The Finance Ghost describes Deere & Co with a strong fundamental story to tell, with a reasonable prospect of increasing its operating margin in years to come.
Tractors-as-a-Service?
If you watch the markets closely enough, you’ll see that the so-called “boomer stocks” – the blue chips that don’t hog the headlines – can also be rather exciting. Deere & Co saw the share price drop all the way down to around $355 as recently as February, before executing an almighty rally to $410 per share.
That’s a casual 15.5% return in a matter of six weeks!
Trying to predict these types of rallies is incredibly difficult. You would have to be watching stocks extremely closely to recognise these patterns and act on them. Even then, you would need a lot of luck.
In theory, it’s possible. In practice, it’s difficult.
What the move does tell us though is that Deere & Co has some pretty strong share price support at the $360 level, having tested that level a few times in the past year. The question now is whether it can push higher to the 52-week high of $450 – and beyond. If it does roll over for some reason and get back down into the $300s, then keep your eyes peeled for an opportunity to tactically buy that bounce.
Why? Because the good news here is that Deere & Co is doing the right things for long-term growth, so looking out for tactical entry points in a buying strategy isn’t a bad idea.
Hardware and software: copying Apple
Internet-of-Things is relevant to any assessment of Deere & Co. The company focuses on being at the forefront of technology in industries like agriculture and forestry, which means a wonderful opportunity to bring in annuitised revenue in the form of software subscriptions for services related to the hardware. This leads to a really fun metric that you won’t see anywhere else: the number of Highly Engaged Acres! Yes, a measure of farmland on which the software services are being used.
If this hardware-software combination sounds familiar to you, that’s because you’ve seen this movie play out at Apple before. When there is significant base of installed devices and the ability to sell value-added services to the owners of those devices, there’s a golden opportunity to ramp up margins and create a smoother revenue profile. Deere & Co certainly isn’t blind to this, with opportunities to offer customers real-time data insights and other technological benefits designed to improve efficiencies in commercial farming.
They call this a “smart industrial journey” and smart is the word indeed. Sales guidance for 2024 is roughly in line with what they achieved in 2022, yet the net income forecast implies at least $400 million more in profit than in 2022 off the same revenue base. This is a meaningful change in the business, driven by customers being willing to pay a premium price for tech-heavy products that are differentiated from the competition.
Of course, better margins tend to mean higher valuation multiples as well!
One of the challenges in executing this strategy is the remote nature of the work being done by the machines. For example, 70% of Brazil’s productive area does not have access to connectivity. This does no favours for the smart strategy, so Deere & Co entered into an agreement with SpaceX to provide satellite connectivity for customers. And before you think it’s only an emerging market problem that they need to solve here, the estimate is that 30% of farmland in the US also doesn’t have connectivity!
These things take time
As lovely as the strategy is, it takes a long time for an initiative like annuitised service revenue to really make a difference to the numbers. At its core, Deere & Co remains a cyclical enterprise. Sales rise and fall with agricultural commodity prices in the case of the Production and Precision Ag segment, or general levels of consumer spending in Small Ag and Turf. Those segments suffered a drop in revenue of 7% and 19% respectively in the latest quarter.
In both cases, price increases were low single digits, so there was a significant drop in volumes. Generally speaking, a decrease in volumes is the danger zone for manufacturing entities, as operating margins inevitably drop as well due to manufacturing inefficiencies that creep in at lower levels of production. Indeed, both those segments saw pressure on operating margin, although both remain lucrative.
The market hated the agriculture outlook
The substantial drop in the share price in February was driven by worrying guidance released by the company. If you though the cyclicality was evident in the most recent quarter, just wait until you see the outlook for the new financial year.
In the US and Canada, they expect a decline of between 10% and 15% in large agricultural equipment sales and a 5% to 10% decline in smaller equipment. This is being driven by normalised demand patterns. In Europe, a drop of 10% to 15% is anticipated, with Central and Eastern European market continuing to be disrupted by the war in Ukraine. South America is also expected to see a double-digit decrease, with current weather patterns in Brazil as a particular source of concern.
Those numbers are industry outlooks. For Deere & Co specifically, the company expects net sales in Production and Precision Ag to be down by a rather nasty 20%. Still, operating margin is expected to be between 21.5% and 22.5%, so the company is perfectly capable of making decent profits even at lower levels of production. The Small Ag and Turf segment is expected to see sales down between 10% and 15%, with operating margin between 15% and 16%. It’s interesting to note that the margins are structurally much higher in the more advanced machinery, which makes sense when you think about it.
Benefits of diversification
We shouldn’t forget the Construction and Forestry segment, which contributed around 26% of revenue in the latest quarter. Although these are certainly cyclical industries as well, they tend to have different drivers to the agriculture side of the business. For example, one of the underpins here is government spending on infrastructure, which is a world far away from rainfall patterns and crop yields.
Revenue was flat in this quarter and they expect sales to be down by between 5% and 10% for the new year, with global forestry markets as the major expected drag. Although that’s also a decrease, it’s not as severe as the expectations in the agriculture business.
What does the future hold?
Despite the cyclical nature of the business and the disappointing outlook for the 2024 financial year, a decision to invest in Deere & Co is longer term in nature. That’s certainly how the company thinks, with numerous targets shared with the market for 2026 and 2030. For example, the target is to connect 1.5 million machines by 2026. They are also working hard on automation, with the goal of delivering a fully autonomous, battery-powered electric tractor to the market by that year as well. By 2030, the hope is that recurring revenue will be 10% of enterprise revenue. This would do good things for operating margins, as we know that software margins are vastly higher than hardware margins.
Still, a target of “only” 10% is also a reminder that a shift in business model takes a long time to execute. It’s also never guaranteed.
What does the valuation tell us?
You need to be careful with valuation multiples when profit is forecast to fall. The forward multiple (based on next year’s profit) is higher than the trailing multiple (based on the last twelve months) in this situation, which can make the company look artificially “cheap” if you only consider trailing multiples.
This chart from TIKR shows when the trailing multiple was higher than the forward multiple (in the purple circle), which means that profits were growing quickly. The red circle shows the opposite situation, with the trailing multiple below the forward multiple:
The trailing multiple (blue line) currently looks “cheap” based on the last five years, sitting well below the average over that period (currently 10.7x EV/EBITDA vs. the average of 16.5x). This is a terribly misleading metric when profits are falling. The black line (forward EV/EBITDA) is the one to look at, currently at 15.8x vs. the five-year average of 16.2x. This suggests that the recent rally in the share price has taken the multiple far closer to the average.
A share price return is a function of earnings and what the company is willing to pay for those earnings. If a multiple is trading in line with its historical averages and will stay there, then the share price return will be in line with earnings growth. Where the multiple moves higher or lower over time, it significantly impacts the share price returns.
So, what can we learn from this?
I do not currently hold Deere & Co in my portfolio. Having said that, the long-term share price compound annual growth rate (CAGR) is interesting enough that I would strongly consider it, particularly with the direction that the company is taking in coming years. I would just prefer to see a correction in the share price first, particularly given how range-bound it has been in recent years and how sharply it has recently moved to the top of that range:
For all the reasons given above, this is one for my watchlist. I want to own it. I just don’t want to pay this price for it.
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