Deere: Cultivating Technology
A deep dive into a good business that is getting better
You can read the PDF version of this deep dive here.
Hello and welcome to Best Anchor Stocks,
I thought it would be a good idea to release one of my deep dives to the public so you can get a sense of the type of content I share behind the paywall at Best Anchor Stocks. Deere is the last company I added to my portfolio, and thus it remains quite relevant. Note that the Deep Dive you will be reading here is not organized in exactly the same way I organize it for Best Anchor Stocks subscribers. For these I typically break down the deep dive into 5 or 6 articles, although the content you’ll read here is exactly the same that was contained in those 6 articles.
This is the outline for this deep dive:
Section 0 brings a brief introduction and a short investment thesis.
Section 1 will discuss the company’s long history and what it does.
Section 2 will dissect the financials and growth drivers. The financials are very misleading for Deere unless one puts in the extra work. You should be able to understand why once you read this section.
Section 3 goes over the competition, the moat, and the risks for the company. These are three key topics for any company, especially when looked at through the lens of a long term investor.
Section 4 will discuss yet another three key topics: management and incentives, capital allocation, and valuation. Just like the financials, capital allocation is a somewhat misleading topic for Deere as the consolidated number misses the inherent return profile of the company’s equipment business.
Section 5 will bring my thoughts on cyclicality and where the company stands today.
Finally, section 6 will go over how Deere complies with the Best Anchor Stock traits. These traits help me adhere to my investing philosophy and therefore are very important in my process to make me stay within my guidelines.
Without further ado, let’s get on with the deep dive.
Section 0: Introduction and the short investment thesis
In the past, we would rely on planting more acres, increasing horsepower, and applying more nutrients. In short, we could always do more with more. However, today, in agriculture, we must do more with less, and our ambition at John Deere is to help our customers do exactly that.
John May, John Deere’s CEO, during the most recent Investor Day
I imagine you might be familiar with Deere’s most recognizable brand and somewhat familiar with what the company does…
I researched Deere for a couple of months and ended up growing comfortable with the investment thesis, which can be briefly summarized in the following characteristics:
Low probability of permanent loss of capital over the long term
A very decent probability of earning a double-digit return long-term
Upside optionality from technology and multiple expansion (not counting on this for the thesis, but it can potentially amplify the returns)
At first sight, Deere might seem like a low-growth, boring company, but the company is currently in the midst of a transition that will not only bring faster growth but also a transition to higher quality and more recurring profits. You’ll hopefully understand what I mean by the end of this deep dive.
Before going right into the company’s history, here are some basic facts about Deere:
Before jumping right into the company’s history I thought it would be a good idea to share my short investment thesis, which will be then outlined in more detail throughout the deep dive.
1. Deere is becoming a better business
Deere is transitioning from just selling equipment, maintenance, and parts to selling solutions that will be monetized through a recurring revenue model. This will have a profound impact on the company’s quality and cyclicality:
We are confident in our ability to produce higher levels of returns through the cycle while dampening the variability in our performance over time. This will lead to higher highs and higher lows for our business.
Josh Jepsen, Deere’s CFO during the 2023 call
2. A durable and growing business
Few things are more durable than feeding the population, and I believe most of Deere’s industries will enjoy long-term secular tailwinds. Deere has been around for almost 200 years, and I don’t foresee a scenario where the company is not with us for much longer. In my opinion, the company has a high terminal value and is poised to benefit from the technological trend thanks to its installed base.
3. A very strong moat and an aligned management team
Deere has a very strong moat (explained later) and an aligned management team (also explained later). These characteristics significantly reduce the variability of future outcomes and terminal risks. It’s a sleepwell investment for me, irrespective of the cycle.
4. A reasonable valuation
Deere is a cyclical company, which makes valuation a dangerous topic. Cyclicals tend to appear cheap at cycle peaks and expensive at cycles throughs, and Deere right now looks optically cheap. The company is currently trading at a forward PE of 14, and a trailing PE of 11 as sales and profits will most likely drop this year:
Source: Finchat.io (you can get yourself a 15% discount using this link)
Shouldn’t this be a warning sign for a cyclical? The short answer is yes, but I would also caution against looking at prior cycles to judge valuation. Several reasons behind my reasoning:
Deere will remain more profitable through the current cycle than in any cycle in the past, meaning that past multiples are misleading as the company should, in theory, command higher multiples today.
Management argues that after this year’s drop, the company will be trading around mid-cycle earnings, meaning that the company might be trading at a normalized PE multiple of 14 times, which does not seem expensive at all.
Management has guided to $5.5 billion in Free Cash Flow this year. If this is mid-cycle, the stock is currently trading at a 5.5% normalized FCF yield, which is not expensive. We can see that a double-digit return is doable if we add the expected FCF growth rate to this normalized FCF yield (to calculate our expected returns).
Let’s say Deere grows its revenue at a 3-5% CAGR through the cycle (1-3% tends to come from pricing). This doesn’t strike me as optimistic, considering the company achieved a 5% CAGR from peak (2013) to peak (2023) in the prior cycle. To this, we have to add the margin expansion the company will enjoy from pricing and technology, meaning it might grow its earnings at around a 5%-7% CAGR through the cycle. If we add this growth rate to the current cash flow yield, we get an annual return of around 10.5% to 12.5%.
This return would be achieved being conservative and without counting on multiple expansion, which can be a part of the equation as the company’s transition will make it a better business. I don’t know what the current cycle will bring, but I do believe Deere is fairly valued if we take a long-term view. Should the market punish the company for a worse-than-expected cycle I would most likely take advantage of it, which could also amplify these returns.
Without further ado, let’s jump right into the deep dive.
Section 1: History and what the company does
Ironically or not, Deere was founded in 1837, precisely the same year as Hermes, the oldest company in my portfolio. This makes Deere the oldest company in the portfolio together with the French luxury house, something that should be considered a mere coincidence (but an interesting one nonetheless). Their founding year is probably one of the few things these companies have in common, which portrays one of the things I like the most about investing: excellent companies and investments can be found in widely different industries operating under widely different business models. In short, quality can take many shapes and forms.
Deere was founded in 1837 in Illinois by blacksmith John Deere, with the company still bearing his name to date. Worth noting is that Deere is very proud of its heritage, which has served as the bedrock of its values, culture, and how the company views its relationships with its customers. Proof of this is the fact that the headquarters are still located in Molines, Illinois, the place where John Deere decided to establish the company in 1848.
The first product John Deere ever commercialized was a steel plow. Plows existed back then, but they were typically made of cast iron. This material brought a significant problem to farmers: the soil in Illinois was characterized by its stickiness, so farmers had to spend quite a bit of time cleaning the soil of their plows every couple of feet. John Deere did not invent the plow, but he came up with one that enabled higher productivity. The steel plow gathered a lot of attention from farmers:
Many cite John Deere’s invention of the steel plow as the beginning of a revolution in America’s farmland, and for good reason. The product was a commercial success, soon selling 2,000 units a year. It also underscored what Deere remains focused on even to this day: making farmers more productive and, therefore, more profitable.
It was not until 80 years after its founding (1918) that Deere would enter the market it is known for today: the “heavy” equipment market. The company launched two tractor models that year, although once again, it built off the innovations of others. Those years were characterized by the arrival of mechanization to American farmlands, and just like Hermes (that diversified away from horse accessories due to the arrival of the car), Deere had to reinvent itself to adapt to the shift away from horses (maybe these companies have more in common than we think!). The company tried, at first, to develop its own tractor model but ended up capitulating and buying the Waterloo Gasoline Engine Company, famous for the production of the ‘Waterloo Boy’:
The company gathered expertise from this acquisition and decided to manufacture tractors under its own brand. Deere launched the Model B tractor, which remained a best-selling tractor for 15 years:
Deere then embarked on several decades of innovations through which the company improved existing products and launched new ones, all with the same objective of increasing farmer productivity and profitability.
Especially of note was Deere’s transition to more powerful equipment throughout the 20th century. Farmer needs were shifting as the population grew, requiring more powerful equipment; Deere delivered. The company showcased its “New Generation of Power” in 1960 to many dealers and farmers worldwide. The event gathered a lot of attention and kickstarted a new era in the company’s history:
Power kept the company busy for the next 4 decades, but the arrival of technology at the end of the century marked yet another revolution inside the company. Deere acquired Navcom in 1999, a pioneer in GPS technology. The company soon started deploying this technology across its machinery. From that moment on, technology became a focus for Deere, a venture in which it continues to invest heavily to this day.
The company focused its efforts on improved equipment and technology for a great part of this century, but 2017 also brought a significant event: the acquisition of the Wirtgen Group. Deere purchased Wirtgen for $5.2 billion, its largest acquisition ever by a considerable margin. The acquisition provided Deere with a stronghold in the construction machinery market, more specifically in road construction, a segment where Wirtgen was a world leader.
This niche market enjoys significant synergies with agricultural equipment (both in manufacturing and technology) and is also expected to enjoy strong tailwinds (more on this in section 2).
What should stand out from Deere’s history (and what also makes it somewhat comparable to Hermes) is that despite the ebbs and flows in its operations and industries, the company's core has never changed. This was partly facilitated by the Deere family, who ran the company for most of the 20th century. The family is no longer involved but managed to build a culture that has endured across many CEO tenures. Key here has been the company’s policy in leadership continuity (something that I’ll discuss more in-depth in another section).
Deere remains focused on making farmers (and other customers) more productive; the only difference is it now targets increases in productivity through technology rather than materials and power. The times have changed, but Deere’s core has not. As Deere’s former CEO Hans Becherer rightly pointed out…
This company is bigger than all of us. We just want to effectively pass it from one generation to the next.
As you’ll discover throughout the deep dive, “longevity” and “generation” are two essential words for the company and its customers.
What Deere does
So, what does Deere do? I’ll try to simplify it as much as possible so that it’s understandable, although I think the company is not very complex. At its core, Deere manufactures heavy and semi-heavy equipment for the agriculture, construction, and forestry industries.
The company operates across four segments, three of which comprise its equipment operations, with the other offering financial “support” to these:
Before digging deeper into these segments, I would like to outline several commonalities across the company’s equipment operations. Firstly, they all have a cyclical (to a greater or lesser extent) component of equipment sales. These equipment sales are complemented by a maintenance, service, and parts component, which can be considered somewhat recurring (although not all the segments are exposed to this recurring source to the same degree). AGCO, one of Deere’s competitors, has never had a down year in service and parts, which speaks greatly to its resilience. Thanks to technology, Deere (and the industry as a whole) is transitioning into a predictive maintenance model that diminishes downtime. Downtime minimization is especially crucial in agriculture as most of the profits are generated in relatively short periods when the equipment must operate at its full potential.
Unfortunately, management does not disclose what portion of equipment operations sales comes from equipment sales and how much comes from recurring revenue sources. Still, they expect the recurring part to make up around 40% of the business by the decade's end.
Secondly, most of the company’s equipment operations are supported by its dealer network. This dealer network is typically exclusive and offers its customers selling, support, and maintenance services (the dealer network will be discussed in more depth in another section).
Let’s dig a bit deeper into each segment.
(a) Production and precision agriculture (PPA in short)
Deere sells mid and large agricultural equipment and precision farming technologies through its PPA segment. These products and solutions target large farmers, as these typically require high horsepower machines (large ag equipment) to farm their lots and also get outsized returns from even minor yield improvements (precision agriculture). Volume and scale tend to be key characteristics of PPA’s customers.
Deere spent significant time and money throughout the 20th century creating large equipment that would suit US farms. According to USDA (US Department of Agriculture), around 41% of US farmland was operated by farms with sales above $500,000 and the average farm size was 445 acres. For context, almost 64% of European farms are less than 12 acres in size, meaning that an average US farm is more than 30x larger than its European counterpart. South America paints a similar picture to that of the US.
The good news for Deere is that the current trends in agriculture (discussed more in-depth in the following section) are impacting farm consolidation in Europe, meaning this geography might eventually become a key customer for large ag equipment:
Regulations are also putting a strain on farmer resources like herbicides in Europe, so precision ag technologies might also become a good fit soon.
The company commercializes a wide variety of large ag equipment, with the combine probably being the better-known product of all. A combine is used to harvest and looks something like this:
Deere has always focused on covering the E2E equipment needs of any production system. The company used to market its products according to their function (harvest, planting…) but now markets its products according to production systems (for example, corn production):
Farmers tend to go “all-in” with an equipment brand because it simplifies operations. Deere also provides hefty discounts for farmers who purchase entire production systems, making it tough for farmers to say no.
