Deere & Company (“Deere”) (Ticker:DE) manufactures and distributes various equipment worldwide. The company operates through four segments: Production and Precision Agriculture, Small Agriculture and Turf, Construction and Forestry, and Financial Services. Deere offers an extremely wide range of products and machines that range from all-purpose farming machinery, such as tractors and harvesting equipment, to golf course maintenance equipment, all the way to individual lawn and garden turf equipment. Their construction and forestry products include backhoes, pavers, log harvesters, and much, much, more. Chances are if you see a large piece of machinery in a field or worksite, Deere either made or makes it. Their financial segment offers financing and leasing agreements for their products.
At the time of writing, Deere’s market capitalization is about $123.89 billion and its revenue and free cash flows for the 2021 fiscal year were $44 billion and $7.24 billion, respectively. Currently trading at $403.57, the stock has hit a 52-week low of $320.50 and a 52-week high of $446.76. At today’s price of $403.57, is Deere’s stock undervalued?
To start, when trying to determine a company like Deere’s intrinsic value, which has a history of mostly consistent growth, the first thing you might consider would be to determine its debt-to-equity ratio.
Buffett says that ideally, we should try and find companies that have a debt-to-equity ratio of .5 or lower. When we find Deere has a 2.66 debt to equity ratio as of Q1 2022 (2.66 dollars of debt to every 1 dollar of equity) then you might think to look for other companies that have a better debt to equity ratio as a potential investment, and you wouldn’t be wrong to do so. However, there are a few different reasons I didn’t turn away immediately when noticing Deere has such a high D/E ratio.
Firstly, and potentially most importantly, with companies who hold high debt, it’s best to find their current ratio, which is an indicator that a company can pay off its current debt with its current equity. Buffett likes his company’s current ratios to be above 1.5 and Deere has an excellent 2.25 current ratio.
I wanted to make sure this wasn’t a fluke and decided to dig in further, dating back 10 years, and found the average current ratio over those 10 years was 2.11, never once going below a 1.92. So, while Deere does have a high D/E ratio, its ability to manage its equity and pay its debts, as shown by the high current ratio over 10 years, gives me the confidence that the company has vigilant leadership. Still, I found myself wondering, with such a high debt to equity, does it even require further investigation, or should I just move on and find all the many other companies who don’t have these levels of debt?
When contemplating this, we must keep in mind that different industries use different instruments to finance growth. As I mentioned at the beginning of this article, Deere has four different segments of its business, Production and Precision Agriculture, Small Agriculture and Turf, Construction and Forestry, and Financial Services. I’ll come back to that in a moment, but let’s first look at the industries which typically use debt as an instrument to facilitate growth to see if it’s worth it to determine if we should further investigate Deere’s intrinsic value.
First and foremost, the Financial Sector. This is a sector that is very well known for high D/E ratios. Financial institutions such as JP Morgan Chase & Bank of America (a company, Buffett himself holds) currently sit with D/E ratios of 2.25 and 2.11 respectively. As these are much closer to Deere’s 2.66 D/E ratio, we can assume that because of how these businesses use debt to finance growth, it isn’t a clear and present danger to Deere, and shows they’re navigating the financial segment of their operations quite successfully. Typically, when evaluating a company in the financial sector, you hardly, if ever, use a D/E ratio simply because it’s how companies in this sector must operate.
Moving on to the Industrial Goods Sector. This sector encompasses a wide range of industries ranging from defense and aerospace to farm and construction machinery. This sector is commonly understood as a capital-intensive industry where companies often leverage high debt to manufacture growth because of the cost that goes into the manufacturing taking place. Deere, for example, has manufacturing facilities in Brazil, Germany, Argentina, Finland, France, India, Mexico, the Netherlands, and China. This diversity in manufacturing facilities is in large part because of the difficulty and high cost to ship large machinery, but no doubt indicates that Deere has another business segment, and a large one at that, in a high debt sector.
Typically, a 2.66 D/E ratio wouldn’t require any further investigation into a company’s intrinsic value, but because of the two reasons mentioned above, I’ve decided to continue digging to determine if there is potentially hidden value in this company. A company that, I’ll remind you, started its innovative journey by inventing the first steel plows in America and continues its innovation, today, by investing in technologies such as 5G, automation, AI, drones, green energy, and more.
