of overall sales by 2030 as they take advantage of their massive installed base – currently 642k connected machines (double its level in 2022, and expected to triple by 2026 ) and 415 million engaged acres  (up from 340 million in 2022), 104 million of which are highly engaged .  As management said, “The data flywheel gets more powerful as we connect more equipment, collect more data, and generate insights that are not available to individual farmers alone nor to our competitors.”  Their medium-term goal is to connect 1.5 million machines across 500 million engaged acres. 

The recurring revenues from this flywheel should not only be stable, buffering the inherent cyclicality of the equipment business, but also high margin. It also shifts the customer burden of paying Deere out of capital expenditure budgets and to operating expenditure budgets. Operating expense budgets are more resilient as the demand for food production is super steady (and growing). We can see how management might be viewing the potential to evolve Deere’s business model towards a “razor/razor blade” kind of model in the future. For instance, Deere could move to a model where it sells the equipment at low or no margin in exchange for a high monthly per acre subscription fee. This would free up cash at the farmer level while providing Deere with a highly valued SaaS revenue stream. On top of the SaaS revenue, Deere has other less cyclical revenue streams, like service parts or Deere Financial Services. Management believes the combination of these less cyclical revenue streams with its SaaS revenue could represent 40% of revenue by 2030. 

Although we’ve spent much of the above discussion around Deere’s innovation initiatives as it applies to the ag industry, there are many corollaries in the construction and forestry industries as well. Here is management on the topic: “Our ability to leverage the technology investment that we've made in production precision ag into construction is vast. There's a handful of examples that we can point to already, things like, John mentioned, the telematics gateway, the connectivity devices from a hardware perspective and all the backend to get the data into the cloud and in a useful format in the form presented to the customer. So, that's just one example. But also in addition to connectivity sense and compute, things like inertial measurement units, things like graphical processing units, those things are highly leveraged role for us, not just within ag across products, but also from agriculture into construction.” 

Perhaps the biggest “knock” on Deere’s business quality is the cyclicality inherent in the farming industry. Unlike a normal business cycle, which ebbs and flows based on GDP and other macro factors, the ag cycle can jump around somewhat unpredictably year to year as non-economic factors (like weather) play a big role. Net farm cash receipts are the biggest cyclical driver of demand for Deere’s high sticker price equipment. Here is the historical data on farm income in the US:

Crop, livestock, and dairy commodity prices are clearly a major factor in farm incomes. The following charts give a good, blended basis to see how commodity prices have moved in recent years:

Many other factors also contribute to farm income, including acreage planted, crop yields, government policies (like global trade policies, the amount and timing of government payments, and policies related to climate change), general economic conditions, farmland prices, farmers’ debt levels and access to financing, interest and exchange rates, agricultural trends (like the supply and demand for renewable fuels, labor availability and costs, energy costs, tax policies, other input costs associated with farming), the value, age, and level of used equipment, weather and climatic conditions, and innovations in machinery and technology. It’s a complex global industry with many moving parts, and handicapping it too precisely is a fool’s errand.

Deere also has cyclical exposure to housing market conditions, weather conditions, consumer spending patterns, and general economic conditions as it relates to demand for its lawn and garden tractors, compact utility tractors, residential and commercial mowers, utility vehicles, and golf and turf equipment. 

In the forestry, construction, and roadbuilding industries, demand influences include the prevailing level of residential, commercial, and public construction, investment in infrastructure, the condition of the forestry products industry, general economic conditions, interest rate levels, the availability of credit, and certain commodity prices (like oil and gas, pulp, paper, and saw logs).

This slide gives a sense for how the cycle impacts the financial performance, and how management characterizes in terms of the cycle in each of the years since 2014: 

The boom years of 2022 and 2023 are interesting. In 2022, margins and returns were held back by supply chain issues stemming from the pandemic. By 2023, the supply chain had normalized and the true boomtime earnings power was on full display. A structural shift in profitability is evident in the historical and projected results. For example, they expect 2024 to be a moderately below mid-cycle year, as the USDA’s forecast for net cash farm income in 2024 is down 20% from 2023 levels. Despite this, Wall Street expects Deere’s operating margins to be around 20%, which compares favorably to 2014 (16%), 2018 (15%), and 2019 (15%), the last three years that were close to mid-cycle levels. This improvement comes despite unfavorable mix shifts in terms of products (weaker large tractors and combines) and regions (weaker Brazil and North America). Management contends that efficiency gains and pricing power have led to a permanently higher plateau in margins. It’s worth noting that much of the growth in 2022 and 2023 came from double-digit price increases (partially due to input price inflation) rather than volume growth. Volume is historically the big driver of cyclical movement – from 2013-2020, prior to the Covid-induced commodity price inflation, Deere’s price increases consistently averaged 1-3%, regardless of where the industry was in the cycle.