As discussed in the history section, technology, or as Deere calls it, ‘precision agriculture,’ is at the core of the company’s operations; why? Because the company is no longer selling equipment, it’s selling solutions:
You are buying a solution for your farm; you are not buying a piece of equipment anymore.
Source: AGCO expert call
The company has invested quite a bit of money in developing its tech stack, which is by far the most comprehensive in the industry:
Part of this tech stack has been built organically, whereas other parts have been built through targeted acquisitions like Bear Flag Robotics (Autonomy, acquired in 2021) or Blue River (AI and ML, acquired in 2017). What Deere has managed to build is an ecosystem for the farm.
This ecosystem is sold as a win-win proposition, aiming to make farmers more profitable while enabling Deere to reap part of this value add through a per-use and/or subscription-based model. Take, for example, See and Spray.
Thanks to this technology, farmers can enjoy significant savings as it only fertilizes bushels that require fertilizer. Before See and Spray, farmers had to spray all the crops, even if only 20% of the crop needed it. Using less fertilizer can help farmers make significant savings, as fertilizer costs can make up to 30% of variable costs per acre of corn (for context, equipment makes up around 15% of the cost per acre of corn). The best news is that these savings don’t come at the expense of yield, a KPI for farmers.
There are many more features in precision agriculture, most of which I will not discuss for the sake of time. This short video by John Deere describes some of the benefits of applying technology to the farm:
These technologies are distributed progressively, typically by retrofitting them into used equipment. Once adoption rates get to the 70% to 80% milestone, the company makes them standard in all new equipment and hikes the price of this equipment:
When a feature moves into base, the base price moves up with it.
Josh Jepsen, Deere’s CFO
Another exciting application of technology in the farm is the John Deere Operations Center, which allows farmers to “unlock the full power of their farm data.” These are some of its features:
Through the Operations Center, a farmer can check how all its operations are running on their mobile phone. Smooth operations and careful planning are paramount in farming, as most profits are generated in relatively short periods. Reacting slowly to a problem can bring thousands of dollars in losses to farmers. This short video shows how the Operations Center works:
What’s key is that the Operations Center feeds from a very large data set thanks to the company’s installed base. This data is aggregated and then used to help farmers become more profitable:
What if Ted could learn from 40,000 other lifetimes through powerful insights gleaned through the digitalization of the farm.
Deere has started deploying its precision ag technology across its large agricultural equipment, but the goal is to deploy it across most equipment operations segments in due time. The reason why it might have started in precision agriculture is two-fold…
It’s where it can currently add the most value: minor improvements in yield can bring enormous benefits thanks to scale.
It’s where it can collect the most data to improve the technology further: Deere’s installed base in this segment is unprecedented.
There’s no denying that the agriculture industry is transforming from an equipment-based industry to a SaaS-based one, enabling farmers to do more with less. Farmers are embracing technology at a fast clip, although even those who are reluctant will have no choice but to hop onto the trend if they want to remain competitive. Agricultural products are commodities, so farms are price takers, and thus, their production costs determine their profitability.
(b) Small Agriculture and Turf (SAT in short)
The SAT segment specializes in the sale of smaller equipment, and this is important because it somewhat changes the customer base. Deere’s large agricultural equipment has historically targeted large farms specializing in large crops, whereas the small agriculture and turf segment targets…
Individuals or companies who might want this equipment to take care of their backyards
Smaller farms that focus on higher-value crops such as fruits, for example
Golf courses
I will not go through all of the equipment the company sells in this segment, but here’s one of the best sellers, the Gator:
Differences between the PPA and SAT segments stand out when we compare tractor sizes. This is a tractor that Deere sells through its SAT segment:
And this is a tractor that’s sold through its PPA segment:
The differences in size and power are evident just by looking at the images. I wouldn’t say one piece of equipment is better than the other; they are simply different and target different use cases. The second tractor would not be a good fit for a European farm, whereas the first would not have sufficient power for a large US farm.
As the SAT segment targets the retail customer (to an extent), Deere started selling its small agriculture equipment through big box retailers like Home Depot and Lowe’s more than 20 years ago. This is yet another difference with PPA, as most of that segment’s sales take place through the company’s exclusive dealer network.
Despite the stark differences across both segments, it was not until 2021 that Deere separated its former Agriculture and Turf segment into these two. Many things might have led management to make the distinction. The main one is probably the rise of precision ag, which is currently much more suited to large agricultural operations. Another reason might be that these segments’ cycles are very different.
(c) Construction and Forestry (CF in short)
We have learned about Deere’s agricultural segments, but the company also manufactures Construction and Forestry equipment. The company started manufacturing construction equipment in the 1950s to complement its agricultural operations and then solidified its position in this industry by acquiring Wirtgen in 2017. When Deere acquired Wirtgen, it was the leading manufacturer worldwide in the road construction industry. Uncoincidentally, road construction is one of the tasks in construction that’s most prone to automation and something Deere was actively looking for:
The acquisition of the Wirtgen Group gives Deere far greater exposure to transportation infrastructure. This sector that’s faster growing and less cyclical than the broader construction markets today.
Max Guinn, Head of the CF division in 2017
It’s also a market expected to enjoy strong tailwinds going forward, but I’ll talk about this in more detail in the next section.
Deere also provides solutions for large and small projects through its construction division and also aims to provide customers with the equipment necessary to cover the whole construction project:
Lastly, Deere also offers equipment used in forestry applications:
Equipment operations’ distribution
This is how equipment operations are distributed across segments and geographies:
The company is most exposed to Production agriculture and North America. This makes sense because Deere is the undisputable leader in large ag equipment, and North America is much more prone to this type of equipment and is the most mature market.
(d) Financial services
The last of the company’s operating segments is its financial services segment. Deere does not aim to maximize profitability in this segment but instead uses it as an enabler of its equipment operations. Despite equipment not making up a large portion of a farmer's total cost, it does require a significant outlay of capital upfront. This is precisely where Deere Financial comes in handy, allowing farmers to smooth out this outlay.
Deere provides financing for two parties:
The dealers that buy the new equipment from Deere
The individuals who buy the equipment from the dealer
There’s not much more to it. Despite the word “financial” sounding scary, I think there are several things that should be reassuring:
It’s not a profit maximization operation. Profit maximization is a key driver of financial fraud.
Deere has been providing financing to its customers and dealers for decades, and financial losses have always been under control, even in downcycles. It’s fair to assume it’s a niche the company knows well.
Deere Financial provides somewhat recurring revenue through downcycles.
In fact, how the company has treated customers through its financial operations has helped it strengthen its moat. You’ll understand why after reading the section on the moat.
So, if we were to summarize Deere’s operations, it would look something like this:
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Section 2: The Financials and Growth Drivers
I’ll discuss the company’s financials and growth drivers in this section. One of the best things about Deere is that its reported financials are somewhat misleading, which might make many ignore the company from the get go. I must admit I was close to being one of these people, but I fortunately decided to dig deeper.
The Financials
I will review the company’s three most important financial statements: the income statement, the balance sheet, and the cash flow statement. Context is required for all of these because they each have their puts and takes, although they have one thing in common: they tend to be volatile through the cycle (especially the income and cash flow statements). For this reason, I will share a snapshot of the company’s 2023 numbers and some historical data going back to 2013, the prior peak of the agricultural cycle. This way, you’ll be able to understand the cycle’s impact.
While I do believe Deere will be cyclical in the future, I think there are caveats: I don’t think the future will look exactly like the past. I believe Deere is becoming a better business by transitioning to a more recurring revenue model, which should translate into lower financial variability going forward:
What’s unique about this time and a little bit different is some of the business model changes that we have; it’s going to allow us to take some of the standard deviation around that 20% out.
By reading this section, you’ll also understand why many investors disregard Deere as an investment. Very few (if any) financial providers manage to dissect the company’s financial statements accurately. Deere has two very differentiated segments: equipment operations and financial services. The characteristics of both are very different and thus should be viewed independently. Looking at Deere on a consolidated basis might make us reach the wrong conclusions.
The income statement
Deere’s 2023 consolidated income statement looks something like this:
This table paints a static picture but already brings several interesting insights. First, we can see that Deere enjoys excellent margins, mainly achieved at the operating level. The company has a “lowish” gross margin due to the nature of the equipment-selling business, but it later manages to pass a good portion of this margin through to the bottom line, enjoying a net income margin of almost 17%. This income statement is somewhat similar to Copart’s income statement, where the most significant cost burden is buried in the ‘cost of revenue’ line.
The second thing is that Deere includes interest expenses as an operating expense. This makes sense because this interest comes primarily (not all) from its financial services segment, which generates income included in its consolidated revenue line. Deere’s Financial Services segment works like a bank, and interest expenses are considered operating costs for financial firms because they are intrinsically linked to the business. Note that, as discussed above, Deere does not aim to maximize profitability in its Financial Services segment, so why do we tend to see some kind of variability in the spread of interest income and expenses? The reason lies in interest rate movements. As per the company’s annual report:
Historically, rising interest rates impact our borrowings sooner than the benefit is realized from the financing receivable and equipment on operating lease portfolios.
All this said, the above income statement might not be entirely representative of the company’s normalized earnings power. Deere is a cyclical business, which, when coupled with a high fixed-cost base structure, makes the company suffer from operating leverage/deleverage. If we look at the period from 2013 to 2023 (peak to peak), we can see this operating leverage/deleverage in play:
Note how margins peaked in 2013, only to fall quickly once the downturn began until bottoming in 2016. Management tends to make some adjustments to prepare for downturns, but there’s so much one can do when running a manufacturing business. There are two good news, though.
First, the company remained profitable (and by no small margin) during the last downturn. Secondly, management focused its adjustments more on SG&A than on R&D. This is key because R&D is crucial for the company’s future, and management has repeatedly stated that their willingness to cut back aggressively on these costs is low. This willingness has been low for a pretty long time:
John Lawson was with the company for 44 years and never remembers a time anyone suggested cutting back on research and development spending, even in the toughest times.
Source: ‘The John Deere Way’
Management knows that cycles are temporary but that the competitive position is permanent. Remaining profitable through the cycle obviously facilitates this countercyclical behavior.
What’s pretty evident is that the company has enjoyed operating leverage over the long term, leading to better margins through the cycle (note that Finchat does not include interest expense as an operating expense for Deere, which is why you see higher margins in the graph below, but is the trend that I am interested in, not the numbers per se):
This operating leverage has been quite pronounced over the last couple of years, and there might be several reasons to explain this. The first one is that a good portion of the growth generated over the last years has come from price increases. Price increases do not come with a comparable capacity surge and thus help the company enjoy operating leverage. The second reason might be related to Deere’s focus on subscriptions and parts. These ventures enjoy significantly higher margins and are more scalable, so they obviously come with considerable operating leverage.
As cycles inevitably bring margin volatility, management sets expectations of operating margins through the cycle. The current expectations are set at 15%, but management expects to achieve 20% through the cycle operating margins in the foreseeable future. This obviously makes sense as technology, subscriptions, and parts revenue grow faster than overall equipment revenue. Not only are these higher-margin revenue sources, but they are also more recurring, taking away a portion of the volatility. High recurrence and profitability are precisely the characteristics that make software and parts companies great, and that’s where Deere wants to transition.
Don’t forget that management targets around 10% subscription revenue in 2030, which should help take the recurring piece of the business to around 40% of total revenue. We don’t have disclosures to understand how this number looked in the past or even what it looks like today, but that would probably be the highest in history. Also, note that this 40% number is a sales ratio and what we should care about is profits. With recurring sales carrying significantly higher margins than equipment sales, I think it’s conservative to see a path to 60%+ of recurring profits.
Maybe an underappreciated part of the company’s margin story that makes it more credible is that every other competitor is also looking to expand margins following a similar model, meaning farmers will have little choice but to adapt to the new model.
All in all, Deere’s income statement is currently in good shape, has continuously improved through cycles, and is transitioning to more recurring and higher-margin revenue. This doesn’t mean it will improve linearly from here, though. With a potential downcycle on the horizon, we might see it worsen significantly next year. However, this should not matter much if we focus on the long term.
You might have noticed that I did not separate the equipment operations segment from financial services when reviewing the income statement. The reason is that including the interest expense as an operating expense should give us a somewhat normalized picture.
