|Shares Out. (in M):||370M||P/E||9.7x||10.4x|
|Market Cap (in $M):||34,355||P/FCF||9.3x||12.2x|
|Net Debt (in $M):||-3,636||EBIT||6,225||4,768|
*We adjust net debt for finance receivables (from the finance business)
Deere & Co
John Deere is the global market leader (in $ terms) in the manufacture of tractors and combine harvesters. With 39% of the global market, it is 1.8x its nearest competitor and its relative market share in the US, its home market, is substantially higher. In 1900, there were 166 tractor companies; today there are only 3 full-line tractor companies (Deere, CNH and Agco) and they control 72% of the global market. Deere’s two main competitors have grown through acquisition and their revenue is split between multiple brands. Deere’s growth has been largely organic and it operates just one tractor and combine brand: John Deere, recognisable by its ubiquitous green and yellow livery.
Deere trades on a forward multiple of 10x. The shares peaked in 2011 and have underperformed the S&P by 50% since this peak. This surprised us as the positive long-term dynamics for food consumption and agricultural production are well chronicled. The more we looked under the hood of this stock, the more we liked it. During its 175 year history, the business has had just nine CEOs. This consistency of management has embedded deep customer oriented values. Employees are encouraged to think of each business relationship as one which could survive 75 years or more; this might seem absurdly high until you realise that many of its customer, dealer and employee relationships are multi-generational. Integrity is at the core of these values but also a focus on making their customers’ businesses successful. Sometimes such zeal can be to the detriment of shareholder value, and during its long history, there have been times when Deere’s capital allocation discipline can be questioned. This changed in 2000. The then new CEO, Bob Lane (newly promoted having been with the company since 1982), recognised that with all of Deere’s strengths, the business was “spending too much money to make money”. Lane introduced a new financial measure which he called "Shareholder Value Added": a measure of return on capital, which survives today. Armed with this tool, he executed a number of operational changes which have delivered terrific returns to shareholders in the last 13 years. The company backs up this shareholder friendly culture by returning the bulk of its free cashflow to shareholders each year through dividends and buy-backs.
Through research reports and direct interviews, we learned that farmers are surprisingly price insensitive when it comes to purchasing tractors and combines. They have incredible loyalty with often multiple generations of a farming families sticking with the same brand. The purchase decision is focused on reliability, resale value and most importantly proximity to good service and parts – which is achieved by Deere through an unrivalled Dealership network. This is not an irrational perspective; when the cost of large tractors for example is spread over the time that a farmer will own them, it represents c.2% of farm revenue. This is a much lower percentage than a farmer would spend on seed, fertiliser and labour and yet these machines are vital. Farmers have a short weather restricted window in which to complete a task such as seeding or reaping and it is critical that the large farm machinery is working when it is needed, and if not, can be fixed very quickly.
Deere spends 4% of its revenue each year on R&D, 2.5x more than its nearest competitor CNH. This R&D has not only gone into building larger, more powerful and fuel efficient engines but also into technology to improve productivity (through more accurate GPS guided driverless tractors) and control for the customer. In one interview, sitting at his desk in the City, a farm owner could tell us which field his combine was harvesting and even the moisture content in the crop being harvested – all through software and hardware provided by Deere.
Deere’s single brand strategy enables it to spread its marketing cost over a much greater volume sold. Deere dealers are all exclusive and geographically positioned to limit the overlap. CNH and Agco dealers often find themselves competing with a different brand of tractor from the same manufacturer.
Deere’s dominance gives it a 2% operating margin advantage over CNH and 6% advantage over Agco, its 3rd largest competitor. At the Gross Margin level, the advantage over CNH is close to 4%. In the last ten years, it has grown its market share from 35% to 39%.
The reason the stock is cheap
Much of our analytical effort was focused on why Deere was so inexpensive. Here, we found a remarkably high correlation over time between crop prices and the share price of Deere. More importantly, this was grounded in reality in that over the short term, the financial performance of the tractor manufacturers is highly correlated with crop price movements. This makes a lot of sense, a farmer’s cost base of labour, seed and fertiliser is largely fixed whilst revenue is cyclical and driven by climate and the supply / demand curve in crop markets. What has particularly concerned us (and the market) is that crop prices, in particular corn (maize), which is the largest North American crop, have increased materially in the last 7 years. Corn prices are up over 2x in that period and this has driven very positive returns for the agricultural equipment makers. The key driver has been legislation. From 2007 onwards, US law mandated that an increasing proportion of gasoline was come from ethanol. Ethanol can be derived from Corn and in the period since, the percentage of the corn crop used for Ethanol has increased from 10-15% to 40%.
