Global Portfolio Update – A new holding : Deere & Co

We have followed the company for many years, but the cyclicality of the business previously deterred us. So what has changed that makes us more comfortable with a holding in Deere?

John Deere is the global number one manufacturer of farm equipment.  They are at the forefront of innovation and automation.  We have followed the company for many years, but the cyclicality of the business previously deterred us.  So what has changed that makes us more comfortable with a holding in Deere?

The biggest component is management shifting the business model more towards software, automation and AI.  As the revenue split between hardware and software sales tilts toward the latter, the revenue profile will become less cyclical and margins are expected to increase.  The recent acquisition of Bear Flag follows this path.  Bear Flag offers autonomous kit for retro fitting: e.g. sprayers that can run from algorithms from the IT cloud which uses data collection from targeted counties, states and countries.  These algorithms calculate the exact amount of spray needed per square metre and applies it accordingly.  There is no need for the farmer to be in the field anymore.

While Deere has pushed the technological advances greatly in recent years, with 5% of sales invested in R&D, the big difference is their focus on data collection and consequent application calculations which in turn will be executed by autonomous equipment.  For the farmers it has the advantage of reducing the need for labour, while at the same time having access to the most up to date data for their fields.  For Deere, the recurring revenue from subscriptions to the data service will become a growing part of the company’s sales line.  While software revenue is seen as non-cyclical, it could even be considered to be anti-cyclical: if the weather gets more extreme or underlying crop prices more volatile, farmers will want to adjust their crop treatment immediately and rely even more on external data.

The shift to a less cyclical company won’t happen overnight and we might not see the proof in the numbers for a few years yet.  In the meantime Deere is experiencing one of the best trading environments in decades:

  • Farmers are currently in a strong financial position after benefiting from Covid related subsidies and are experiencing high soft commodity prices.
  • The age of fleet is the oldest it has ever been and management see a multi-year replacement cycle. This follows 3 years of uncertainty for farmers when capex was cut to the bare minimum and even the enormous amount of government aid didn’t spur equipment demand. This is reflected in the order book which is the strongest in years, as demand outstrips supply well into next year and supports increased top line growth for the next 2-3 years.
  • It also feeds through to elevated prices in the secondary market, which in turn helps Deere’s pricing on new equipment (similar to what we see in the auto industry).
  • A change in strategy in 2018 which emphasised operating performance within executive compensation shifted the margin profile to a higher sustainable level.

Looking at the medium-term, we see multiple tailwinds promoting growth drivers for the core business, such as:

  • growing demand for high-capacity machinery globally
  • increasing labour costs in developed countries leading to more automation
  • more demand for self-propelled machines globally
  • focus on productivity to maximise ROI from agriculture in Asian countries
  • improved availability of credit in Asian countries

When we revisited our Deere template we were surprised that despite a recent rally from 2020 lows the shares were still offering value at 16x 2022 PE and a Y5 valuation of just 11x based on our conservative forecast.  We can see double digit earnings and dividend growth for the next 5 years, while an improving ROIC profile and increased revenue stream from software should lead to a revaluation of the shares. We believe their prospects are not fully reflected in the current share price.

We initiated a position during November.

Deere’s share price vs. consensus estimates

Source: Refinitiv Datastream

 

Deere’s share price in black has recovered strongly from 2020 lows as have consensus EPS estimates 1Y and 2 Y forward (above).  Consequently, the PE Y1 and PE Y2 spiked in 2020 but fell back to more reasonable levels in the recent past (below).

Deere Valuation

Source: Refinitiv Datastream

 Deere ROIC

Source: Refinitiv Datastream

Deere’s ROIC has already seen a strong improvement after the new strategy was implemented in 2018. Going forward, we would expect to see further expansion in ROIC.

 

 

 

Graham Campbell (graham@saracenfundmanagers.com)

Bettina Edmondston (bettina@saracenfundmangers.com)

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