In addition to structural margin improvements, the company can partially mitigate cyclicality through its early order programs for seasonal sprayers and planters, which provide discounts to retail customers that place orders well in advance of the use season. This allows Deere to better manage its production schedule as they often have close to a full year’s worth of orders in hand early. Another mitigating factor is Deere’s global operations, which exposes it to different regional farm cycles in different parts of the world at the same time, so strength in one market can offset weakness in another. 

Growth

Industry sources project the market for global ag equipment to grow by 7.3% annually from 2023-2030, reaching nearly $300 billion in value. Some markets will grow faster than others, especially in lower- and middle-income countries. 

Within this industry context, Deere should be a share gainer. 

• Deere’s innovation pipeline should lead to outsized revenue gains as it distances itself further from the competition.
• The big three players are still only 45% of the industry, leaving a lot of room to take share from smaller players.
• Farm consolidation has been a trend for some time, as farmers generate considerable efficiencies from increasing land density (better utilization of labor and equipment). Consolidation should benefit Deere as bigger farms have more resources to invest in modern equipment. 
• Brazil is a growth market for Deere, with a robust and sophisticated farming industry. Brazil has 2-3x as much crop rotation as in North America, making the math for adoption of precision ag equipment favorable as it leads to much higher payback. For instance, Brazilian soybean or cotton farmers might spray 20x a year vs. only 3x in the US. 

Global climate change is a bit of a wildcard. While it could represent a risk given its potential adverse impact on farmers’ financial health, it could also be an opportunity for Deere. Shifting geography for farming different crops coupled with the need for better equipment to make the most of harvest yields considering the damage from more frequent and severe weather events should lead to higher demand for agricultural equipment. 

In the near term, management believes that 2024 will finish at around 90% of mid-cycle levels, following some exceptionally strong years in 2022 and 2023. In the most recent quarter ended April 2024, management reduced guidance on the heels of a worsening outlook for the ag industry due to rising global stocks, lower commodity prices, higher interest rates, weather volatility, and increases in late-model-year used inventory levels. While there are positives in the form of elevated fleet age, stable farmland values, and strong farmer balance sheets, on net the souring mood has led to greater customer discretion in equipment purchases. Demand for riding lawn equipment in the turf sector has also dimmed, due primarily to the impact of higher interest rates. 

Most glaringly, management saw a pullback in large ag tractor demand as well as an increase in high horsepower used tractor inventory. They now expect North American large ag equipment industry sales to decline by 15% (prior view was down 10-15%) and small ag and turf to decline by 10% in 2024 (prior view was down 5-10%). In Europe, they expect the industry to be down 15% on the heels of wet conditions and elevated input costs. This compares to down 10-15% in their prior view. In South America, the see a 15-20% decline (prior view was down 10%), with Brazil being the largest affected market, due to pressure stemming from lower commodity crop prices from strong global yields. Within construction, the expectations for a 0-5% decline in North American earthmoving equipment and flat compact construction equipment didn’t change from last quarter. Markets continue to be healthy with demand increases from US government infrastructure spending on the horizon. Residential housing looks a bit better while commercial real estate is softening. They expect global forestry markets to decline 10% and global roadbuilding markets to be down 0-5% as strong US spending mostly offsets weakness in Western Europe.

At the company level, they see both Production & Precision Ag sales down 20-25% (prior down 20%), with a 20.5-21.5% operating margin (100 bps worse than the prior view). They see Small Ag & Turf sales down 20-25% (prior down 10-15%) and a 13.5-14.5% operating margin (150 bps worse than the prior view). They see the Construction and Forestry segment down 5-10% for the year (same as prior) and a 17% operating margin. They anticipate 1.5% positive price realization for each segment.

The lower company forecasts relative to industry are a function of underproducing demand as they control inventory in the back half of the year. Management plans to manage the business conservatively as the market weakens. They expect to run worldwide ag production to retail sales in the ~92% range. This should drive down field inventories in all major markets around the world and set them up for a better 2025, when they will launch a record number of new products. Management claims that as an industry, they have not always been quick to react to slowing conditions. This time, Deere is taking a leadership role and getting out ahead of it. As the CFO Josh Jepsen said, “Compared to historical, we are ensuring that we're getting inventories in the right place, being as proactive as possible and not prolonging demand, not stretching out the potential to have higher demand a little bit longer, which is a lesson learned clearly from the past. So being able to do that more proactively, we think puts us in a better position. It also impacts I think duration of what we see from an overall cyclical impact.” 