The cash flow statement
As you might well know, we should care about cash profits rather than accounting profits. Accounting rules do a somewhat good job of portraying a company’s economic reality, but management teams can typically tweak them through their assumptions to make them look better than they are. This can also be done with cash flow, but to a lesser extent.
One of the first things I look at in any company is its cash conversion. There are many ways to calculate this metric, but I usually take Operating Cash Flow and divide it by Net Income. You can also take Operating Income, but recall that, for Deere, you must include interest expense when calculating operating income.
If cash conversion is close to 100% or above, then great; if it’s significantly lower, we must ask ourselves why this is the case (it might simply be the nature of the business). Let’s see how cash conversion looks for Deere. I have built two tables, one with the equipment operations business and the other with consolidated figures. This way, we’ll understand both individually. I also included two periods, the last three years and from 2013 to 2016. This way, we can see how cash conversion varies through the cycle. This is equipment operations:
As you can see from this table, Deere enjoys good cash conversion in its equipment operations segments. What’s most interesting is that this cash conversion does not tend to worsen materially during downturns. The other interesting thing that I’d point out is that the company has significant Capex flexibility. When it entered the 2015 downturn, Capex dropped from 3.2% of sales to 2.6% despite a significantly lower sales level. This flexibility obviously helps the company’s free cash flow conversion remain resilient.
However, the above is not the whole story. Deere receives distributed earnings from its financial services subsidiary but doesn’t record the rest of that business’ cash flows in its equipment operations. This makes this segment’s cash conversion numbers look somewhat misleading, so we must look at the consolidated figures. Here they are:
The consolidated cash conversion figures look worse but still pretty acceptable. For the last 3 years, Deere has converted, on average, 80 cents to cash for every dollar of net income, not bad. We must not forget Deere is a manufacturing business, meaning it’s tough to get to a Free Cash Flow conversion rate close to or above 100%. The company not only carries inventory but also requires Capex to build manufacturing capacity. The good news is that, as I discussed above, the company can adjust Capex accordingly when a downturn begins, meaning Capex is somewhat a variable cost.
Another thing worth noting, which I will discuss in more detail later, is that Deere can significantly improve its cash conversion by successfully executing its current business strategy. This said, I think cash conversion is at an acceptable level currently and will be resilient during the next downturn due to Capex's flexibility and because management claimed the company’s inventory position is at the best level it has ever been. Management is even guiding for an improvement in cash conversion in FY 2024 despite the expected sales and earnings drop.
The balance sheet
One of the most interesting things about Deere is its apparently high debt load. When I come across a new company that might be interesting, I tend to run it through a series of parameters (a quantitative checklist) to see if it gets me more or less convinced to dig deeper. The first thing that stood out when running Deere through these parameters was its net debt position. According to several financial providers, the company ended 2023 with a net debt of around $59 billion. This amount is pretty significant for a company of Deere’s size (around $110 billion market cap).
However, this number is extremely misleading for several reasons. The reason that stands out the most is that a good chunk of this debt belongs in the financial services segment. Debt is necessary for any financial business to generate adequate returns, and Deere’s Financial Services Segment would not be different. The good news for those investors willing to read the full annual report is that Deere dissects both balance sheets, and thus, we can calculate the real indebtedness of the equipment operations business.
Deere ended 2023 with borrowings (both short and long-term) of $56 billion, but only $8.44 billion of this amount could be attributed to the equipment operations segment, the remainder being attributable to financial services. You can find this highlighted in the table below:
The equipment operations segment also has $5.7 billion in cash and equivalents, yielding a net debt position of $2.74 billion. If we compare this with the segment’s operating income of $12.2 billion, we get to a net debt/EBIT ratio of 0.22x, which is pretty conservative if you ask me. Several caveats here, though. First, this ratio will probably increase during a downturn due to lower operating income. That’s the “bad” part. The good part is that as the company transitions to a more recurring model, its financial position strengthens even if this ratio does not change.
Now that we know that Deere’s equipment operations segment is not as highly indebted as it might look at first, let me comment on its financial services segment. There’s no denying that financial services runs with high leverage; it’s a financial business, and leverage is a “requirement” to obtain acceptable returns. We also know financial businesses tend to get into significant trouble due to this leverage when things turn south occasionally (the Global Financial Crisis is a good example). Am I not worried about Deere following a similar path? The answer is “no,” and for several reasons.
First, the company has been operating in this niche for almost two centuries, and we could argue it knows its customers (both farmers and dealers) well. It’s reasonable to think that risk is under control in this sense. Looking back, we can see that the company’s loss provisions have never spiraled out of control, not even during harsh downturns. This makes sense, considering Deere understands the cycles, farmer economics, etc. To this, we have to add that equipment costs typically make up around 15% of farmers' total costs, so they have other places where they can try to save money, places where Deere is trying to help them save money.
Secondly, Deere uses its financial services segment as an enabler of its main business, not as a profit-maximization operation. Leverage does not create problems when run conservatively but when run too optimistically/aggressively, which tends to happen when someone tries to maximize their profit.
Lastly, but not less importantly, most of Deere’s debt is backed up by its equipment, which typically carries a high residual value. If some customer defaults (something inevitable), Deere gets the equipment and can resell it to recover some of the outstanding amount. This is from the book I shared before:
If John Deere Credit had to collect on a default loan in the agriculture industry, the collateral - a John Deere tractor or combine - was a known and valuable piece of equipment, even used.
I don’t think Deere is risky despite the leverage in its financial services segment for the reasons discussed, and I must say I am not alone here. Most CRAs (Credit Rating Agencies) believe the company is in a pretty good financial shape (I know, I know, these are the same CRAs that messed up during the GFC):
Note that it’s in Deere’s interest to maintain such a financial position, as it ultimately gives the company access to cheap financing, which it then uses to finance dealers and customers and, thus, sell equipment.
All in all, I hope this section has helped you understand why Deere’s financials are much better than they appear at first glance. I was close to rejecting the company just based on numbers I got from some financial providers that don’t distinguish between the company’s financial branch and its equipment operations. Luckily, I decided to dig deeper after reading the book about its history. Lesson learned!
The Growth Drivers
Growth is an essential consideration for any investor unless one is buying stocks at a FCF yield of 12%+. In that case, an investor should worry more about the resilience of that FCF than about growth. However, this is not the case for Deere as it’s currently trading at a FCF yield of 5.5% (Next Twelve Months based on management’s guidance). This means that to achieve a market-beating return, we, as investors, are expecting some Free Cash Flow growth over the coming years.
The question is: where will this growth come from? There are four sources of free cash flow growth: revenue, margins, cash conversion, and capital intensity. Let me discuss each individually.
Revenue growth
Deere enjoys several long-term secular top-line growth drivers. First, let's see where we come from. Deere has managed to grow its revenue at a 5% CAGR over the last decade. This is very acceptable, considering the company was at a peak in 2013, and the industries it’s exposed to typically grow in line with GDP. But why will this growth continue going forward?
First, the agriculture industry will benefit from several growth drivers, one of which is population growth. The world population keeps growing, and emerging markets increasingly consume higher protein foods which come from animals that must be fed grain. This means the need for food is increasing, which obviously positively impacts the agriculture industry. The industry has two ways to meet these needs:
Use more land
Make the land more productive
Land availability in places where the weather supports agricultural practices is diminishing, so it’s highly likely that farms will need to lean increasingly on #2. Technology will be key to this increased productivity, which Deere is already actively deploying across its fleet. This technology will be sold as a win-win proposition as it will add value for the farmer while Deere captures some of this value add. This value add evidently comes from helping farmers lower their cost base:
On an acre of corn, nitrogen and fertilizer represented about 35% of the variable cost structure and about 75% of the greenhouse gas footprint.
Management has sized this value add opportunity at $150 billion, of which they plan to take around 25%:
This means the potential revenue for the company is $37.5 billion ($150 billion * 25%), revenue which would come at a pretty high margin due to its nature. Now, I will not take management’s word at face value, less so when we are talking about TAM, but I think it’s pretty clear that the opportunity is very significant even if one decides to be more conservative. Note also that competitors expect to be more aggressive in taking value-added share, which might benefit Deere’s value proposition. AGCO’s management recently mentioned they expect to take half of their value-add, 100% more than Deere.
Farmers will have no choice but to adapt to the new model even if they are initially reticent due to regulation and competitiveness. Regulators are increasingly pushing farmers to be more productive with less inputs, and technology will play an essential role in this “more with less” trend. Secondly, if other farmers deploy technology, then farmers that don’t will become less competitive, which will eventually lead all farmers to make the transition. This is how John May, Deere’s CEO, laid it out during the most recent investor day:
The days of abundant resources and farming inputs is over. Labor, fertilizer and crop protection inputs, just to name a few, are all growing in scarcity and they’re increasing in cost.
Technology also brings interesting dynamics to the industry. For example, data is very important for farmers because it allows them to improve yields. This data is most useful when consolidated and used across homogeneous equipment, meaning that going all-green might be a case not only of brand loyalty but also of productivity. Network effects might come into play in an industry where they have historically been absent.
Deere’s construction segment is also expected to enjoy significant tailwinds. In 2021, the US government passed the Infrastructure Act to fund US infrastructure. This Act received bipartisan support, which is a testament to its importance. Deere will benefit to an extent from these investments, especially from the construction of roads and bridges ($110 billion) due to Wirtgen's leadership in road construction. Quantifying its impact is tough, but it will definitely be a tailwind.
Also, note that there’s onshoring going on right now after COVID and geopolitical conflicts wrecked chaos across the supply chains. Many companies have decided to establish all or a portion of their supply chains on domestic soil, and Governments are incentivizing this onshoring (the Chips Act is a good example). These mega projects require considerable construction efforts and constitute another business tailwind. I must say that I think this trend will be quite relevant in the future, which is why I am looking at companies that might directly benefit from it. Deere will definitely benefit, but more so indirectly.
All in all, I think the company’s top-line growth will not be a problem going forward, as there will be significant growth opportunities available.
Margin expansion
This section is much simpler to explain: Deere’s margins should expand as it transitions to more recurring and higher-margin revenue. Management expects around 40% of recurring revenue in 2030, with 10% being subscription-based. This, of course, has led them to claim the company can now achieve a 20% margin through the cycle, an unprecedented level in its history.
Improved cash conversion
Margins are not the only place where the transition will prove beneficial; cash conversion is another one. Subscription-based businesses enjoy negative working capital (which is like free financing) because they get paid at the start of the year, and Deere should also benefit from this characteristic once the transition is more mature. Additionally, as equipment sales become less important to revenue (albeit continuing to be critical), cash conversion should also improve thanks to inventory making up a lower portion of the company’s cash conversion.
Lower capital intensity
Free Cash Flow is normally calculated as Operating Cash Flow minus Capex, meaning that we should not only care about the former but also about the company’s capital expenditures. I think the conclusion here is straightforward too: capital intensity should naturally decrease as the equipment sales per se make up a less significant portion of overall sales. The reason is that the recurring revenue the company expects to generate requires little capacity expansion, or put similarly, it’s capex light.
I don’t anticipate Deere will look like a software business in the coming years, but the transition to a more software-like model should undoubtedly improve the company’s margin and cash conversion profile. To this, we have to add that growing the top line is unlikely to be a challenge for Deere over the long term.
With the company trading at a 5.5% FCF yield at mid-cycle (according to management), we “only” need around 5-7% FCF growth to make this a worthwhile investment (as this would get us to a return of around 10-12%). I think this will most likely prove to be conservative, but we can only wait and see.
Section 3: Competition, moat, and risks
This section will discuss three topics that are very relevant to any company: the competition, the moat, and the risks. Of course, the relevance of these topics depends on ones investment horizon, as I highly doubt someone willing to hold a company for months should really care about these.
The Competition
This section on competition can only be fully understood once you’ve read the next section on the moat. I can give you an overview of the competitive environment here, but you’ll only truly grasp Deere’s competitive position when you understand what protects it against other players. Let’s start with agriculture.
The competitive landscape in agriculture
The agricultural equipment industry is pretty consolidated across the large players, with the top 5 gathering a combined market share of 64%. The industry has historically enjoyed high barriers to entry because a new entrant needs expertise, the money to spend on Capex, and the dealer base to service and sell their equipment. These three things have been progressively built by the existing players not only with abundant amounts of capital but also with time. We should also remember that the equipment per se is somewhat a commodity, so it would be extremely tough to convince farmers to switch to a new piece of equipment unless it’s significantly better. As you’ll see later on in the section on the moat, even this would probably not be enough to justify a switch.