At first glance, you would likely consider an almost 200-year-old company, like Deere, to be mature by nature. One where a Buffett-style valuation would be the most logical. However, after calculating the average change in book value for the past 10 years, we notice that Deere is pushing up towards the growth territory with a 14.69% annualized change in book value.
After determining the Buffett-style intrinsic value of the company, the initial assumption would have been correct. Deere, with its high D/E ratio, is vastly overvalued based on its current market price at the time of this writing, at $403 with an intrinsic value of $205. However, it is important to understand that because of the high annualized change in its book value for the previous 10 years, being that of 14.69%, it indicates that although Deere is an older, more mature company, they’re effectively using their large amounts of debt and free cash flow (FCF) to successfully manufacture sustained growth.
Enter Discounted Cash Flow
After calculating its recent 10-year growth in book value, I decided to calculate Deere’s intrinsic value using a different method, the DCF method. A discounted cash flow (DCF) model, instead of Buffett’s approach, is likely the better model to predict the kind of growth we are currently seeing at Deere.
To calculate this model, the first thing I did was annualize Deere’s growth in Free Cash Flows year over year for the past 10 years. This came out to be an incredible 71% YOY annualized growth. I will caution that this was not stabilized YOY growth, drawing back one year as much as -66%, and another year as much as -50%, and although inconsistency makes predictions less accurate, I wanted to include as much data as possible to better understand where the company will be in 10 years.
One important thing to note is that Deere typically uses its cashflows to reinvest in the business, whether that be through acquisition or expanding the range of services and products it offers. In 2012 they had free cash flows of -154 million, with their most recent year-end free cash flows at 7.2 billion. More recently, however, their trailing twelve-month (TTM) FCFs were 4.4 billion, which, when included, took the 71% FCF growth over the previous 10-year period and brought it down to an equally impressive 59% annualized growth.
What does all this mean? Based on Deere’s sometimes inconsistent Free Cash Flows, it’s difficult to predict with a high degree of certainty, where their FCFs will be in 10 years.
Having said this, you’ll notice the trendline above indicates a steady increase over such a large period. Outside potentially a year or two where they might have a slump in their Free Cash Flows, the overall trend when combined with their average 2.11 current ratio over the same 10-year period (which indicates their cash flow and debts are well managed) allows us to safely predict their overall Cash Flows will move in a positive direction over the next 10 years.
All things considered; I’ve decided to evaluate Deere on two levels because of the inconsistency in their cash flows. I’ve gone ahead and created a conservative model in addition to what I believe will be the most likely scenario for Deere over the next 10 years, the latter of which is the first model we will cover.
To explain further, for the first DCF model, I gave Deere a growth rate on the Upper Band (best case) of 35% growth (I cut their previous 10-year FCF annualized growth rate in half) with a 5% chance of that actually occurring. I thought it prudent to keep this estimate on the larger end primarily because their FCF did increase from -154 million to most recently 4.4 billion, however, I wanted to be realistic and conservative in my assumptions, which is why I cut the previous 10-year FCF growth in half.
I then used Buffett’s Intrinsic Value Calculator, which as previously mentioned, gave Deere an average book value growth rate of 14.7% (conservatively rounding down to 14% for the model), which I believe to be an accurate forecast of Deere’s 10-year growth. I included it as the most likely scenario with a 50% likelihood of occurring. Lastly, I put a 45% chance Deere only grows at 5% per year for the lower end of the estimate. This gave me, at the current price of $403.57, a 12% Annual Expected Rate of Return.
Next, for my conservative model, I decided to adjust the starting point in the DCF model to the TTM free cash flows which were 4427 million. I then adjusted the UB to 15%, assuming the previous 10-year book value growth was the best case and assumed that had a 15% likelihood of happening.
For the most likely scenario, I assumed Deere would only grow at today’s current inflation rate of 8%, with a 50% likelihood of that happening, followed by a 3% growth rate, and a 35% likelihood. You might be thinking to yourself, this doesn’t seem very conservative. However, I don’t see the services and products Deere provides going away and the world will no doubt continue to need food, build infrastructure, and obtain commodities, all while Deere continues to prove it is a cutting-edge company.
This estimate, as you can see in the chart below, gave us a 4.7% IRR, which sits right above the Simple Expected Yield for the S&P 500 at 2.97% for the same period, and above the 10-Year Treasury Yield of 2.9%.
The beauty of TIP’s Finance Tool, which I am using for the DCF models as depicted in the last two charts, is that with a company like Deere and all the data we have on them for the previous 10 years, it gives us a much clearer picture on our assumptions of how the business will continue to perform in the future. This, of course, should go without saying that any previous results will not be indicative of a company’s future earnings or profits.