Looking a bit further out, Wall Street consensus shows flat revenue in 2025 followed by 4% growth in 2026. Morningstar forecasts ~5% revenue growth from 2026 through 2028. On the positive side, farmers are still relatively flush with cash from the recent boom times, and the fleet age of equipment is older than in prior business cycles.  On the negative side, farm income is contracting off the peak, and the geopolitical environment is fragile. In construction equipment, strength from infrastructure spending and rental fleet replenishment is partially offset by moderation in residential home, office, and retail construction. Roadbuilding demand is solid in the US but weaker in Europe, and there is considerable pent-up demand in emerging economies. 

We think a mid-single-digit revenue growth expectation over the medium-term is reasonable if not conservative. About half of this growth will come from price realization: management says that 2-3% per year is normal,  consistent with overall price realization Deere reported from 2014 till the beginning of Covid in 2020. The rest will come from underlying industry market growth and share gains.

Financial Results

Note that we adjust all profit metrics to exclude non-recurring items.

Deere’s historical financials tell the story of recent cycles and structural margin improvements. For instance, in the revenue chart below we can see the prior cyclical high in 2013 followed by trough years in 2015-2017, and then the Covid boom in 2021-2023:

The company produced stable gross margins through the cycle at around 30-35% from 2013 through 2022, before increasing to 40% in the LTM period:

These higher margins have held even as revenues have weakened in recent periods, though we do not expect that to last through the year as Deere control inventories by underproducing the softening retail demand.

The company has seen good operating leverage as well on the heels of sales growth and cost control:

Expense leverage combined with improving gross margins has resulted in a strong 25% operating margin in recent periods:

While the recent margins are a cyclical high and should not be projected forward, Deere has achieved structural improvement of their margin profile over the last few years. The gains came through the reorganization the company undertook as part of its Smart Industrial Operating Model implementation, particularly aligning operations with production systems. This involved matching the organization to the way customers did business – shifting from an equipment focus (i.e., make the best tractor) to a system focus that tracked every job a customer did in growing a crop and solving for the optimal way to accomplish that comprehensive task. This opened a huge market opportunity (the $150 billion discussed earlier) and led to major efficiency gains internally as management removed duplicative teams (like centralizing technology development) and streamlined the focus. Consistent with the structural improvement, management expects to earn 18% margins in the current mid-cycle year of 2024 and 20% mid-cycle margins by 2030, both of which are well above prior mid-cycle levels of ~15% (which itself is up from a prior level of 12.5%). 

Stronger sales, improving profitability, a lower tax rate, and a shrinking share count (diluted shares are down 25% from 2013 to 2023) have contributed to strong earnings per share (EPS) growth. During the “peak to peak” period of 2013 to 2023 Deere grew its EPS from $9.62 to $34.85, a compound annual growth rate (CAGR) of 14%. 

Deere’s high margins contribute to a solid after-tax return profile in both the relatively underleveraged Equipment Operations and relatively highly leveraged Financial Services businesses:

Deere achieves these strong returns in the Equipment Operations business despite a relatively low inventory turn profile:

Next, we drop down into the segment financials (note that we only have separate disclosure on Production & Precision Ag and Small Ag & Turf since 2019, though we can combine these segments back to 2013 to equal the historical Ag & Turf segment). This chart gives revenues by segment:

We can see that Ag & Turf (which itself is predominantly Production & Precision Ag) is most of the revenue, but Construction & Forestry has been increasing as a percentage of the mix.

The next charts show segment EBIT margins (note that the Financial Services segment profit is actually EBT as it is shown after interest expense): 

All the segments earn a healthy margin, though Financial Services and Production & Precision Ag show particular strength. 

The Financial Services segment deserves a bit of a closer look given its leverage profile. We have already seen the ROEs above, which tend to run in the low teens. Management generates these returns by maintaining leverage in the 5.5-7x debt-to-equity range: 

While the segment’s leverage is optically high, it is conservative given the credit quality. The “A” credit rating for John Deere Capital Corporation (“JDCC”) across the ratings agencies provides some additional comfort, as does the ~5% yield to maturity on their 10-year fixed rate notes, which is only a 65 basis point spread to 10-year Treasury notes. The credit ratings and market prices are well earned. For instance, this chart from the company shows performance back to the financial crisis: 

The retail portfolio is 97% current today, in line with its normal level, including 1.4% non-performing loans, while the wholesale portfolio has virtually nothing past due. 

Deere has grown its loan book over the years in line with the overall business:

The business has been a consistent earner, but the increase in rates since 2022 has led to decreased spreads for Deere Financial:

The fall in profitability (rather than issues with credit quality) has caused interest coverage ratios to tighten:

The leverage metrics are something we will be keeping a close eye on, but we do not expect it to be a real issue with lenders given the strong credit quality and historical performance.

