Deere & Company (NYSE:DE) designs and manufactures innovative agricultural equipment, construction equipment and forestry equipment. The company has been operating since 1837. Since its founding, Deere has developed a strong brand that stands for quality products and has developed loyal customers around the globe. In this article, I outline why an investor with a 5-year investment time-frame could achieve compound annual returns of 17% or higher by purchasing shares of this excellent company right now.
Deere has experienced solid growth in revenues and earnings over the last decade. From 2003 through 2012, Deere increased annual revenues from $15.5 billion to $36.2 billion (an increase of 133%) and earnings per share from $1.32 to $7.63 (an increase of 474%). Deere is a cyclical company, and so it is difficult to evaluate the true meaning of growth in earnings per share. However, Deere has increased its earnings per share and revenues every year for the past 10 years except during the 2008-2009 financial crises. During the financial crisis, when many other cyclical durable goods companies got into deep trouble, Deere continued to have positive earnings per share.
In terms of valuation, Deere currently trades at a trailing P/E of 10.3 and a forward P/E ratio of 9.9. Over the past 10 years, Deere has traded between a P/E of 6 to a P/E of 28. Warren Buffett's Berkshire Hathaway, an organization that is well known to seek out bargain prices for great companies, bought about 4 million shares of Deere in late 2012. Warren Buffett's friend Bill Gates also owns an extremely large stake in Deere shares; he currently owns about 7% of the entire company. When two of the richest men in the world are taking big stakes in the same company, it makes sense to pay attention (please note that Berkshire's purchase of Deere was probably made by Todd Combs or Ted Weschler rather than Buffett himself). What Berkshire and Gates see in Deere is a company is trading at a reasonable price that has (i) a strong brand, (ii) macroeconomic global tailwinds, (ii) long-term shareholder friendly management, and (iv) an aggressive, but feasible, growth strategy.
Deere has established a valuable brand over its 175 year history. People throughout the United States and Canada have seen Deere's famous green machines. Deere currently has a 60% share of the farm equipment market in the U.S. and Canada. The strength of the Deere brand has been recognized by Interbrand as one of the 100 best global brands. According to Interbrand, Deere's brand value in 2012 was estimated to be worth $4.22 billion dollars (a 16% increase over 2011). Deere's brand value is higher than other well-known brands such as Starbucks (NASDAQ:SBUX), Mastercard (NYSE:MA), Harley Davidson (NYSE:HOG), and Ferrari. Deere's focus on delivering excellent products known for innovation and reliability are increasing the value of Deere's brand year after year.
To build on its strong track record over the past 10 years, Deere's management unveiled a new strategy in 2010 [pdf] that calls for aggressive expansion of revenues and profits to meet increasing demand for agricultural and construction machinery throughout the world. Deere's management has set forth concrete goals that would create substantial shareholder value through 2018 if the goals are met. It is aiming to achieve $50 billion in annual sales at mid-cycle by 2018 (which means normal, not extraordinary sales volumes). This would represent a 38% increase in sales from the 2012 level of revenues. The strategy also calls for operating margins of no less than 12% at mid-cycle by 2014. Deere's management is optimistic that it can meet these aggressive goals because of two long-term macro-economic tailwinds that support Deere's global growth opportunities.
The first macro opportunity for Deere is the necessity for global agricultural output to double by 2050 due to global population growth and increasing demand for food from emerging markets. The rate of productivity of farmland must accelerate to meet this demand using the same land and possibly even less water, and Deere is in a prime position to benefit from this trend. The second big opportunity is the phenomenon of increasing worldwide urbanization. The percentage of people living in urban areas is expected to grow from 50% currently to 70% in 2050, and this will require more construction machines to build out and improve infrastructure.
When speaking about these global opportunities at a shareholder meeting in 2011, Deere CEO Samuel Allen said "Trends of this nature should sustain demand for innovative farm, construction, forestry and turf-care equipment for years, if not generations, to come. And there is no company in our view that is better-equipped, or better-prepared, to capitalize on these favorable developments than John Deere." Some companies put out new strategies often and fail to follow through as management changes result in abrupt changes in strategic direction. However, Deere has a history of strong and stable leadership with only nine CEOs over the past 175 years. So Allen had credibility when he said in 2011 that "John Deere is not a company that changes strategy often. The last time was roughly a decade ago when the SVA operating model was launched. By all accounts it worked exceedingly well." The previous strategy change, focused on SVA or "Shareholder Value Added," resulted in Deere delivering the exceptional financial results discussed above. Deere's focus on SVA has created an organizational mindset focused on delivering shareholder value in the form of increased cash flow, dividends, and share buybacks. The new strategy builds on the previous one and aims to accelerate the rate of revenue and profit growth at Deere while meeting important world-wide needs.
Deere's management has been making specific investments to meet its aggressive new revenue targets. Deere has been investing in factories in Europe, Russia, India, China, Argentina, and Brazil to increase output for its international growth objectives. Deere's management has also been investing heavily in research in development to stay at the forefront of farming equipment technology. Deere has developed tractors that can be customized to meet the different demands of farmers all over the world and Deere has been working towards solutions that will help farmers automate much of its fleet of farm equipment to work with less and less labor. These initiatives should help Deere to continue to be the leader in agricultural equipment technology.
Deere's long-term focused management, strong brand, aggressive international expansion and innovative new products should allow Deere to achieve its strategic plan targets for 2018. If Deere can achieve revenues at mid-cycle of $50 billion with 12% margins, its normalized earnings would be $6 billion. Assuming that Deere's share count remains the same as today (a conservative assumption since Deere has been reducing its share count and plans on continuing that trend), then earnings per share in 2018 would be $15.46. If Deere traded at a multiple of 12 times these earnings in 2018, its share price would be $185.52. Additionally, dividends should continue to grow at a reasonable rate. Over the past five years, Deere's dividend has grown at about 15% annually. Assuming that the dividend grows 10% per year over the next 5 years, a share of Deere would distribute a total of $14.75 in dividends through 2018. The total gain on this transaction over the next five and a half years would be $101.56 in capital gains plus $14.75 in dividends, or $116.31. This would translate into an approximate compound annual growth rate of 17% over today's quotation. Upside to this rate of return would be an increase in Deere's P/E ratio, further reduction in share count through share buybacks, faster dividend growth, or management exceeding its revenues and earnings targets.
Deere faces plenty of risks that could prevent management from achieving its strategic goals and resulting in this investment idea to not come to fruition. The market for Deere's products might not be as strong as management expects. There may be unexpected economic distress that causes customers of Deere's products to not purchase new equipment. Competitors of Deere could come out with more innovative or cheaper products that take market share from Deere. However, Deere's strong brand, experienced management, and innovative products should allow Deere to come close to management's projections for 2018, and investors should be able to profit handsomely.