Deere’s Q4 2024 Earnings

The market is waking up

Hi reader,

Deere reported Q4 and FY 2024 earnings last week. The market liked these quite a bit, and the stock shot up significantly. Deere was up more than 10% during the week; the strength has persisted, and it has breached all-time highs (albeit it has been relatively flat for more than three years):

Many people believe this market reaction and the brand-new all-time highs are related to an inflection in the current agricultural cycle, but the reality is that this reaction seems to have more to do with the market waking up to a structurally better company rather than with the cycle per se (as it has not inflected). The earnings call brought several excellent examples of this structural improvement, but before reviewing these, let’s look at Deere’s summary table.

The summary table and some comments

Here’s the summary table for Deere:

Source: Made by Leandro

I usually comment quite a bit on the numbers, but this time, I thought it would be better to share three main messages and jump to more relevant topics. The first of these messages is that Deere is still immersed in the agricultural downcycle. This is evident not only in this year’s numbers but also in next year’s guide. Net income is expected to decrease further next year, albeit the decrease will probably be less violent than this year. 

Recall, though, that Deere’s numbers are not necessarily a good proxy for the cycle (i.e., end demand). This year, management chose to significantly underproduce its end markets to work through the inventory its dealers held. This means the industry was down less than Deere this year, but “the industry” also carries higher inventory levels on average. 

Industry inventory-to-sales ratios for new equipment are more than double Deere’s ratios for both 100 horsepower and above tractors and combines.

The opposite is expected to happen this upcoming year. Deere is expected to perform better than the industry now that it has worked down its inventories to “record” lows.

The second message is that Deere is becoming a structurally better company through the downcycle. Nobody knows when the next upcycle will come, but it’s becoming clear that Deere will come out of this downturn with significantly higher margins than it went into it (I’ll discuss this later). These higher margins, together with the fact that…

1. The company will see a restocking benefit from its currently low inventory levels: “In the last 10 years, inventory to sales ratios for 220 horsepower tractors have only been this low twice.”

2. The company is repurchasing shares

…should position the company for significant growth and operating leverage coming out of this downcycle. If management achieves the midpoint of its FY 2025 guidance, the company is currently trading at 24x (what might be) trough earnings. I believe the market is now waking up to this structural improvement by granting Deere a higher multiple, but it still seems like a low multiple for a company expected to enjoy strong earnings growth coming out of the downcycle (I’ll go into the valuation in more detail later).

The third and last message I would give is that one shouldn’t over-obsess with quarterly numbers. There’s quite a bit of volatility across quarters due to the over/underproduction I discussed above. This under/overproduction also has a direct impact on cash flow generation. Despite lower earnings, Deere generated more operating cash flow this year due to several factors. The first of these was favorable working capital dynamics:

We successfully reduced in-process inventory levels, which drove much of the cash flow outperformance relative to our Q3 guide.

To this, we must add that Operating Cash Flow includes both Financial Services and Equipment operations. Operating cash flow for the latter was $6.9 billion compared to $11.9 billion last year (which honestly seems like an outlier). We can better understand the underlying movements when Deere publishes its annual report. What we can see is that Deere generated this year 10% more in OCF in its equipment operations than in 2022, a year when the cycle was in a much better shape. In my Deere research, I also mentioned that we would likely see cash conversion improve over the long run.

This situation is expected to “correct” next year, with cash flow expected to come in significantly lower. That said, Deere will remain a cash-generative business during the downturn, which is great for two reasons…

1. Management can continue to reinvest in the business: R&D and Capex were both up this year despite top-line pressures

2. Management can continue returning cash to shareholders through dividends and buybacks

I highly doubt Deere’s competitors, which have significantly lower margins, will be able to do both to the same extent as Deere during the downcycle.

Where are we in the cycle?

Markets are inherently short-term oriented, so the question everyone has been asking themselves for a while is…

When will the cycle inflect?

The market seems to have obsessed so much with this question that it completely ignored the underlying shifts that were going on at Deere (good news for us). Timing the duration of the cycle is impossible, but we can at least understand where we are today. According to Deere, shipment volumes are currently below mid-cycle levels. This means that Deere's financials are not normalized and are in a slightly worse position than they should be in a normalized scenario. 

Industry volumes are expected to deteriorate even further next year, but the slowdown is expected to moderate somewhat (at least at the Deere level) due to the inventory dynamics I discussed above. Management even sees an opportunity to return to growth during some quarters next year:

As you move throughout the course of the year, those year-over-year comps get better, particularly in the back half, and you get to kind of flattish, if not up a little bit, as you look at Q3 and Q4 2025.

So, yes, Deere is still weathering the agricultural downcycle, but it’s not my intention to time the inflection point. When I released my research on Deere, some people told me that Deere is a cyclical company that should be bought when valuation multiples are optically high. While this is true in most cases, it’s less accurate for cyclicals improving their margin profile to the extent Deere is. The reason is that the market might look back to past cycles to forecast this cycle in terms of margin decrementals and operating deleverage, but this might not be the best way to forecast the future when margins are structurally higher. It’s still soon to tell, but this is what might have happened with Deere.

The thesis is playing out: Deere is becoming a better company

Core to the Deere thesis was a structural improvement in the quality of its business. Deere is taking the necessary steps to make its revenue more recurring and higher margin, and it seems to be working out. Here are some examples given during the earnings call:

“It is important to emphasize that our implied guidance of around $19 EPS is at sub-trough levels, with expected sales for fiscal 2025 below 80% of mid-cycle.”

