DE - Deere: The 5 Tailwinds Supporting A Buy Rather Than A Sell

2023-03-23 10:46:53 ET

Summary

• Some analysts recently downgraded Deere to a sell.
• Deere runs a business whose cyclicality is indisputable. Yet, it is targeting a new way to create a stream of recurring revenue.
• Thanks to easy comparables, Q2 results should be impressive, as strong tailwinds suggest this agriculture machinery replacement cycle may last longer than expected.

Introduction

When considering farming machinery and equipment manufacturers, Deere ( DE ) is the undisputable market leader, with high brand recognition and a TTM revenue of $55.65 billion that is more than twice as large as CNH Industrial's ( CNHI ), which is its closest competitor.

However, as some SA readers may know, I spent most of 2022 saying that CNH Industrial was a better buy than Deere. Recently, I turned bullish on Deere, too.

In the past days, the stock had some weakness, which created a new entry point as the price dipped to the $380-$400 range, even though recent news sees the stock picked as a top short-sale idea .

Deere's bull-case

The thesis I developed was simple and based on the following points.

1. Strong demand for new and more technologically-advanced equipment
2. Supply chain bottlenecks stretched demand fulfillment over an unusual period of time
3. In this situation, some demand "trickles down" from the market leader to other competitors
4. These competitors benefit from premium customers who are used to high prices
5. As a consequence, these suppliers have an increased pricing power to close the profitability gap with the market leader

So far, these points don't seem like a bull-case for Deere. In fact, I used these points to argue that 2022 would have been a great year for CNH Industrial, as it actually turned out to be.

However, Deere's bull-case starts as these 5 points develop into a few others.

1. Deere's margins in the first half of 2022 were very low because supply chain issues made it ship model year '21 machines. Now that there are fewer supply chain disruptions, Deere is effectively delivering model year '23 machines YoY results that are actually comparing a two year difference in delivered models. This is why Deere reached $12.65 billion in net sales and revenues (+32% YoY) and a 117% net income growth YoY which lead to $6.55 diluted EPS, up 124% YoY.
2. Deere has been able to use its brand recognition to significantly hike prices and offset higher costs due to inflationary pressure. In the first half of 2022 Deere had not been able to do so and it saw its margins shrink to the single digits, whereas the company has gotten investors used to agriculture margins above 20%.
3. During the last earnings call , Deere disclosed its order books are still on an allocation basis and they extend well into Q4 and are almost full for the whole year.
4. We read in the 2022 Global Agriculture Productivity Report that "the Organization for Economic Cooperation and Development (OECD) is predicting 1.4% annual growth in food demand during 2022-2031, mostly due to population growth. Total agricultural output growth averaged 1.93 percent during 2011- 2020. According to OECD's population growth projections, world per capita GDP growth will exceed population growth, meaning that net per capita income should increase worldwide. This trend is predicted to be especially pronounced in India, China, and Southeast Asia. In contrast, population growth in Sub-Saharan Africa will be more than twice that of GDP. Thus, increasing TFP (total farm productivity) growth will be especially critical in this region to meet food demand and maintain an affordable food supply while protecting the natural capital on which agricultural production relies". These words help us understand why Deere's technological innovation in precision and autonomous farming is a key driver of Deere's current and future success.
5. Even though agricultural equipment replacement is a cyclical process, this cycle seems to be different from the previous ones for two reasons:
   • As Deere's management said during the earnings call: "production levels in 2023 are still 20%, 25% below prior replacement cycles." As a result, large tractor age in 2023 is expected to remain elevated. This sets the ground for a longer than expected replacement cycle.
   • Deere is pushing hard on digital, automation, autonomy, and alternative propulsion technologies. Through these, the company wants to increase its products' efficiency while boosting its economic value. At the end of 2022, the company reported 500k connected machines with 329 million engaged acres. The most important thing is that connected machines are a source of recurring revenue, which, according to Deere's Leap Ambitions, should become at least 10% of total revenues by 2030. While Deere seems to be lagging behind Caterpillar ( CAT ) as far as the development of this business, we are before a strong effort to go after a high-margin recurring revenue. This is able to offset at least part of the traditional cyclicality in the machinery business. As Deere's management stated during the last earnings calls: "we're getting started. I think we're off to a good start. But it's really - you need to consider both our goal to get to sort of through-cycle margins of 20%, but then also minimize the volatility around that 20% as part of the goal suite as well". Investors will need patience, but I am expecting Deere's revenue to be more stable than usual due to this important business model shift.

We can add to these points a few macro-trends that are actually implied: growing world population, land scarcity, and a tight labor market leading to autonomous solutions.

My expectations

As I said above, Deere will have very easy comparables in the first half of the year, since in the first two quarters of 2022 Deere was actually still delivering 2021 machines. Now that it is back to a more normal way of operating, Deere is delivering 2023 models with 2023 prices. Thus, I expect another strong quarter with net income and EPS growth that could still be around 80% YoY. Of course, these results are not sustainable, but I think they will help the stock's price as investors will likely react favorably once these results are published.

In addition, farmer profitability is still high thanks to high commodity prices and this situation, when coupled with very favorable government policies in many countries around the globe, should help to further extend this replacement cycle well beyond 2023.

To be honest, Deere did report in Q1 some softness in its turf and utility equipment division, which is more directly correlated with the general economy and housing in particular. However, it is also usual to see some inventory build during the winter season as sales pick up speed during spring.

Deere raised its FY 2023 guidance to $8.75-$9.25 billion of net income, with net operating cash flow coming in between $9.25 and $9.75 billion.

I actually believe that with the current visibility Deere has on its order books, the company has enough room to operate in terms of efficiency and cost management, leading me to think that Deere will either end the year in the upper range of its guidance or it will even exceed it, coming close to $10 in net income and breaking the $10 billion barrier when considering net operating cash flow.

Even in case Deere's market will slow down a bit, I see this as favorable for Deere because it will be able to gain back some of its customers who had to turn to CNH Industrial or AGCO until now. In this way, Deere will claim once again its real market share.

Conclusion

I recently wrote an article " Deere becomes a buy " where I explained why I thought that under $400 a share we are in buying territory. After Deere's earnings report, I think it is even more reasonable to buy below that price as both the fwd PE and the fwd EV/EBITDA ratios are below 14, which I think is fair for a company with such a strength in an industry where there is a strong oligopoly of 3/4 major players, among which Deere is more than twice the size of the second largest one. This is why I just bought some more shares, doubling the small position I initiated in January. For the sake of transparency, Deere still makes up only 1% of my portfolio. But I plan on patiently building a bigger position quarter after quarter, dollar cost averaging whenever the market will present me with the opportunity to.

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