Something I like to look at, which I find important and helpful when determining a company’s future, is the consistency of a company’s Earnings per Share (EPS), as well as expected future EPS. On the chart below, you see the previous 10-year EPS in addition to expected future EPS (reflected in green).
By no means is this a steady increase, it does, however, indicate that expected future EPS is in line with how the company is currently growing, which also gives me more confidence in the DCF models above. Understanding that, let’s go ahead and dive in a bit deeper on what exactly Deere’s future may look like based on its current business operations.
Deere’s Competitive Advantages and Opportunities
We’re going to break down what exactly gives Deere its advantage moving into the next 10 years, and beyond, and specifically how it’s positioning itself from an innovative standpoint. This will be broken down into three major categories.
Technology. Deere is no newbie to the technology space, having acquired back in the 90’s the GPS startup NavCom, they built a satellite guidance system for their equipment that was state of the art, accurate within a few centimeters back in 2003. Eventually partnering with NASA, the two developed the very first internet-based GPS tracking system, enabling farmers the ability to use self-driving tractors for more than a decade. More recently, Deere announced in the 4th quarter of 2021 that they acquired Kreisel Electric, an acquisition expected to speed up the completion of their entirely electric and autonomous tractor prototype that was initially launched in 2016. Farmers this year will also have the ability to buy a fully functional tractor capable of plowing 24 hours a day..and night.
Even without Deere planning on cultivating mars sometime soon and partnering with the Musk’s of the world (attempting to break into Astro-agriculture) their technology segment, including 5G, precision innovations, partnerships with companies like Volocopter (which broke Deere into the drone space), will continue to improve. Thus, enabling the agricultural, construction, and forestry industries access to their continuously innovative cutting-edge technologies.
International Exposure. As mentioned earlier, Deere is a global presence with a physical location of some sort on all six habitable continents. Growth is expected to continue in places all around the world, even if we consider on a macro level what is happening with the war in Ukraine, one of the largest grain producers in the world. This could additionally be included in the risk column (something I discuss below) however, because of Russia’s actions, we are seeing a major change with European countries attempting to shift away from purchasing anything Russian. Abandoning Russian farming and machinery equipment is an easy shift, considering Deere is already in Europe’s front yard, with manufacturing locations in Germany, Finland, France, and the Netherlands. While there might be issues in Ukraine for Deere to deliver replacement parts and products in the near term, this is exactly the reason that in the long term, once they’ve taken a larger share of the European market away from Russian manufacturers, Deere will benefit by having a “sticky” product.
Software. Deere is a company that has long understood the importance of software and how it will play a part in its future. With autonomy and robotics, their software is so valuable and complex that anyone needing to fix Deere’s Equipment must call a Deere dealer to come out and fix that piece of equipment, hence the “sticky” product. If this trend continues, with the adoption of even more complex technology and high-level analytics that farmers can use to better survey their land, then a SaaS business model pairs quite nicely for ensuring customer satisfaction. In addition, it will also improve shareholder satisfaction considering it would help stabilize future cash flows. With the improvements in their software, the ability to fix customer breakdowns remotely with software updates, and the increasing need for Deere dealers to be the ones who service their autonomous equipment, Deere has a serious competitive advantage it has been carving out for itself over the last few decades.
I want to quickly highlight how Deere and the services and products it provides will benefit or suffer in the near term depending on certain global events. To start, if we are to enter an environment of rising commodity prices, this will have a positive ripple effect on all segments of Deere’s business. On the most recent sales call at the time of this writing, Brent Norwood, Manager of Investor Relations, says he sees 5-10% growth in the next year in regions such as South America and Europe as commodity prices increase.
If we take one more step back, and look at a 30-year horizon, as Buffett would invite us to do, we see that food and infrastructure are not going anywhere. According to The World Bank Group, the population is expected to hit 9.7 billion people by 2050. If we assume longer life expectancy, and a less, albeit still impactful, potential shift in diets, as more people are deciding not to eat meat, agriculture will continue to be an important and growing industry for the foreseeable future, especially when considering Agricultural Development is one of the most important pieces to end poverty.
As we see the gradual rise out of poverty from developing countries around the world and as they then transition into “developed country status”, Deere and all its products and services, including specifically construction machinery and farming, will be right there innovating along the way.