Deere is by far the largest company in the industry, commanding a 25% global market share. CNH is the company’s closest competitor, but its market share is not even half that of Deere’s. Other relevant players are Kubota and AGCO, which are much closer to CNH. The bottom line is that there’s one outlier, and that’s Deere:
We should not, however, take this market share data at face value. It’s a global number encompassing all agricultural equipment, but it requires context because market shares vary significantly across geographies and product types. For example, Deere has a considerably larger market share in the US, commanding 40% of the agricultural equipment market. On the other hand, AGCO, through its Fendt brand, is much more dominant in Europe than in the US. Something similar happens to CNH through its brand, New Holland. Deere also leads the European market, but by a thinner margin than the US.
This divergence in market shares not only makes sense due to Deere’s origins (US) and focus but also due to the characteristics of US farms. As discussed in another section, farms in North America are much larger than elsewhere and, thus, more tailored to large agricultural equipment, where Deere is the indisputable leader thanks to its long-time investments (remember the “New Generation of Power” event?).
The competitive landscape across other geographies is different. Although I will not go over them individually, they all have one commonality: Deere seems to be an established player everywhere but does not enjoy a competitive position as strong as that in the US. Other geographies seem more competitive, sometimes due to their relative youth and others because small agricultural equipment is dominant. For example, Deere has a market share of around 9% in India, whereas Mahindra dominates the industry with a 40%+ market share.
If we look at equipment types, we can see that Kubota is a pretty strong player in the small ag equipment niche. In fact, the company does not even try to manufacture large ag equipment (other manufacturers do). The company’s largest tractor has a power between 130 - 170 HP,
This pales compared to Deere’s largest tractor, which has between 484 and 913 HP.
This doesn’t make Kubota a bad company (we’ll see later on in the risks section why it can do great in the future). Kubota has simply focused on a niche where Deere is not as established. There are also differences between market shares of any given piece of equipment. For example, Deere is famous for its combines where it has an even greater market share in the US than its overall US market share:
So, what do these companies compete on? Or better said, what drives a farmer’s purchase decision? Agricultural equipment is somewhat commoditized, so farmers ultimately care about the cost of ownership, which is not the same as price. If any given piece of equipment is more productive than another, its purchase might make sense even if it’s more expensive.
So, what variables go into the total cost of ownership? Many… things like price, productivity, and downtime…but what I want to stress is that it’s not a decision based solely on price. As I’ll explain later in the section about the moat, several things should allow Deere to protect its market share and grow it going forward; none of them are related to the price of its equipment. In fact, there are reasons to believe that the industry dynamics will start favoring the large players much more than they have in the past.
Competition in construction equipment
I’ll be brief here because it makes up a smaller portion of Deere’s total sales. Caterpillar and Komatsu dominate the construction equipment industry, with market shares of 16% and 10%, respectively. Deere has a decent size but comes in at a 5% market share, which is significantly lower than the leading operators:
Interestingly, the construction industry is more fragmented than the agriculture industry. The top 5 agricultural players comprise around 64% of the market, whereas the top 5 in construction comprise 43% of the industry. This might be related to various factors I’ll discuss in more depth throughout the article. For example, farming is known for being a family-run industry, whereas this is not the case for construction (or at least not to the same extent). It also seems easier to differentiate a piece of equipment in agriculture than in construction because many more inputs are going into agriculture, which the equipment can directly influence.
So, Deere has a respectable market share in the construction industry but not an outstanding one. The only caveat here is that, as I discussed in another section, Deere has managed to carve a leadership position in a niche in the construction industry thanks to the Wirtgen acquisition: road building. I could not find specific and/or updated numbers, but I did find this article that shared Wirtgen’s market share in 2016:
Worldwide, in the milling business, they have a 72% market share. They are number one by far, and for number two you will see a single digit. For the pavers, it is 37% market share worldwide, and for rollers it is 19% market share worldwide.
These numbers might have changed over the past years, although judging by recent news, the competition seems to be having quite a bit of trouble going after Wirtgen’s dominance in road building:
As discussed several times throughout the article, road building enjoys several secular tailwinds, especially in the US, where a good portion of the Infrastructure Bill will be destined to construct roads and bridges.
All in all, I believe Deere enjoys a solid competitive position in both the agricultural and construction industries. It’s definitely much stronger in the former, but we should not discount it in the latter, especially in road building, thanks to Wirtgen.
The moat
A solid current competitive position is of utmost importance but how the company protects it over the years is arguably much more critical. This is where the moat comes in.
I believe there are several prongs to Deere’s moat, most of which stem from the company’s historical industry leadership. Many investors will claim that the past is not important to invest, but I put a lot of weight on it during my research process, and Deere is a good example.
The installed base
Deere has operated in the agricultural industry for over 180 years and has led the industry for a good portion of those years. The company passed International Harvester in 1963 as the leading manufacturer of farm and industrial tractors and has never looked back. That’s 61 years leading the industry.
So many years of leading the industry have allowed Deere to build an extensive installed base and brand. This brand has grown and endured through generations, making farmers very loyal to Deere. Let’s not forget that farms in the US tend to be family-owned, meaning that the brand tends to rollover from one generation to the next:
97 percent of all U.S. farms are family-owned, and family farms account for 90 percent of all farm production by value.
I’d imagine that if the farmer’s son or daughter has grown up operating Deere equipment, the probability of them switching once they run the farm is relatively low. This brand reputation is a real competitive advantage (discussed later), but it’s hard to justify as durable. Brands come and go, and the agricultural equipment industry is fairly competitive, so how will Deere turn its installed base and leadership position into a durable competitive advantage? The answer lies in technology and scale.
Let’s talk about technology first. As discussed throughout this deep dive, the agricultural industry is transitioning to a price-to-value model thanks to technology. Equipment manufacturers will aim to unlock a win-win proposition (both for farmers and equipment manufacturers) by applying technology to farming operations. As we’ve seen play out in many other industries, the better the technology, the more value it will add.
Data is crucial to improving any technological application, and that’s precisely what Deere has plenty of: data. Deere currently has more than 340 million engaged acres (reflects the number of unique acres with at least one operation pass documented in the Operations Center in the past 12 months) and expects to expand to over 500 million in the coming years. This expansion will be driven by the company’s ambition to have 1.5 million connected machines.
Engaged acres are important because they are constantly generating data that Deere can then feed its algorithms to develop the best technology. This improved technology adds more value for farmers, so Deere’s differentiation improves. As I commented above, farmers sell a commodity, so cost is paramount. This means that if Deere owns the equipment that provides the best ROI (Return on Investment), then farmers will have no choice but to switch (if they are not Deere customers) or renew their equipment (if they are existing customers) to remain competitive. These dynamics should further increase the company’s installed base, powering its data advantage. It’s a flywheel that works something like this:
Management described this flywheel pretty succinctly during its most recent investor day:
We have in agriculture a significantly larger installed base. This allows us to collect a larger database that allows us to make our products better, deliver more value to the customers, keep improving them, and develop new products and solutions faster. This is a flywheel that we’re able to keep turning and make our products better, and the more we make our products better the more customers we attract, which feeds back into more customers and better models.
Operating models with technology as a foundation have historically resulted in “winner-take-all” dynamics, and I don’t see why it would be any different here. The largest player in the agricultural industry (Deere) will most likely use its larger footprint to develop the best technology, strengthening its competitive position. Note that this is not exactly the same case as software because hardware is a critical piece in agriculture. This hardware collects the data, meaning the technology is more challenging to disrupt unless you can match the physical presence.
Note that despite these dynamics, I don’t believe Deere will take all of the market. I do believe, though, that the interplay between the largest installed base and the best technology will strengthen Deere’s moat and probably increase its market share.
The dealer base
Deere markets its products through its exclusive dealer base. These dealers buy the equipment from Deere and later “resell” it to farmers or construction customers. Dealers are not only in charge of reselling this equipment but also of building (and maintaining) customer relationships and servicing the equipment throughout its lifecycle. This should already indicate that dealers are a crucial part of Deere’s value chain and also an integral part of its moat.
Service in the agricultural industry is vital because farmers make most of their profits during relatively short periods. This fear of “downtime” is why the dealer infrastructure to keep the equipment up and running is so critical. Deere currently has around 2,156 dealer locations across pretty much every US state:
The company has incentivized dealers to concentrate over the last couple of years. This concentration has two beneficial impacts:
The dealer base becomes more efficient and professional
The financial risk for Deere is lowered because the financial health of dealers improves
Their (Deere) dealers are unprecedented, number one. They did that starting in 1965- 1995. Now, they continued phase two of that is consolidating those dealerships and reducing the number of corporate owners.
Today, in the big equipment, the average John Deere dealer has 16 locations. That makes them more efficient to operate. They can spread costs. They have efficiencies. I'm very envious of Deere.
Source: Expert Call
The company’s dealer base is by far the largest in the US and one of the primary reasons it has remained the leader for so long. The longevity of this dealer base has also been key, as farmers have had relationships with these for decades. I anticipate dealers will play a key role in enabling Deere’s transition to more recurring revenue sources, as they’ll be ultimately responsible for selling those services.
Just so you can grasp what kind of competitive advantage the dealer base brings, take a look at what an expert said about AGCO, its products, and its penetration in North America:
The Fendt tractor is an awesome tractor. It's very well built, typical German engineering. Its acceptance in North America is moderate. I think a lot of their issues in North America is they just don't have the dealer base to service those things.
There’s much more to a buying decision than the product; it all comes back to the dealer, and Deere clearly leads with its footprint:
I think the biggest thing that people need to, it's even something for people in the business, the mentality of the farmer, the buying decisions. I've seen this firsthand, so I'm going to speak. They'll look at a product. They'll sit in a tractor. They'll drive this tractor. They may say, "This is literally the best tractor I've ever sat in. This is the best tractor I've used." They will make those comments. You sit there and go, "Great, how many are you going to buy?" They go, "No, I'll never buy this tractor because I have a dealer that I deal with. That guy has been really good to me and my father before that. I'm a red guy, or I'm a green guy.
Source: Expert Call
So, how can competitors build a similar footprint? It’s tough, mainly because Deere’s dealers have very little to no incentive to switch brands:
The conversions of a John Deere dealer making a change to another brand, that has to be done with a lot of thought and a big consideration. For the most part, the major machines are commodities. A sprayer sprays, a planter plants, and a harvester harvests. Now, it's down to my dealer choice.
Source: Expert Call
Deere’s dealers enjoy the most significant volume and the best margins, so switching to another brand would require something substantial. The only incentive would be if other brands manufactured equipment vastly superior to that of Deere, which not only doesn’t seem to be the case but might also become less likely over the coming years for the above reasons.
Scale
Thanks to outstanding execution throughout many decades, Deere has gathered significant scale. This scale is also essential because it allows the company to enjoy significantly higher margins than its competitors while outspending these on R&D to build its tech stack. In short, Deere can spend more than its competitors on R&D while remaining more profitable (this is probably the reason why many big tech companies have remained dominant for so long).
Let’s look at some numbers. For example, Deere spends 20 basis points less of its sales on R&D than AGCO, but spends almost 4 times more on an absolute basis:
As the flywheel I have discussed above comes into play, this scale advantage should only expand because the industry should favor “winner-take-all” dynamics. The companies’ operating margins evidence this scale advantage:
Higher profitability is important because, if there’s a downcycle, Deere has much more flexibility to continue investing in R&D than its competitors, who might look to cut expenses there to remain profitable. We also see that scale and higher profitability can make a difference for Deere regarding the share of value-added value its competitors intend to take. AGCO wants to take 50% of their value-add, which is pretty aggressive compared to Deere’s 25% cut. Of course, Deere is in a position to take less because it does not “need it” as much as AGCO. This ability to be less aggressive might strengthen Deere’s value proposition relative to AGCO’s.
(Brief note: AGCO is a company focused entirely on agriculture, whereas Deere is not due to its construction and forestry operations. This makes the comparison slightly misleading, but the message still applies.)
Brand reputation
At the beginning of this section, I mentioned that I don’t consider brand reputation a strong competitive advantage for any company because brands can go out of favor eventually. This claim, of course, is nuanced. For example, I’d say the above is definitely true in retail, where customers tend to be fickle. On the other hand, the brand might be much more important in the luxury or ratings industries, where they typically carry a greater meaning. In luxury, that would be heritage, whereas, in ratings, that might be trust. But what about Deere? I don’t think Deere is comparable to luxury or ratings regarding brand reputation, but I believe it matters more than for any given retail company. Deere stands somewhere in between both groups.
