Alex Hughes

Written by Alex Hughes, International Analyst, StocksInValue

Original article first published in StocksInValue


 
We have been admirers of Deere & Company, DE.N (see valuation) for some time, releasing our initial full research report in February 2015. However despite our appreciation of the business, we have been reluctant to add it to our international model portfolio as we felt that weak soft commodity prices were likely to pose operational headwinds in the near term and this was not adequately reflected in the price. With the price now 16.5% lower at $74.61, Mr Market is now serving up Deere at a more interesting price, prompting us to revisit our thesis.
Before we begin, let’s touch on the philosophy behind our international model portfolio. We seek to operate with a very simple yet effective modus operandi, encapsulated in the often quoted and even more often forgotten principles of Warren Buffett:
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”
With that said, let’s reassess Deere & Company against these three key factors of understandability, certain long term earnings growth and rational pricing.

Easy to understand

Deere certainly meets the easy to understand test. It sells farm and construction equipment under the John Deere brand. It operates a global manufacturing base, sells to exclusive independent distributors who then sell to the end user, which is predominantly farmers and commercial construction companies. With 80% of EBIT, the agriculture division is the key contributor to earnings.
Deere is the leader in an almost duopolistic market, with market share over 50% and tremendous brand value; for a tractor company, you have to appreciate the level of brand awareness they have been able to achieve throughout the world.
Deere’s tremendous economics stem from the preferences of customers. As the duration for harvesting most crops is just weeks and months, the total cost of lost productivity due to equipment failure is extremely high. It is for this reason that farm customers place far higher importance on equipment reliability over price. This suggests most people are likely to continue to favour Deere, as it regarded as the highest quality and therefore the most reliable option, and this insensitivity towards price supports its industry leading margins. Further, Deere’s equipment retains its value the best in the used market which is also an important consideration.

Certain long term earnings growth

It is very difficult to pinpoint earnings long into the future, however one can assess growth and competitive dynamics to form a view about how industry growth, market share and product pricing will evolve.
The demand for food is almost certain to be higher in five, ten and twenty years time simply from population growth which suggests the industry is highly likely to grow. Based on current trends, global population is estimated to grow at 1% p.a. for the next 25 years.
However, the practicalities of feeding ever high populations with finite resources means it is absolutely crucial that productivity increases dramatically. This is where Deere comes in, as greater use of machines in the food production process is central to greater productivity, and this dynamic has been a tailwind for Deere in recent years and is one that is likely to intensify with time. This suggests that agricultural equipment is likely to grow much faster than underlying population growth, as its use increases with time, particularly so in emerging markets.
The agricultural equipment industry is highly consolidated and barriers to entry are also high, which suggests the existing players are likely to continue to operate with rational competition with minimal threat from new entrants. Just consider that Caterpillar (CAT.N) attempted to enter the agricultural equipment market in the 90’s under the Challenger banner, however they struggled as they had an unknown brand and they failed to understand the service requirements of farmers, and the brand was ultimately sold to Agco in 2002.
These factors suggest to us that the underlying growth and competitive drivers behind Deere are favourable, and hence the onus is on management to ensure that operating and capital costs are minimised. Further, future capital management is likely to play an important role. Deere management have historically invested a considerable portfolio of free cash flow in stock buybacks, reducing shares on issue by one third since 2004. This is likely to be a further tailwind behind earnings on a per share basis in to the future.

Rational price

Deere currently trades on 13.7x cyclically low FY15 earnings, or 10.7x the peak earnings achieved in FY13; both multiples are certainly far from ritzy and would likely appear cheap in hindsight if earnings stabilise and grow in the next few years. Our valuation of $82.40 exceeds the current price by over 10%.
However, Deere is expected to announce its fourth quarter earnings pre-open on November 25th in the US. Given that the company continues to experience short term challenges, we are reticent to invest before an earnings announcement that is likely to result in a binary and potentially dramatic price movement. As watchers with long term interest, we hope the earnings disappoint, big time, so we can enter at even more attractive prices.