The United States Department of Agriculture believes that the net farm income is forecasted to grow by 6% by the end of 2013. The performance of Deere & Co (DE) is considered to be a reflection of the growth and development of the agricultural industry. Owing to its agriculture-based business model Deere's future prospects are deeply linked with the growth and development of the agriculture industry. It is easy to estimate the long-term growth of the company as it can be analyzed along with population growth. Despite the rising revenues and profit margins the shares of Deere haven't performed well in the past several months.
During the second quarter, the company's revenue grew by 4.3 percent. The growth was primarily driven by the agriculture and turf business. The revenues contributed by this segment increased by 7.9% compared to revenues of the corresponding quarter of the previous year. This growth in sales was mainly due to increased stock and price gains as well as a higher number of shipments in North and South America. Conversely, revenues from the construction and forestry segments decreased by 5.7%.
The rise in the revenues is also reflected in the profitability margins of the company. Deere's profit margins reached 15.5%. The agriculture and turf segment is also leading in terms of profitability. Its profit margins reached 17.1 percent. However, due to slow economic growth, the construction and forestry segment failed to report any increment. Instead, the profit margin decreased by 8 percent in the Last quarter.
Expected Growth from Emerging Markets
The company has a firm foothold in its market that allows it to expand from the U.S. into Russia, China and also in Latin America, particularly Brazil, where future growth is estimated. As one of the fastest growing economies of the world, Brazil has a growing demand for high-powered tractors. To meet the demand of the emerging South American market, Deere has announced it will invest $400 million to manufacture 8R tractors. Deere had been manufacturing 5R, 6R and 7R models and the production of the new model 8R tractor will significantly produce additional benefits for its customers.
The new model will offer increased power along with less fuel consumption for customers. Moreover, the investment will increase its suppliers in the region along with the revenues for the agriculture and turf segment.
In order to expand its portfolio of agricultural equipments and to further enhance its ability to serve larger global markets, Deere has announced its plans to acquire its long serving partner, Bauer. The deal includes acquisition of Bauer's designs, intellectual property, inventory and equipment. Deere expects that the deal will accelerate the growth of its planter business worldwide.
Valuation: Dividend Discount Model
Deere & Co. is a solid dividend paying company. Currently, it is paying a dividend yield of 2.5%. Moreover, it announced that it will pay a dividend of $0.51 per share beginning November 2013. The current dividend yield is higher than the average yield of 2%, which also makes the stock an attractive investment. The company has a solid history of making dividend payments and share repurchases. Therefore, I have chosen the Dividend Discount Model to evaluate the company.
The chart above shows the projected growth rates of dividends and earnings per share. To project the modified payout ratio I have considered the following factors: historical growth rate of dividends and repurchases, the analyst estimates, consensus estimates and fundamental growth. Also, the impact of entrance into emerging markets is incorporated. So after allocating appropriate weights, I have determined the growth rates.
To determine the required rate of return, I have taken the RM at 12.3%, which represents a 5-year average return of the S&P 500 index. The risk free rate reflects the yield offered by the 10-year Treasury note. Therefore, given the above estimates and assumptions, the share price is projected to be $85.89, giving an upside potential of 4.74% from the current market price.
A sensitivity analysis has been conducted above for those who dispute the assumptions and estimates used in calculating the fair value. The sensitivity analysis calculates an upside potential of 36%, given the required rate of return is 13.78% and the growth rate is 32.42%. In the worst case scenario, given the required rate of return of 18.23% and the expected growth rate is 28.42%, the down side potential will be equal to approximately 18%. Therefore, the share price ranges from -18% to 36%.
Deere is counting on Brazil for a future increase in its revenues and margins. However, the emerging market poses certain risks with respect to the country's macroeconomic growth, currency fluctuation and stability. Moreover, IMF, in its recent report, has a less than positive outlook for Brazil's economic growth. It has decreased its GDP growth estimates for 2013 and 2014.The country's development is a matter of concern for Deere & Co.
The global recovery in housing will also spur the demand for construction machinery. Furthermore, Deere sales will continue to benefit from investment in new products as well as a strong demand for agricultural machinery.
In the long term, Deere is a good investment opportunity. Based on the dividend discount model, the upside potential of almost 5 percent may not seem to be very attractive but the current dividend yield of 2.5 percent is above the average yield and makes the stock an attractive investment.