The reason stems from farming being a family-based industry. Many farmers have been operating Deere equipment for many decades, which is important not only because they have gotten used to it but also because the company has historically been there for them when things got rough. This is from the book ‘The John Deere Way’:
Many John Deere customers are still loyal to the company because their families were able to keep their land and farms during the Depression because of the company (Deere).
We should not underestimate the importance of this loyalty in a market where 97% of farms are family-owned. This brand loyalty does not avoid disruption risks but mitigates them significantly. Farmers currently loyal to Deere must find a good reason to switch to a competitor, especially when such a competitor does not strongly differentiate against Deere.
The risks
I believe Deere is a wonderful company, but it’s not risk-free. Let’s review some of its most significant risks.
Unions
The most relevant risk for Deere probably comes from labor unions, although I believe this risk will diminish over time. In case you don’t know, labor unions are organizations that help workers achieve better conditions in their respective workplaces or, maybe better said, that help them avoid unfair working conditions. It’s very typical to see unions involved in manufacturing businesses because these tend to be labor intensive, and labor tends to be somewhat of a “low-value add” in such businesses. In short, where a lot of labor is required and the labor supply is large, you tend to find more unfair working conditions.
Management notes in the annual report that around “80% of production and maintenance employees are unionized.” This already seems pretty significant by itself, but it becomes even more important considering these unions have been active lately.
Deere suffered a strike in 2021 that negatively impacted its operations (as all strikes do because that’s the main goal). The strike was organized by UAW (United Auto Workers) and was the company’s first in over thirty years. UAW might sound familiar because the union wreaked havoc across the automobile industry in 2023 by organizing three separate strikes at General Motors, Stellantis, and Ford.
In Deere’s case, the strike involved around 10,000 of the company’s workers and lasted around 5 weeks until workers signed a new labor agreement. This labor agreement obviously came at a cost for Deere, which will see increased labor costs over the coming years. This is a summary of the terms of the new agreement:
Both included a 10% immediate raise, an $8,500 signing bonus, additional 5% raises in the third and fifth year of the proposed six-year deal, and additional lump sum payments equal to 3% of pay in years two, four and six. In addition it restored a cost-of-living adjustment to protect workers from increases in consumer prices. Such clauses used to be common in union contracts but have become relatively rare in recent years.
Source: CNN Business
Josh Jepsen, Deere’s CFO, quantified these costs in a relatively recent earnings call:
Over the 6-year contract, the incremental cost will be between $250 million and $300 million pretax per year with 80% of that impacting operating margins.
This is undoubtedly a significant amount, but I think there’s something even more “dangerous”: the strike sets a dangerous precedent as other unions might ask for better terms in the coming years. With other labor agreements expiring between 2024 and 2027, we might see more strikes lead to one of the following or probably both:
Disruptions in the company’s operations
Increased labor costs going forward
“Luckily” for the company, the 2021 strike came when the entire industry was suffering a supply crunch. This supply crunch eventually led to a favorable pricing environment that somewhat mitigated the company’s reliance on volume, which is evidently the variable most impacted by a strike. The strike was not really that noticeable in the company’s financials:
The good news is that this risk should somewhat diminish going forward. First, we have to consider the rise of automation. Manufacturing processes are getting increasingly automated, making them less reliant on labor. In my opinion, continuous strikes only increase the willingness of such businesses to invest in technology (Amazon is another good example here). This, by the way, doesn’t mean that some strikes aren’t justified.
Secondly, and maybe less straightforward, Deere’s transition to more recurring revenue sources like technology should also insulate it more from this risk in the future. If a larger portion of profits comes from ventures that are not labor intensive, then the potential impact of strikes on profits decreases.
Competition: A shift to smaller equipment and emerging markets
I have already discussed competition in this article, and the conclusion you should’ve come away with is that Deere is the leading player in the agricultural industry. This doesn’t mean there are no competitive risks; I believe there are a couple we should be very aware of.
The first one is that autonomy might make the industry shift to smaller equipment. While researching the company, I came across several experts who claimed that autonomy might reduce the need for large equipment, and I think their argument makes sense. The agricultural industry in the US has historically transitioned to larger equipment because it has always been labor-constrained. These labor constraints ultimately meant farmers needed to plant or harvest with the least iterations possible to optimize their labor. Large equipment solved this problem.
With the arrival of autonomy, the landscape might change because farmers will supposedly be able to do these tasks with less labor, meaning that the importance of the number of iterations diminishes. For example, a farmer might be able to leave a combine working at night and will not care if the combine takes 3 or 4 iterations to do its job so long as it doesn’t require labor.
The argument makes a lot of sense, but I am skeptical about the transition’s success unless owning smaller equipment is much more profitable than owning large equipment. Farmers are pretty intelligent and focus on profitability, so I highly doubt they will switch unless they see strong evidence that it’s better. If this shift were to happen eventually, I would say Kubota (a Deere competitor publicly traded in Japan) might benefit materially. The reason is that Kubota is one of the leading manufacturers of small agricultural equipment. It’s a smaller company than Deere, but if we were to look at Deere’s SAT revenue (Small Agriculture and Turf), we would see that it’s actually smaller than Kubota in this segment. I would, however, be careful making such a comparison because there might be some product overlap between Kubota and Deere’s large ag equipment:
That said, I don’t see any reason why Deere can’t also dominate this market if it chooses to focus on it. The company has developed the industry's most comprehensive tech stack (which should technically lead this transition) and has decades-long relationships with US farmers.
The other competitive risk comes from emerging markets. Deere is the leading agricultural equipment player in the US and many international countries, but the markets where it dominates tend to be more mature. Emerging markets are less mature and, therefore, tend to be more competitive. Countries such as Brazil, India, or China are considered growth markets in the agricultural industry, and while Deere has exposure to these, they are much less consolidated. I don’t think Deere completely relies on this growth to succeed due to its price-to-value strategy, but I do think it’s something to monitor.
What’s pretty obvious is that Deere is the global leader in agricultural equipment, which means that every other company is “coming for Deere.” Complacency is the real risk here, something that’s always the case for companies that have been leading for so long.
Right to repair complaint
The last, but no less important, risk is related to a letter of complaint that a group of farmers sent to the FTC (Federal Trade Commission). According to some farmers, Deere and other companies in the industry are unfairly blocking them and other third parties from servicing the equipment. They believe this constitutes anticompetitive behavior and want the FTC to intervene to make manufacturers comply with the right-to-repair principle:
The right to repair is the notion that consumers should have the right to repair their lawfully purchased products directly, or by selecting a repair service of their choice, as opposed to returning to the manufacturer or manufacturer-approved providers for the repair.
Source: WIPO
It’s interesting because the complaint does not come from price per se (which tends to be the main reason) but from service levels. Farmers claim that Deere’s dealers are becoming slower in servicing their equipment, which is very important in a business where most of the profit is generated in a relatively short period.
According to Deere, there’s no good argument behind the complaint because the farmers can still conduct around 98% of the repairs. The repairs the farmers can’t do (again, according to the company) require some sort of software update or modification. The reason why farmers are not allowed to conduct these is because such repairs can potentially make the equipment non-compliant with existing environmental regulations.
I have read the FTC complaint, and I honestly don’t know what will be the outcome. If the FTC forces Deere to “open up” their service and maintenance practices to a greater extent, that would obviously be bad news because parts are a very high margin and recurring business. There are reasons to believe, however, that this will not be the case. For starters, the entire industry is doing the same, and there will probably be intense lobbying going on. Secondly, the company’s new price-to-value strategy might make farmers look less at these things and more at their returns, which are likely to be higher in the future regardless of not being able to service their equipment.
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Section 4: Management & Incentives, Capital Allocation, and Valuation
This section will also discuss three key topics for any company: management and their incentives, capital allocation, and valuation. Deere ranks pretty well in all three, and you’ll find out why here.
Management & Incentives
Deere’s management is comprised of 10 executives. We could say that around half of these individuals are in “corporate” functions, whereas the rest are in more specific areas, such as leading a specific function or a business segment:
Tenure across the management team is relatively high, with managers having worked for Deere for an average of 20 years. This metric is somewhat distorted by two managers who recently joined the company, but if we were to exclude them, average management tenure would go up to almost 25 years:
The chart above also shows that most managers are relatively new to their current positions. This, in my opinion, is not really worrying because most of them are not new to the executive team. Some examples…
Rajesh Kalathur, now president of John Deere Financial, served almost 6 years as the company's CFO.
Ryan Campbell, now President of Construction and Forestry, also served as CFO.
The highlight of this dynamic might be John May, who has served as CEO since 2019 but joined the executive team in 2012. There’s no denying that Deere’s board of directors likes to hire executives from within the company when possible. This is a great practice and is pretty common in companies with strong values and a long-term orientation.
Another key trait in Deere’s management practices is not visible in the table above: management continuity. Throughout its 186-year history, Deere has “only” appointed 10 CEOs, making for an average tenure of almost 19 years. However, this metric is skewed toward the first CEOs as these were family members who stayed in the role for a long time. For example, John Deere, the company’s founder, served as President for 49 years! To understand if management continuity is still alive and well today, we can look at the tenure of the company’s last 4 CEOs:
Robert Hanson: 8 years
Hans Becherer: 10 years
Robert Lane: 9 years
Sam Allen: 10 years
These tenures rank great against the average company. According to Fortune, the average tenure for a CEO in the US is around 4.6 years, which honestly doesn’t seem enough for a great CEO to leave their mark. Deere’s board of directors incentivizes leadership continuity, which in turn incentivizes long-term thinking.
Occasionally, I come across a company that is “constantly” changing CEOs. This, let’s call it CEO shuffle, is terrible for value creation because the strategy changes constantly, and there’s no clear direction. If you are wondering if I look at management continuity before starting a position in any company, you might want to look at the quality table where I include CEO tenure as a KPI (Key Performance Indicator). Spoiler: I do look at it.
John May has not brought anything disruptive to Deere, but he has indeed brought a new focus: to transition the company from an equipment manufacturer to a technology company. This new focus called for several changes, like appointing a new position to the executive team: the chief technology officer. This appointment, the appearance of Jahmy Hindman (the CTO) in several earnings calls, and the focus of the latest investor day should make it clear that John May is committed to his strategy. The strategy might play out well or not (I obviously think it will play out well, or else I would not be a shareholder), but there’s no denying that commitment is the first step to success.
The compensation structure
I have explained the importance of management’s compensation in many of my articles. This importance is not static, though. If insider ownership is high, compensation matters less, as managers have already tied a significant portion of their net worth to the company’s shares (this is the case of Hermes, for example). If insider ownership is low, then I believe compensation becomes a crucial topic because you know what they say: “Show me the incentive, and I’ll show you the outcome.”
Deere belongs to the second group, as insider ownership is pretty low. Note that lowish insider ownership is somewhat normal for a $100 billion market cap company that was founded almost 200 years ago and where the founding family is not involved. Why? Because building a high insider ownership would probably entail one of two things:
Organic build-up of the stake by the insider: this would probably require more money than the insider is worth.
Inorganic build-up through extremely high stock-based compensation: this option would be terrible for shareholders.
I obviously prefer high insider ownership (it’s actually one of the first things I look at), but I don’t think we should be too worried about this. The only thing we have to do is focus more on compensation. Note that John May, Deere’s CEO, has around an $81 million stake (including exercisable options), which is actually not bad considering he makes around $20 million per year (a good portion of this in stock). He undoubtedly has an incentive for the stock to do well, even if his ownership does not appear high in the table I shared above. It’s also worth noting that stock ownership is a requirement for certain executive employees. This requirement is 6 times the base salary, but John May owns around 50x his base salary in stock.
On a different note, this is something that I don’t typically bring to the articles because I believe it constitutes more noise than signal, but insiders have not sold much stock over the past year despite many claiming the industry is going into a prolonged downturn and that Deere is “overvalued” despite appearing undervalued:
As a minor curiosity, there’s a pretty interesting >5% shareholder. In the case of large companies, these tend to be the Vanguards and Blackrocks of the world (who own shares as part of their passive and active funds). In Deere’s case, the fund with the largest position is Cascade Investment, which owns more than 8% of the company:
For those of you who don’t know, Cascade Investment is Bill Gates’ investment vehicle, and it’s funny because Bill Gates is also known for owning the most farmland in the US. Some estimates claim he owns around 260,000 acres, equivalent to around 200,000 football pitches.