It seemed that our investment thesis for Deere rested on the success or failure of the ethanol lobby. We looked at various aspects of this to get comfortable that we should at least start to build a position in Deere. Whilst there is pressure to relax the ethanol mandates, the proposed changes to the rules merely slow the growth in the percentage of ethanol which refiners need to mix into the Gasoline. Ethanol replaces MTBE, another thinning agent, which is considered to be environmentally hazardous. From all that we have read, it seems unlikely that Ethanol is going to be legislated back out of gasoline.
Modelling a negative scenario where farmers significantly alter their buying patterns for tractors, from an average of 6 years replacement cycle to 8 years, would cause sales of equipment to decline by 33% but we estimate that agricultural equipment drives less than 50% of Deere’s profits. The rest comes from financial services, parts sales (very lucrative and non-cyclical), construction, and turf (golf courses and lawns). In 2009, when corn and wheat prices plummeted at the same time as a recession in all of its other markets, Deere’s sales dropped by 25% and net profit declined by 60% but operating cashflow was hardly impacted. This is a cyclical business but not in the same mould as the automobile or construction equipment sectors which make losses in the bad years. Deere has had no loss years in the last ten years and only two in the last twenty; in all that time operating cashflow has been positive every year.
Potentially offsetting any short-term downward pressure on corn prices is the positive impact of the Chinese market, which has only very recently crossed over to become a net importer of corn. The long projected impact of a growing meat eating population in Asia is only now beginning to have an impact on the global demand for arable crops.
Finally, when we modelled Deere’s revenues to crop prices over a 25 year horizon, Deere was able to grow its revenues by nearly 6x during a period when crop prices increased by just 2x. In other words, the relationship between crop prices and Deere’s revenues, profits and share price is strong over a short time horizon but Deere’s superior business model wins in the longer term. Corn prices are indeed lower this year and the business is expected to perform less well in the 2014 than in 2013.
Another risk we considered was the potentially negative impact of a normalisation of interest rates on a business which is reliant upon a financial services model to sell its equipment. The interest cost over the average life of the tractor is just 7% of the total cost of ownership. Furthermore the current rates being charged on finance deals are 6%. We estimate that a normalisation of interest rates could impact farmers by adding a further 2-3% of their total cost of running the equipment. This would probably happen gradually and indeed can be manipulated by Deere as a gradual adjustment (by Deere taking a temporarily lower margin in financial services) so we doubt that it would have a significant impact on demand.
The financial services business does need to be given some consideration since the size of the debt in this business is higher than the market cap of Deere today. However, this is possibly the best bank in the US today. Its asset base is supported by substantial down payment requirements; its clients are asset rich customers (land owners) and the equipment, which depreciates at a slower rate than the financial services repayments, has a very liquid second hand market. This results in a very high margin financial services business which has a ten year average credit loss provision of 0.28%.
In December 2013, Deere announced an increase in its share buy-back mandate to enable it to buy back a further $8 billion of its stock (25% of the market cap at the current share price). We believe that a long-term position in Deere will be rewarded through long-term increases in earnings per share and a normalisation towards longer term multiples as the market starts to look through the current hiatus in earnings.
As an example, without any further growth in earnings from the depressed levels expected in 2014, the EPS should grow from $8 to $11 through the share buy-back. If the PE multiples expanded to a more normal (for Deere) but not expensive 14x and all of this happened over 3 years, then we would achieve annual returns of +22% (including dividends). It is worth noting that the company is bullish about the macro economic drivers for its business and targeting 40% growth in revenues over the rest of this decade as it expands its international business. If just some of this business plan is achieved, then the returns will be much greater.
Deere is a 7% position in our fund.
We do not specifically look for a catalyst since our view is that if the market can see a catalyst, then it is more than likely to be priced into the stock. With Deere, without any further growth in earnings from the depressed levels expected in 2014, the EPS should grow from $8 to $11 through the share buy-back. If the PE multiples expanded to a more normal (for Deere) but not expensive 14x and all of this happened over 3 years, then we would achieve annual returns of +22% (including dividends). It is worth noting that the company is bullish about the macro economic drivers for its business and targeting 40% growth in revenues over the rest of this decade as it expands its international business. If just some of this business plan is achieved, then the returns will be much greater.