Valuation

The chart below shows Deere’s current trading multiples at a share price of $378:

LTM multiples are misleading, however, as that period reflected peak conditions for the business and are therefore artificially low. Forward multiples tell a more useful story given that 2024 is looking to be about a mid-cycle year (if not a bit below that). In a sense, this makes investing in Deere right now a relatively more straightforward task than buying at cyclical highs or lows, as the 2024 results should be reasonably indicative of current mid-cycle earnings power. Using 2024 estimates puts the current mid-cycle price-to-earnings (PE) multiple at around 15x.

Another way to look at the multiple is to take management at their word when they say they target a dividend payout ratio at 25-35% of mid-cycle earnings power. On that basis, the shares look a little richer, closer to 19x:

Looking at mid-cycle multiples and the implied yield is a reasonable approach to valuing this business. On that basis and considering its growth trajectory and quality attributes, Deere looks attractively priced. 

Another way we can look at valuation is to see what EPS growth assumptions are imbedded in the stock price today and determine whether we think those assumptions are too optimistic or too pessimistic. The chart below shows a targeted 5-year return CAGR across the top (including dividends), and an out-year P/E multiple down the left:

Here again, the growth rates necessary to generate low teens returns (highlighted in yellow) look largely achievable, especially considering the growth ahead as Deere sells more connected equipment. For context, we can look at the mid-cycle to mid-cycle EPS CAGR from 2018 to 2024E, which pencils to 17%, or the peak-to-peak EPS CAGR from 2013-2023, which worked out to 14%. All signs point to that yellow box – and teens returns – as imminently feasible. For context on the multiple, our calculations show that Deere’s current 15x mid-cycle multiple is around 6x lower than the average mid-cycle multiple the market has awarded Deere over the past six years. If anything, the secular pressure on the multiple should be higher, not lower, as Deere’s technology advantages become more obvious through share gains, and it shifts its profits more towards recurring SaaS and service and less from cyclical equipment sales. This would push expected returns even higher.  

Risks

Cyclicality

As already mentioned, cyclicality is a feature of Deere’s end markets and is an unavoidable aspect of owning Deere stock. The cycle can lead to volatility in the stock, creating risk around entry points.

The farming industry is a global, complex beast, with a huge number of influential and often uncorrelated factors. To name one, regional economic weakness could lead China to pull back on agricultural imports, which would weaken demand for crops around the world. Or trade tensions between China and the US, or between other countries, could lead to tariffs on crop imports. Or bad storms or frosts could take out large swaths of a particular crop.

Management misreading the cycle can lead to excessive inventory buildup and/or factory underutilization during downturns and missed revenue opportunities from demand outpacing supply during booms. 

Financial Services Segment

The financing segment has several risks specifically associated with it. Most importantly, financing large equipment purchases involves significant amounts of leverage. While the financing segment is operated as a distinct subsidiary, JDCC, the parent company is on the hook to maintain a 1.05:1 ratio of earnings to fixed charges at JDCC and keep JDCC’s tangible net worth at or above $50 million. 

Another risk is from weakening credit quality. Historically this has not been a material issue, and we do not expect it to be one in the current cycle (buffered by security interest in the equipment). However, credit deterioration presents a risk for any financing business. 

Weather

As mentioned, we think climate change could be both a positive and/or a negative for Deere. However, it is possible the damage to farm incomes (and consequent inability for farmers to afford Deere’s equipment) could end up far outweighing the potential positive consequences of global weather trends. 

Unions

Deere is exposed to potential union-related issues as 80% of its US production and maintenance employees are unionized, as well as most international employees. Some of its workers went on strike in 2021.

Changing Diets

Widespread adoption of plant-based and lab-grown meats could change the landscape for agriculture more broadly and hence demand for related equipment.

Other Risks

Global economic conditions can impact Deere’s business in numerous ways, including rising interest rates (reducing demand for capital equipment, squeezing spreads in the financing segment where increases usually hit borrowings before benefits are realized from the receivable and lease portfolio), inflationary impacts on farmer budgets and demand for crop commodities, etc. Other risks include foreign exchange movements and the impact on sales conversions and competitiveness overseas, raw material inflation / supply chain issues (a major problem during Covid, though now back to normal), a class action lawsuit alleging monopoly behavior, and an FTC investigation around repair of equipment and information security practices. 

Important Disclosures & Information

The information contained herein has been derived from public information believed to be reliable but the information is not guaranteed as to accuracy and does not purport to be a complete analysis of any security, company or industry involved.  All data and analysis are unaudited and should not be used as the basis for any investment decisions. Neither the advisor, nor any of its officers, directors, partners, contributors, employees or consultants, accept any liability whatsoever for any direct or consequential loss arising from any use of information in this analysis.  The user of the information assumes the entire risk of any use it may make or permit to be made of the information.

Neither the advisor nor any of its employees holds a position with the issuer such as employment, directorship, or consultancy.

The adviser, through accounts that it advises, may hold an investment in the issuer's securities.

Catalyst

New product introductions

Further proof of structural margin gains

Farm cycle turning