Going back to the topic…if the management team does not have such high insider ownership, we should look closely at compensation. Deere made a crucial change to its compensation structure around the early 2000s by adding shareholder value added as the core metric of compensation. The change was conducted by former CEO Robert Lane, who believed that Deere was an excellent company for employees, farmers, and communities but had not been a great company for shareholders. With this change, the former CEO’s objective was to make Deere an outstanding company for shareholders as well…and it worked.
Since the inclusion of shareholder value added to their compensation structure, management teams at Deere have pursued a more recurring model and have focused on adding value to shareholders. Deere is an excellent example of how compensation structures can play a vital role in determining forward returns, albeit it’s not the only variable that matters. The board has gone further in 2022 and implemented other metrics to make management focus more on returns and less on making the company larger. For example, the short-term incentive was previously based on net sales and revenues, but these metrics were replaced by Operating Return on Sales (OROS) in 2022. The other metrics that determine the short-term incentive are Operating Return on Assets and ROE for the company’s financial services segment:
The objectives of OROA and OROS are not fixed and vary depending on where the company is in the cycle. This makes sense because penalizing management on industry conditions (not in their control) rather than company performance (in their control) would be somewhat unfair. It’s also great to see that the board has differentiated between the equipment operations segment and financial services (just like I did when looking at the financials), as these should each have their own KPIs and performance metrics due to the different nature of the business (you’ll understand why in the capital allocation section).
The company’s long-term incentive is based on shareholder value added over a three-year performance period with a modifier based on total shareholder return. Shareholder value added measures earnings in excess of the company’s cost of capital, so it measures how many of the earnings the company is generating are value accretive. Its goal is two-fold:
This is great for shareholders because management only gets paid when growth is generated in a value-enhancing manner. If the incentives were focused on EPS, for example, a management team could achieve EPS growth while destroying value along the way; shareholder value added corrects this flaw and ensures that all growth adds value, or better said, that management is only compensated based on the growth that adds value.
With both the short and long-term incentives focused on returns and shareholder value added, it’s pretty evident that management is incentivized to do the right thing for shareholders: make the company better, not simply larger.
Capital allocation
Capital allocation should be one of the most critical topics for any investor. The reason is that our forward returns will be determined by two metrics (assuming valuation stays constant):
The reinvestment rate
The return management achieves on that reinvestment
Both metrics determine how much the company grows and how much cash is left after achieving growth. I tackled the first metric (reinvestment rate) somewhat when discussing the growth opportunities, and this section will focus on the second metric.
Note that, as I wrote in my most recent article about my investment philosophy, past returns are probably our best guess about the future. The goal should be to find out how the company’s returns have looked like in the past and judge the probability of the continuation of such returns. We already took care of this last part in the previous section by looking at the company’s moat, and we concluded that Deere has all it takes to continue leading and maybe even strengthen its competitive position going forward.
So, let’s look at Deere’s returns. The first thing we can see in the chart below is that the company’s returns are somewhat volatile. This is normal if we consider the cyclicality of its industry, as discussed in other sections:
If we look at the company’s Return on Equity, we can see that this is significantly higher than its Return on Capital Employed. This should have been expected because its Financial Services segment operates with significant debt:
So, what can we conclude based on this information? It seems that Deere generates decent but volatile returns. This said, to understand the company's actual returns, it might be a better idea to look at its equipment operations and financial services segments individually. For the former, I’ll focus on its Return on Invested Capital. In contrast, I’ll focus on Return on Equity for the latter because a financial business requires leverage to generate good returns for its equity holders.
Returns in equipment operations
This is the ROIC that Deere generates in its equipment operations. You’ll notice that it skyrocketed starting in 2020, but there’s an explanation for this:
The recent rise in ROIC comes from favorable industry dynamics. While these appear temporary, I think they can give us some clues about a permanent improvement the company might enjoy going forward. Starting in 2020, the company saw two things come its way which acted as tailwinds for ROIC:
The resurgence in demand thanks to high commodity prices and the ongoing recovery from the prior downturn
Supply chain disruptions
Now, while #2 might not appear to be a good thing, it helped create (together with #1) a surge in pricing across the industry. Price increases don’t require any additional invested capital and thus profoundly impact ROIC. That’s precisely what we saw play out over the past 4 years.
While there’s no denying that these two conditions seem somewhat temporary, we must not forget that the transition the company is making to become a technology company will also profoundly impact what its ROIC will look like going forward. Management has openly stated they expect to deliver higher-value equipment, meaning that price increases will match productivity increases. This should translate into pricing becoming a more relevant component of Deere’s growth algorithm going forward. Likewise, the company will aim to increase its subscription penetration. Both of these ventures should help the company boost margins, and, what’s best: with a much lower requirement of invested capital. Software businesses are great business models because they can generate good growth without much additional capital needs. With Deere’s transition to this model, it’s tough to envision a scenario where its returns don’t get better.
Now, I am not saying they will get better than where they are today; I am saying that they’ll get better than where they have historically been in a steady-state market. If everything goes well, in the future, Deere should be a company enjoying higher margins and higher returns through the cycle, or in short, a better company. I don’t think Deere will get close to the returns or economics of a software business, but there’s a lot between being a pure manufacturing business and a pure software business!
Returns in Financial Services
Deere’s Financial Services segment has generated pretty good returns over the last decade:
Note that these returns are very appealing for several reasons. First, they seem to be cycle agnostic. 2013 marked the peak of the prior cycle, and although ROE dropped somewhat until 2017, it remained at an acceptable level all throughout. Management has said several times that they view this segment as a source of recurring profits when times get tough.
Secondly, we shouldn’t forget that these returns are achieved without assuming too much risk. I explained why in the second section:
First, the company has been operating in this niche for almost two centuries, and we could argue it knows its customers (both farmers and dealers) well. It’s reasonable to think that risk is under control in this sense. Looking back, we can see that the company’s loss provisions have never spiraled out of control, not even during harsh downturns. This makes sense, considering Deere understands the cycles, farmer economics, etc. To this, we have to add that equipment costs typically make up around 15% of farmers' total costs, so they have other places where they can try to save money, and Deere is precisely helping them save money in those places.
Secondly, Deere uses its financial services segment as an enabler of its main business, not as a profit-maximization operation. Leverage does not create problems when run conservatively but when run too optimistically, which tends to happen when someone tries to maximize their profit.
Lastly, but not less importantly, most of Deere’s debt is backed up by its equipment, which typically carries a high residual value.
You might have noticed the recent dip in ROE in 2023, which dropped below 10% for the first time in the last decade. Management attributed this weak performance to the recent interest rate trends, which have negatively impacted the company temporarily:
Rising interest rates have historically impacted our borrowings sooner than the benefit is realized from receivable and lease portfolios. As a result, our financial services operations experienced $170 (after-tax) less favorable financing spreads in 2023 compared to 2022.
Source: 2022 Annual Report
Uses of excess cash
Another important thing we should look at is where the management team invests our money and what they do with the excess cash. Over the last decade, Deere has generated around $47 billion in Operating Cash Flow, which it has distributed as follows:
Capex: $31 billion
M&A: $6.6 billion
Dividends: $9.6 billion
Buybacks: $22 billion
Management reinvests significantly into the business and returns the excess capital to shareholders through dividends and buybacks. I believe Deere has the potential to become a share cannibal, especially if we go into an agricultural downturn. The company has retired around 20% of shares outstanding over the last decade and has recently approved a significant buyback program through which management could retire +10% of the shares outstanding:
With the company’s nascent transition to become a technology company, I believe cash generation will only improve from here while reinvestment needs will be lower (as a percentage of sales). This should translate into more excess cash, which the company can return to shareholders through dividends and/or buybacks. It’s worth noting that the company’s dividend policy states a payout ratio between 25-35% of mid-cycle earnings.
M&A is also a relevant consideration for any company. As most of you might know, M&A tends (not always) to destroy shareholder value, and thus, we should be skeptical when we come against it. Deere has only conducted one significant acquisition, the purchase of Wirtgen in 2017 ($5.2 billion). This acquisition seemed to be a pretty good deal, though. Deere purchased a niche leader for a 9.5x forward EV/EBITDA without knowing the massive tailwinds the US infrastructure bill would bring. This acquisition was an exception, though. Deere primarily focuses on tuck-in acquisitions to continue building its tech stack. Over the past decade, around 80% of the $6.6 billion spent on acquisitions comes from Wirtgen, and the rest was invested in much smaller acquisitions.
All in all, I hope this section served to demonstrate three things…
It’s better to analyze the different segments individually to judge the company’s returns: the company’s equipment operations returns are “masked” behind the high invested capital the Financial Services division requires.
Deere’s ROIC is currently very high, and while this level might not be sustainable, there’s no denying that the company’s nascent transition can improve its steady-state returns going forward.
Management focuses on capital allocation because their compensation is adequate. When they have no use for the cash, they return it to shareholders through dividends and/or buybacks.
Valuation
I have decided not to do an inverse DCF for Deere because I think there are significant challenges due to the company’s Financial Services division. The good news is that the inverse DCF will not be necessary to demonstrate that the company is attractively valued (in my view).
Using the FCF yield to estimate Deere’s valuation
Management has guided to $5.5 billion in Free Cash Flow this year. If this is mid-cycle (which management claims it is), the stock is currently trading at a 5.5% normalized FCF yield, which is not expensive. We can see that a double-digit return is doable if we add the expected FCF growth rate to this normalized FCF yield (to calculate our expected returns).
Let’s say Deere grows its revenue at a 3-5% CAGR through the cycle (1-3% tends to come from pricing). This doesn’t strike me as optimistic, considering the company achieved a 5% CAGR from peak (2013) to peak (2023) in the prior cycle. To this, we have to add the margin expansion the company will enjoy from pricing and technology, meaning it might grow its earnings at around a 5%-7% CAGR through the cycle. If we add this growth rate to the current cash flow yield, we get an annual return of around 10.5% to 12.5%. And with well-planned buybacks, the return could even be higher.
This return would be achieved being conservative and without counting on multiple expansion, which can be a part of the equation as the company’s transition will make it a better business.
Deere is, in my opinion, a high-quality company that currently trades at a very reasonable price. Its products and services are not going anywhere and the industry is transitioning to one with better unit economics, a transition that Deere should lead over the coming decade.
Section 5: Some thoughts on cyclicality and where we are today
The first thing that stood out to me when I started researching Deere was its cyclicality. This cyclicality is pretty evident if we look at the company’s historical revenue growth rate:
For the sake of the discussion, let’s focus on cycles in the agriculture industry, as this is where Deere is most exposed to. Agricultural cycles are determined by many variables (like any economic cycle), with farm cash receipts probably being the variable with the most predictive power. When farmers are making more money, they tend to spend more on renewing the equipment. When they make less money, they defer their purchases and operate with relatively older equipment. In the graph below, you can see how farm cash receipts have historically correlated almost perfectly with Deere’s growth rate:
Cycles are totally normal in industries where customers have to make high capital investments because these investments tend to be cyclical. Another example of such an industry is semicap equipment, where customers tend to build more capacity during upcycles than downcycles.
Where are we today?
After several strong years of equipment operations growth, management has guided for a soft 2024. This is not great, but it should not be alarming either. Part of the investment thesis relies on Deere’s transition to a more recurring model, which should dampen the cyclicality of the business and help the company enjoy higher profitability throughout.
Several reasons should make the potential downcycle less worrying. Let me outline some of these:
The long-term trend is up despite the cycles. Deere operates in a long-term secular industry that faces cycles, just like the semiconductor industry, but obviously with less growth and optionality but arguably with less disruption risk, too.
Deere remains very profitable through the downcycles and has a significant stock repurchase program outstanding. This means that if the stock gets punished, we could see the company retire a significant portion of its shares in the coming years. Deere has retired around 23% of its outstanding shares over the last decade.
As I tend to build my positions over time, I would also take advantage of the opportunity to build my position at even more attractive prices.
What’s interesting and related to #2 and #3 is how Deere’s stock reacts to downcycles. One would think that the stock should drop significantly, but it doesn’t; it typically consolidates until the next upcycle. Despite its cyclicality, Deere’s stock has only been twice below 30% off ATHs over the last decade; one was COVID, and the other one was 2022:
Could we be going into a downcycle? For sure, and management’s guidance seems to say so. I don’t plan to forecast when or how the cycle will turn, but I do think there are reasons to believe that this cycle is somewhat different from past cycles. Let’s see why.
