Deere - Fairly Valued In A Challenging Environment

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Summary

John Deere (DE) finally seemed to be having its act together as the company was on the verge of repeating its 2013 peak results, at least in terms of sales, not necessarily earnings yet, as margins were slightly higher at the time.

Coming out of the financial crisis John Deere generated peak equipment revenues of $35 billion in 2013 on which the company reported operating earnings of $5.8 billion. What followed was a fierce and deep correction in its end markets with sales falling to less than $24 billion in 2016, as the company still managed to report over $2.3 billion in operating earnings that year.

This was followed by a recovery which pushed equipment sales although margins have been lagging compared to the 2013 peak, albeit aided by a significant deal for Wirtgen. While lower margins are a concern, a dramatically reduced share count and lower taxes all help on the bottom line.

The Business

In the discussion above, the sales numbers focus on the equipment side of the business, making up the majority of sales. The core of the business is agriculture and turf, as this segment posted a 2% increase in sales last year to $23.7 billion, with construction and forestry sales up 10% to $11.2 billion. These equipment sales are accompanied by a $3.6 billion financial service unit.

With the company posting net earnings in excess of $3.2 billion last year, earnings topped $10 per share, and with shares starting the year around the $175 mark, this translates into a market multiple. The balance sheet is always a bit tricky as the equity position is reduced by continued share buybacks above the intrinsic value, as the company is not just an equipment manufacturer, yet a bank as well, renting out equipment to many farmers across the globe.

Based on cash holdings and debt, net debt stood at $40.9 billion and that even excludes nearly $6 billion in pension related liabilities. However, if we look at the asset side, the company holds $33.6 billion in financing receivables as well as $7.6 billion in equipment on operating leases, and if these are included, net debt is virtually non-existing (excluding pension liabilities). Nonetheless, the huge financing operation does pose a risk, even as the company has a great track record in managing these receivables.

The company did not guide for a great 2020, citing real headwinds. CEO John May cited trade tensions, as well as difficult growing and harvesting conditions, making farmers reluctant to buy new equipment. Furthermore, the company incurred some losses from operate lease constructions, as a result seeing 2020 earnings at $2.7-$3.1 billion, down quite a bit from the $3.25 billion reported in 2019.

The Expectation Game

With expectation downs a bit for 2020 before the year began, and shares trading at a market multiples based on trailing earnings, it is no surprise to see some weakness emerging in the shares this year. Shares actually plunged in line with the market to a low of $110 in March before now rebounding and settling around the +$140 mark.

This came after the company reported second quarter results in May, based on the quarter which ended early May and thus included about two months of Covid-19 impact.

First quarter results were already a bit soft, although that was not surprising given the outlook. Revenues for the first quarter were down about 4%, with earnings up slightly, only thanks to a lower tax rate, as the company reiterated the full year guidance. Second quarter results have been particularly weak, reflecting the impact of the Covid-19 crisis with sales down 18%, and equipment sales down 20% due to big declines in both the main segments. This has a big impact on margins as net earnings fell more than 40% to $666 million, to $2.11 per share in what normally is a stronger seasonal quarter.

As a result of this the company cut the full year earnings guidance by $1.1 billion to $1.6-$2.0 billion, with earnings more or less seen between $5 and $6 and change in earnings per share. Further, it is a bit disappointing to see net debt still at $40.6 billion although still around the flat line, if this is offset by financing receivables and operating assets being on lease.

With provisions on credit losses amounting to about a hundred million a quarter, which actually looks quite modest, the financial service unit is already on the verge of breaking-even and close to report losses, which is disappointing. This is recognized the by company with the financial service unit posting negative shareholder value-added as no, or very limited earnings power does not create for a compelling risk-reward. This of course stems from a more than thirty billion credit book being apparent on the asset side of the balance sheet.

This has always been a concern of mine, one way or the other. The company is essentially its own bank and while this certainly helps to boost equipment sales, the question is if the financial service unit is as strict or fair as the market and is not subsidizing the equipment unit. If this is not the case, farmers might just as easily go to regular banks.

While there is some sort of conflict here, the counter argument can be made as well. Deere knows its client like no other and the track record of the financial unit is actually quite good. Charge-offs on loans originated by Deere have come in below 1% per annum in each of the years over the past two decades, better than commercial banks over the same period of time.

Some Thoughts

Compared to some peers, notably AGCO, CNH and Kubota, Deere has been performing incredibly well over the past two decades. While it is still is a cyclical business, it used to have much more exposure to the cycle in the past, as the adoption of the EVA (economic value added) model has really made a great difference for investors.

I furthermore like the long term demographic trends and the fact hat Deere is betting heavily on precision technologies and electrification/robotification of equipment, benefiting from adverse demographic trends in terms of the farmer population.

In November 2018 I concluded the quality is paying off in the long run. Shares traded at similar levels as they do today as I recognized stable sales and earnings trends, as well as a well-timed purchase of Wirtgen at the time.

At the time I noted that the company was basically earning $10-11 per share, what has become reality in 2019. This was based on operating margins seen around 12%, as I noted that the company was enjoying relatively good times at the moment, not too outrageous however.

Using an estimated 10% margin throughout the cycle, which worked down to a $9 per share number, valuations look reasonable at around $150, making that I was constructive on the shares, yet not actively adding to the shares trading around fair value.

Fast forwarding in time, shares are down a bit, yet of course the outlook for the current year reveals dismal earnings per share, as this reduced earnings power and challenges of the financial service unit make me a bit cautious.

For all these reasons I still feel that shares trade around fair value and while I remain constructive on the long run potential of the company and its shares, I am not actively seeing a reason to initiate position here, although Deere has been and excellent steward of capital over the past two decades following the adoption of the EVA concept, executed with real discipline and actions, not just words.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.