“Our margins in 2024 exceeded 18%, reflecting nearly 700 bps of improvement from 2020, which was the last time we were at this point in the cycle.”

“Our earnings per share and cash returned to shareholders not only surpassed historical mid-cycle levels, but also historical peaks. We expect to deliver higher margins at trough than we did during the previous peak in 2013.”

As discussed above, this higher profitability allows the company to reinvest countercyclically to the extent that few (if any) competitors can. These investments are paying off in the form of better and more technologically advanced products that ultimately drive margins. Engaged acres grew 20% this year, and highly engaged acres grew “north of 30%.” Technologies like See and Spray and Exact Apply are also gaining penetration:

“See and Spray covered 1 million acres this year alone, reducing herbicide use by an average of nearly 60%. We expect to see a significant increase in the number of acres covered by See and Spray technology in the 2025 season.”

“The adoption of ExactApply technology on model year 2025 sprayers increased by over 10% year over year, reaching a nearly 80% take rate in this year’s early order program.”

Before Deere started this “technological” transition, people feared farmers might be reluctant to adopt technology due to their conservativeness. However, farmers are very savvy and will invest where the return makes sense. Deere mentioned that farmers are welcoming new recurring payment models:

“We are seeing higher levels of adoption using the pay-per-use model compared to our traditional upfront pricing approach.”

They seem to be embracing more technologically advanced features from the get-go, too:

“Over 75% of combine early order program orders have opted for our highest level of harvest setting automation. We expect our customers will experience up to 20% boost on average in harvest productivity from this feature alone.”

It seems pretty obvious to me that the thesis is playing out: Deere is becoming a better company thanks to its transition to technology and recurring revenue models. It’s still soon in this story, but margins are showing great promise thus far.

Two other topics worth flagging

Before jumping into the valuation, I think touching on two other relevant topics is important. The first one is related to financial services. Deere reported lower net income for financial services due to “higher provision for credit losses.” This is something that we should expect during a downturn so long as it doesn’t become worrying. That said, management also mentioned the following:

“One example of the changes we made in 2024 as a result of this engagement is the offering of new financing programs, which have been greatly appreciated by both our customers and the dealers supporting them.”

I don’t exactly know what these “new financing programs” are, but we must ensure that Deere is not relaxing its credit standards, as this could bring problems down the road (we’ll have to wait for the annual report to find out or ask management).

The second thing I wanted to mention is related to the Trump administration. You might recall that some months ago, Trump warned Deere that they would face significantly higher tariffs if they moved production to Mexico. Back when this happened, I saw it as a nothing-burger, and my point of view has not really changed. Most of Deere’s production still occurs in the US:

“Greater than 75% of all products that we sell in the US are assembled here in the US.”

The company’s main competitors are CNH Industrial through the New Holland brand and AGCO through its Fendt brand. Both these competitors are domiciled in Europe, and while I don’t have the exact numbers, I think it’s safe to say that they depend more on imports than Deere. So, tariffs might not even be bad news for Deere (relatively speaking).

I also think Trump’s administration might be positive for Deere by reducing immigration. Most illegal immigrants end up working in agriculture, and with farms already having labor problems, reduced supply might “force” them to renew their equipment to one that’s more technologically advanced and, therefore, more productive. This is just me thinking out loud, and I have absolutely no clue what will end up happening.

Brief thoughts on valuation: the market is waking up

Deere is up significantly since reporting earnings and has breached its all-time highs this week. With declining earnings, this move has come entirely from multiple expansion, but is it reasonable? My short take is that it is.

If Deere meets the midpoint of its net income guidance ($5.25 billion), it’s currently trading at 24x forward trough earnings. This is not a high multiple for a company with three EPS growth engines at its disposal once the cycle inflects…

1. Earnings growth through operating leverage and structurally improved margins

2. Multiple expansion acknowledging a structurally improved business (not counting on this for the thesis)

3. Share repurchases

I wanted to discuss the first of these because, even though we don’t know when the cycle might inflect or to what extent, we can try to understand what operating income might look like when the company reaches a new peak. 

As shared before, Deere’s operating margin is today 700 basis points above its 2020 level when it was also at 80% of mid-cycle earnings. Assuming 2022 equipment operations sales are mid-cycle (and those of 2023 above cycle), with the improved margins the company enjoys today, it would enjoy operating margins of around 27% at mid-cycle. This would result in $13 billion in operating income at mid-cycle just from equipment operations, assuming the next mid-cycle is not higher than the past one.

If we did this exercise with 2023 numbers, Deere could potentially enjoy an operating margin of around 32% of peak equipment operations revenue (a 700 bps improvement compared to the prior peak operating margin). At 2023 peak revenue and a 32% operating margin, Deere would generate equipment operations operating income of around $18 billion, the highest in the company’s history and almost double this year’s operating income. This obviously assumes that the next revenue peak is at the same level than the 2023 peak, which has rarely been the case for Deere as it has been a secular company despite the cycles:

All in all, I don’t think Deere’s current run is unjustified, and I don’t think the company is particularly expensive here. While the cycle is ongoing, the company seems to have outperformed the most optimistic of expectations regarding margins, and the market appears to be waking up to this fact.

In the meantime, keep growing!