Is this time really different?
“This time is different” is a very dangerous expression when it comes to investing, especially when talking about a cyclical business, but let’s give it a go. I think several reasons make this cycle different from the past.
First, a good portion of the revenue growth has come from price increases, not volume growth, and it’s the latter that drives the cycle. According to Deere’s management team, the fleet's average age remains above its 20-year average in tractors and combines, meaning there’s still more runway for replacement. We might be inclined to couple revenue growth with volume growth, but this has simply not been the case over the last couple of years. Just for context, Deere took double-digit price increases over the last two years, significantly higher than its historical 3% price.
This, by the way, is also consistent with management's claim that after this year's 10% to 15% drop in agricultural equipment, the company will be around mid-cycle earnings. Many think we are at the peak of a supercycle, but much of that super-cycle has been price-led. This was well encapsulated by management in its most recent earnings call:
I would like to point out that the 2023 North America large ag volumes will be 20% to 25% lower than the 5-year average volume from the 2010 to 2014 replacement cycle. Our revenues are higher because we’ve increased our value per machine for our customers through precision ag solutions.
Worth noting that price increases come from higher value-added equipment, mainly from precision ag technologies. These developments might also be driving replacement demand as farmers see the need to replace their used equipment with new and more profitable ones:
So a lot of our pricing comes from our ability to deliver technologies and the machines that make them or give them the ability to create more yield or manage their cost differently. So that's a big part of it.
This dynamic is sort of countercyclical as farmers might look for profitability improvements during tough times, which might make replacement demand somewhat resilient.
Another reason to believe that this cycle is not comparable to the last is that the company’s inventory position is in much better shape. As Deere sells through its dealer network, there’s always an inventory component involved in the mix. If the company enters a downcycle with significant inventory across its dealers, then it means that not only will it suffer the impact of the lower end demand, but it will also suffer inventory depletion. This is not the case coming into this cycle, as management pointed out during the 2023 earnings call:
When compared to prior replacement cycles, we've managed inventory much tighter in North America than ever before.
Many are pointing out that higher interest rates are putting a dent in demand, and while this is true for SAT, it’s not for PPA. Higher interest rates make financing more expensive for farmers, but farm balance sheets are healthy, driven by high cash farm receipts over the last few years and rising land prices. Interest outflows are also a small portion of a farm’s total cost.
I don’t know (nor plan to forecast) if we will have a deep cycle in the agriculture industry, but many things point out to this time being different from the prior cycle. The company also remains profitable through downcycles and can take advantage of potential weaknesses in the stock price (just like shareholders), so I am confident the company would come out stronger on the other side.
Section 6: The Best Anchor Stock traits
As discussed at the beginning of this deep dive, the Best Anchor Stock traits are characteristics that help me adhere to my investing philosophy. Here they are:
I would like to say, though, that even though investment philosophy has pretty defined standards, it’s constantly getting tweaked (hopefully for the better) as I read and analyze new companies. It’s (in my opinion) very important to understand that investing is not an end destination but a journey.
In this section I’ll run through this characteristics explaining why I believe Deere complies with all of them. Note that much of the content I’ll go over in the following pages has already been shared (in one way or another) in the sections above, although there might also be new content.
Without further ado, let’s directly jump into the first trait.
1. Experienced and aligned management
I already discussed this topic in another section, but I’ll make a summary here. Deere’s management team is very experienced; most managers have been at the company for most of their professional careers. The average tenure across the management team is around 20 years:
The graph above also shows that they are relatively new to their current positions, but this should not be worrying for two reasons:
Most managers are not new to the executive team and have rotated across different positions.
Deere has a culture of letting managers demonstrate their worth. The average tenure of the last four CEOs is around 9 years, and I don’t think this time will be different.
Note that hiring from within the company and long tenures are classic characteristics of companies with a strong culture and long-term orientation.
As for alignment, I already shared in the section on incentives how Deere’s management team was not aligned with shareholders through significant stock ownership but through an excellent compensation structure. I wouldn’t say it’s the best compensation structure in the portfolio (this title would probably belong to Constellation), but it’s definitely better than most.
The bulk of management’s compensation is tied to shareholder value added. This is great because they only get compensated if growth is achieved while adding value to shareholders. This is what I wrote in that section:
This is great for shareholders because management only gets paid when growth is generated in a value-enhancing manner. If the incentives were focused on EPS, for example, a management team could achieve EPS growth while destroying value along the way; shareholder value added corrects this flaw and ensures that all growth adds value, or better said, that management is only compensated based on the growth that adds value.
As incredible as it sounds, most management teams are not compensated based on value-enhancing growth but simply on growth, regardless of how it is achieved. I am happy to say that Deere is not one such company.
2. Proven track record of outperformance
This is typically one of the easiest traits to assess because we just have to look at the past, although there are a few caveats. For example, in some instances, I’ll look at a company that I believe will improve going forward even if it has not enjoyed good past performance. To invest in such a business, I must be very sure that things are changing and that I don’t expect the future to look like the past. The bottom line is that I don’t like to bet against the past except when there are solid reasons to do so (rarely the case).
But, why do I care about the past when investing for the future? Well, because I don’t believe in turnarounds, or better said, I don’t believe in my ability to identify turnarounds. Companies that have outperformed in the past must have something special that has allowed them to achieve said outperformance. There are, in my opinion, two main tasks we must conduct when analyzing such companies:
Understand what has led to past outperformance: “What is their “magic”?”
Understand whether this is sustainable in the future: “Why will it last?”
If we find a past outperformer in which we believe we understand what makes it unique and believe in the sustainability of these unique characteristics, then there’s a high chance we’ll do well over the long run. Of course, these companies rarely come cheap, but they end up giving opportunities sooner or later due to the market’s focus on the short term. Don’t forget that the market tends to undervalue durability, precisely where long-term outperformers score the most points. Interestingly, most compounders continue to outperform over long periods despite appearing optically overvalued. If you want to understand why this is the case, I wrote an article on the topic long ago which I believe is still quite relevant: ‘What Makes Quality Undervalued.’
Anyways, going back to Deere, has the company outperformed over the long term? The answer is a firm yes. Deere has significantly outperformed the S&P 500 over the last 5 and 10 years:
As you can see in the image, the company’s performance is somewhat similar but slightly below that of the Nasdaq over the last decade. Deere has achieved an 18.6% CAGR over this period, only slightly below that of the Nasdaq (18.7%). This definitely constitutes underperformance on a total return basis, but maybe not so much on a risk-adjusted basis. I would argue that the Nasdaq is not a great comp for Deere, at least not over the past decade. However, if the thesis plays out as expected, it might become a good comp going forward. Seeing a company like Deere, boring and focused on agriculture, almost achieve a 19% CAGR over a decade is what I love about investing: returns are to be had even in the most unexpected places of all because there are no extra points for complexity.
Let’s take a quick look at what drove this outperformance. Over the last decade, Deere has grown its Free Cash Flow per share by 521%, or at a 20% CAGR. Its Price to Free Cash Flow ratio has followed a different route, contracting 15% over the period (not CAGR). This means the company’s outperformance can be entirely explained by underlying business performance rather than multiple expansion. This should be no surprise, though, as it’s the norm once we look at companies over long periods (exceptions apply, of course):
3. Strong moat
I will not dig too deep into the moat in this article because I already reviewed it in section 3 of this deep dive. There are several pillars to Deere’s moat, the most important of which is probably its installed base, as it underlies some of the other pillars. The company has been operating in the industry for over 180 years and leading it for over 61 years. This has allowed Deere to build the most extensive installed base in several geographies, which will prove essential in terms of having access to distribution and development of new technologies. As discussed in my third article, data is critical in technological development, and Deere has access to plenty of it to create a flywheel:
The dealer base constitutes another pillar of Deere’s moat. As most agricultural profits are made over relatively short periods, having a dealer close to the farm who can promptly take care of repairs and maintenance is critical. It’s also worth noting that some dealers have had relationships with family-owned farms for decades, meaning that they act as Anchors (no pun intended) for these customers who will not change brands unless the dealer changes; I already explained why this is highly unlikely.
Scale is also a relevant competitive advantage, and this section ties pretty well with a book I have recently read (thank you, Anchor Kwonil, for the recommendation). Thanks to its scale, Deere can gather more data to improve its technology further and spend more in absolute dollars than its competitors while remaining more profitable.
With the current transition to technology the industry is undergoing, I’d say that scale’s importance is increasing materially. Many investors view scale as bad due to the law of large numbers. Still, history has demonstrated that when an industry transitions to intangibles, it starts to experience winner-take-all dynamics:
In markets where scalable investments are important, you’d expect to see “industry concentration”, a relatively small number of dominant large companies. Winner-takes-all scenarios are likely to be the norm.
Source: Capitalism Without Capital
Not only will Deere remain on top, but it will also probably widen the gap with its competitors. I believe this will happen as the industry transitions into technology, which favors the scaled player. Note that technology is not always beneficial for the large incumbent (in many cases, it’s quite the opposite), but in the agriculture industry, the data to create or improve this technology matters dearly, and Deere has by far the most significant installed base to collect this data.
4. Enjoying long-term secular tailwinds
In a previous section, I also went over the long-term secular tailwinds that Deere enjoys. These are pretty simple to understand and, thus, pretty straightforward to explain. Note that, as mentioned before, one doesn’t get extra points for complexity, so there’s no need to overcomplicate a thesis.
As most of you might know by now, Deere operates in two distinct segments: agriculture and construction. Let’s start with agriculture. There are two main long-term secular tailwinds in agriculture, one of which might impact top-line growth and the other of which might impact profit growth through margin expansion. Let’s focus on the former first.
The global population keeps increasing, especially in emerging markets, and this has two potential ramifications for the agriculture industry:
In mature markets, population growth leads to increasing food needs, which obviously benefits agriculture as the required output increases.
In emerging markets, people are increasingly consuming higher-quality proteins. These proteins typically come from animals that are fed agricultural output like grain.
To this, we must add that the agriculture industry might enjoy dynamics similar to those of the semiconductor industry regarding geopolitics. With geopolitical tensions on the rise globally, many governments are incentivizing the on-shoring of agriculture. I am a firm believer in globalization, but I have always believed that there are three things a country should never off-shore: energy, defense, and agriculture. But, why does this matter here? Well, just like in the semiconductor industry, the on-shoring of agriculture will lead to inefficiencies that will probably benefit the equipment manufacturers. I don’t think the thesis relies on this, but it’s always worth considering.
So what about profit growth? There are also significant growth drivers at play here. As discussed throughout the article series, the industry must deliver more output, but regulations are increasingly pushing farmers to achieve this output with less input. This will only be possible with the increasing penetration of technology, which will, in turn, make equipment manufacturers better businesses: higher margins, lower capital intensity, and more recurring revenue…the pie here is significant, and Deere is perfectly positioned to capture a good chunk of it:
I have discussed the growth drivers for construction several times (not only in this deep dive). If we focus on all geographies, infrastructure is critical for economic growth. This means governments must invest in new infrastructure and renovations to keep their countries growing.
If we focus on the US, we also have the Infrastructure Act, signed into law in 2021. US infrastructure is in a dire state, and both federal and state governments will have to spend significant amounts of money to renovate it. A good chunk of this increased investment will flow directly into roads and bridges, a niche where Wirtgen (a company acquired by Deere in 2017) is the global leader.
We also have to add the onshoring that’s going on to all these tailwinds, which is somewhat related to the geopolitical tensions I discussed above. Governments worldwide are onshoring critical industries, which need infrastructure to support them.
All in all, it’s pretty clear that Deere’s industries enjoy significant tailwinds and that these tailwinds will be with us for a pretty long time.
5. Optionality
Deere’s optionality doesn’t come from new industries but from the digital transformation happening in its current industries. The automation of the farm will bring significant opportunities for Deere to add value and take a reasonable share. While many of these automations are “knowable” today, I am sure that new, unexpected opportunities will emerge in the future.
Optionality typically takes two shapes:
Creating or disrupting new industries: Amazon is a great example here
New growth avenues in the current industry: most companies are great examples here
The best optionality is obviously #1 because, due to its unpredictability, it’s highly likely that the market will not price in it. Of course, this unpredictability also means it will be tough to value. I don’t think we should consider optionality in valuation, but we should indeed take it into account in our research.
Some companies have cultivated cultures of reinvention, and these are the ones most likely to enjoy optionality going forward. In short, good things tend to happen to good companies. Is it possible to forecast all the automations that Deere will solve in agriculture and construction? Not quite. Is it probable that whatever comes the way of the industry, the company will be prepared for it? I would say that the answer to this question is a “yes.”
6. Double-digit growth
This is the trait that I am most “worried” about in the sense that I am not entirely comfortable with it. I have shared with subscribers that I will eventually modify it, but I still have to do this. The reason for this is that we shouldn’t care as much about double-digit growth but about double-digit returns. Growth is an essential variable in the return equation, but not the only one; Deere is a great example.
Let’s set this straight: while I believe Deere can achieve double-digit growth in Free Cash Flow over the coming years, I am not counting on it as part of my investment thesis. There are definitely reasons to believe the future might be different than the past, but a new baseline is definitely not something that I am willing to bet on. The good news is that neither does the market.
So, let’s look at past events so we can build on them. Deere has historically been a somewhat cyclical company, so we must be cautious in extrapolating past growth to future periods. The reason is that the time horizon matters quite a bit for a cyclical business. I’ll look at the last 10 years because this period goes from 2013 to 2023, both of which were supposedly peak years. We know 2013 was a peak year, but we still don’t know if 2023 was, although everything seems to point out it was.
Over the last 10 years, Deere has achieved a revenue CAGR (Compounded Annual Growth Rate) of around 5%:
I think growth can accelerate for the reasons discussed in section 2, but a slide should be enough to explain the opportunity ahead. With the industry's transition to technology, there will be more opportunities to add value to farmers. Obviously, the company will take its fair share of this value add.
The bottom line is that I don’t think Deere will be opportunity-constrained going forward in agriculture or construction, but let’s assume the company achieves the same revenue growth rate it achieved over the last decade: 5%.
To this, we must add the potential implications that the transition to technology can have on both margins and cash conversion. Deere is increasingly transitioning to…
Higher-value add equipment
More subscription revenue
Both of these revenue sources bring with them higher margins, so it’s natural to see margins go up as the transition advances. This is also something that management is expecting:
We are confident in our ability to produce higher levels of returns through the cycle while dampening the variability in our performance over time. This will lead to higher highs and higher lows for our business.
Josh Jepsen, Deere’s CFO, during the 2023 call
But this is not the end of the story. Subscription revenue converts to cash at a much better rate than equipment, and higher-value-add equipment is less Capex intensive. Both of these should theoretically translate into better overall cash conversion. If we add all this up, I don’t think it’s crazy to believe that Deere can grow its Free Cash Flow at a 7-8% CAGR over the next 5 to 10 years. Let’s, just in case, make a reality check. Over the last decade, Deere has grown its FCF at a 17% CAGR, so our estimate is definitely not crazy:
I know that this level of growth would make Deere non-compliant with this trait, but that doesn’t mean that Deere can’t deliver a double-digit return. You’ll understand why when I go over the valuation in the last trait.
7. Strong financial position
‘Strong financial position’ was the trait that I did not expect Deere to comply with when I started analyzing it. The reason is that if we screen for Deere across any financial provider, we can see that it shows an extremely high debt load in relation to the company’s market cap. The company theoretically has a total debt of $64 billion with a market cap of $112 billion:
However, concluding that Deere is in a dire (no pun intended) financial position would be pretty misleading, and the reason lies in its Financial Services segment.
As discussed in section 2, any financial business requires quite a bit of debt to enjoy worthwhile returns, and that’s precisely where Deere has most of its debt: in the financial services segment. We all know what leverage can do to financial businesses (the Global Financial Crisis was a good example), but I don’t think we should worry about Deere’s financial segment for the reasons. I already discussed those in that section, but I’ll bring them summarized here:
The company has been operating in its niche for almost two centuries
Financial Services is not a profit maximization operation but rather an enabler of the company’s underlying business
Debt is backed by the company’s equipment, which has significant resale value
In my opinion, this means that we should not look at Deere’s financial segment like we look at any other traditional financial business. If we strip out this debt, we see that the underlying business (equipment operations) enjoys an excellent financial position. This is from the second article:
The equipment operations segment also has $5.7 billion in cash and equivalents, yielding a net debt position of $2.74 billion. If we compare this with the segment’s operating income of $12.2 billion, we get to a net debt/EBIT ratio of 0.22x, which is pretty conservative if you ask me.
It’s normal for Deere’s management to run a conservative balance sheet due to the historically volatile nature of its business. The net debt to EBITDA ratio can rise pretty fast if EBITDA drops during a downcycle. Still, I believe the company’s transition to more recurring revenue will tame these impacts going forward and the company will have no trouble whatsoever weathering tough times.
Deere might appear to be an overleveraged company at first sight, but the truth is different once we dig deeper. The fact that the company screens badly is an important reason why many pass on it; I was close to being one of those people!
8. Lower than usual volatility
Deere is a somewhat cyclical company, and as such, one would expect to see cyclicality in its stock price. I thought I would come across this volatility when I started looking at the company, but I was quite surprised to see I was very wrong. Note that I don’t necessarily dislike volatility because it can also give us better buying opportunities, but I obviously care about it in the sense that it makes holding a portfolio much more challenging.
If we look at Deere’s past drawdowns, we can see that the company’s stock does not tend to suffer from extreme volatility, not even during industry-specific or economic downcycles. Over the last decade, Deere has never been more than 40% off ATHs, not even during COVID. The company has indeed been twice more than 30% off ATHs, but the market was also significantly down during both of these occasions:
What’s surprising to me is that, despite starting its downcycle in 2013 and only recovering in 2017, the company did not trade by a significant amount off ATHs for long. We are seeing something similar play out today.
Many investors believe the company has been on the brink of a new downcycle for quite a while, but this has not stopped the company from trading relatively close to ATHs:
What we tend to see with Deere’s stock is that it tends to make “quick” increases only to later consolidate for a while. This is evident if we look at the company’s 5-year chart; Deere has been consolidating for 3 years already:
So, why does this happen? I honestly don’t know the reason, but I can speculate. I believe it might be related to two reasons. First, the market might identify that, despite being cyclical, the company is long-term secular in nature. It might make sense to see a cyclical, non-secular company’s stock be very volatile, but for secular companies, the market might allow these to grow into their valuation during tough times. This, by the way, might also be related to the fact that disruption risk for Deere is lower than for other cyclicals, so the market does not tend to react violently to downcycles as it might identify these as business-as-usual.
The other reason may not be a reason to explain why the stock is not as volatile as we would expect, but it should definitely give us comfort. Deere recently approved a significant buyback program that it may utilize if the stocks drop significantly. Seeing a stock drop is never great, but it can be very beneficial for long term shareholders if the company takes advantage of the drop to retire shares. The rationale is that our ownership of the future cash flows goes up without having to invest more of our money. Deere has retired around half of its shares over the last 20 years:
The company currently has $13 billion outstanding in its repurchase program, equivalent to around 10% of the company. Would it be bad to have a downturn under this scenario? Not really, in fact, as I don’t have a full position yet, I would most likely welcome it.
All in all, despite being a cyclical company, Deere’s stock is not as volatile as one might expect. The reason probably lies in the inherent secularity of the industry and the company’s solid moat.
9. Resilient during recessions
As some (or most) of you might know by now, I have two ways to analyze this trait. The first one is simply going back to see how the company performed during a prior recession. There are two requirements for this method to be applicable. First, the company must have been publicly traded at the time of the last recession, which was in 2008 (the Global Financial Crisis). Note that a recession here can be anything from an economic to an industry-specific downturn, so sometimes we don’t need to go back to the Global Financial Crisis to judge the company’s resilience.
The second way we have to analyze this is to understand how resilient the business is. A good starting point probably is understanding its mission criticality and its proportion of the customer’s total budget. For Deere, I’ll use both methods because it’s 200-year-old company that’s transitioning to a different model going forward.
So, how did Deere do during the Global Financial Crisis? The company saw both its revenue and net income drop in 2009, but it remained profitable and recovered shortly after:
It’s not a coincidence that Deere is resilient to recessions, as its customers (farmers) produce something non-negotiable: food. Farmers can indeed delay their equipment renovations, but there’s only so much they can do this if they want to remain competitive. Note that this resilience also applies to construction, as this segment tends to be tied to government expenditures and these tend to be more resilient during recessions.
2008 is not the only recession the company has experienced. Deere was founded in 1837, so it has gone through its fair share of recessions, not only economic but also agricultural. The fact that the company is still alive and thriving today is a testament to its resilience. The bottom line is that very few companies survive for almost 200 years if they are not resilient to economic and geopolitical shocks.
Now, we have to consider that Deere is transitioning to a more recurring model thanks to technology and this has several implications for this trait. For starters, the company’s revenue and profits will be more stable through the next recession as it starts monetizing farmers’ operations, not just equipment purchases. It’s highly likely that food will still be demanded during the next economic downturn, so farmers will likely continue to operate their farms.
Note also that equipment renovations can’t be deferred long if one wants to stay at the leading edge of the industry. If a farmer has better technology than me, I am less competitive, so I have to look into equipment renovation to catch up (the key lies in that they sell a commodity).
Another key piece of this puzzle is that equipment costs don’t make up a large portion of a farm’s budget. This is even more true during recessions when interest rates are likely to be low, and thus, financing for farmers is cheaper. This ultimately means that if farmers are looking to cut costs in the future, it’s improbable they’ll choose equipment to do so, as it’s precisely this equipment that will allow them to save money from inputs and labor, their most significant cost items.
All in all, I don’t think Deere will have any trouble weathering the next recession. This recession will eventually come either in the global economic landscape or in the agriculture industry. The company’s products are mission-critical and make up a low portion of the customer's costs, which is important for farmers and Deere as the loss provisions from its Financial Services remained quite resilient even during past downturns.
10. Reasonable valuation
I have touched on this topic in another section, but it will come in handy here to explain why we don’t need a double-digit FCF growth rate to enjoy acceptable returns. The reason is obviously that the starting valuation also plays an important role in our expected returns.
According to management’s guidance, Deere will generate around $5.5 billion of Free Cash Flow in 2024, which they believe is coherent with around mid-cycle earnings. It’s precisely these mid-cycle earnings that we care about. Some analysts/investors don’t believe Deere will be at mid-cycle earnings next year, but many are missing that the cycle is set based on units sold, not revenue. This means that Deere might have enjoyed a revenue surge due largely to pricing but not to units sold, and yes, this is precisely what happened over the last few years.
So, based on management’s guidance, Deere is trading at around a 5% next-twelve-month free cash flow yield. If we use the quick method to approximate our potential returns by adding the expected Free Cash Flow growth rate to this number, we get to expected returns somewhere between 12% and 13%, which is pretty acceptable for a company with such solid competitive and financial positions.
As you can see, we don’t need double-digit growth to enjoy (if everything goes right) double-digit returns. This said, it’s evident that every expected digit of faster growth at the same valuation is safer than lower growth.
To end this section on valuation, I want to leave you with the following quote that I came up with:
Trading at a 5.5% FCF yield at mid-cycle basically means that Deere could stop growing today forever while returning all its Free Cash Flow to shareholders, and we would still make a 5.5% annual return.
Not bad. Of course this is not the outcome I expect going forward, or else I would not have invested in the company.
Concluding remarks
I’ll not make my concluding remarks long as I believe enough has been said in the pages above. I believe Deere is a great company trading at a fair valuation. The worries around its cyclicality are justified, but my intention is not to time the cycle here but rather to remain a long term shareholder as the business improves. My inability (or better said, my knowledge of my inability) to time industry peaks and throughs exposes me to opportunity cost, but that’s something I am fine with as the impact of this opportunity cost on returns should diminish the longer the investment horizon (this, of course, if we have made a correct decision with the company).
I really hope you enjoyed this deep dive and feel free to send me an email to bestanchorstocks@gmail.com with any comments or for further discussion (this is where, in my opinion, lies most of the value add from the investment community).
I would also be eternally grateful if you can share this deep dive with those who you think would me interested. Thanks a lot in advance.
Have a great one and be sure to follow me on social media:
Leandro
Disclaimer: Leandro holds shares of Deere as of the publishing date of this article, which does not constitute formal advice or recommendation; it was uploaded with informational purposes only. Do your own due diligence.
So huge! Thanks! How many days it take to write all this? :D
Aweomse podcast and deep dive. Keep up the awesome skme work.