Over the weekend, Barron's named Barrick Gold (ABX) and Deere & Company (DE) as two of its top picks for 2014. In this article, I will explain why I like DE but dislike ABX. I like to deal with bad news first, so I will start with Barrick.
Barrick got the recommendation after what could only be described as a horrible year in 2013 that sent shares tumbling 56%! Management got fully caught up in the gold bubble, expanding at the peak. As gold prices fell, its balance sheet was left in disarray and expansionary projects are poised to be far less profitable than originally planned. The company was forced to come to the market in a massive secondary to pay down debt while Chairman and founder Peter Munk has stepped down.
Barron's sees Barrick as a deep value trade with shares at a 10 year low despite the fact the gold prices have more than tripled during this time. At the same time, Barron's is more comfortable with the company's balance sheet after the $2.9 billion equity offering. They believe the company's break-up value could be $35 if an activist got involved to force change. Despite these factors, I am forced to disagree with Barron's about the future of Barrick Gold. While their scenario could play out, I believe the risk far outweighs the reward.
I want to begin by the argument Barrick is cheap because when it last traded at $15, gold was $400. I went back to the company's annual report from 2003 to look at the company's operating performance. It's average selling price was $366 (and on the uptrend) while its cash cost was a meager $189 (annual report available here). Overall, the company had a net cash margin of $177 on 5.5 million ounces of production. Barrick was carrying $719 million in debt at the time. Barrick also had 539 million shares outstanding.
After accounting for the secondary, here is where Barrick stands today. While gold prices have increased dramatically to $1,218, Barrick's cash costs have risen to about $925, yielding a cash margin of $293. The company has also grown production to 7 million ounces. Essentially, Barrick's cash generation (net margin times production) has gone up 110%. It might seem ridiculous that shares are at the same level, but there are two important factors. Even after the debt redemption, the company has $12.8 billion in debt, up $12 billion over the past ten years. If that isn't enough, its share count has more than doubled to 1.16 billion.
In fact while cash generation is up 110%, Barrick's share count is up 115%, which would suggest the stock should be 5% lower than it was in 2003. Furthermore, the company has added $12 billion in debt. $12 billion in debt (or 67% of ABX's market cap) has added significant risk to the company's viability as well as forcing hefty interest payments. The company has already diluted existing shareholders by 16% to start to fix its balance sheet. In my opinion, another secondary or asset sales will be necessary in 2014 if gold stays below $1,300. Many of the company's obligations are not due for several years, so it would be wrong to subtract the whole amount of debt from ABX's equity value. Even if you only ascribed a 10-20% present value (exceptionally generous), ABX's fair price is $13-$14, meaning that it really is not a steal at $15.40.
While it is compelling to say Barrick is cheap because it is trading at a level not seen since gold was $400, that analysis is overly simplistic. While gold prices have risen dramatically, gold cash costs have moved up nearly as much, meaning margins are up far less than the 200% price appreciation would suggest. Moreover, ABX has significantly increased its share count, so that while the price is the same, ABX's market capitalization has more than doubled. To fund acquisitions at the peak, ABX has also taken on tons of debt, which could cause further dilution.
At the end of the day, ABX is generating no free cash flow, and even with reduced capital expenditures, I do not foresee the company generating more than $500 million in free cash flow next year. Also in 2003, the company was expanding cash margins, thanks to a robust gold market. The opposite is happening now as gold prices fall while cost pressures remain. As the Fed raises rates, gold could face continued pressure in 2013, especially with a lower rupee cutting India's demand. If gold prices drop below $1,200 in 2014 for a sustained period of time, ABX will likely be free cash flow negative and forced to issue more shares. For ABX to justify a share price above $20, let alone $35, gold needs to rally 10%.
I believe Barron's ignores the risk with Barrick Gold of future equity offerings to meet its obligations while the stock is not as cheap as its historical price alone would suggest. I understand why Barron's would want to buy a down and out miner as they have seriously underperformed the metal, but I believe Barrick has too much risk to be a wise investment. I prefer Agnico-Eagle (AEM) as a speculative play on gold because it has none of Barrick's debt issues. I would use any pop on the buy recommendation to sell Barrick.
Next, Barron's declared Deere & Company to be one of its top picks in 2014 after a rough 2013 for the stock with shares down 1% while the market has rallied more than 25% (as the following chart shows). As a consequence, DE now has a trailing multiple of 9.4x earnings, though earnings are expected to be lower in 2014. Nonetheless, a forward multiple of 10x is exceptionally cheap in this market. Barron's even goes as far as suggesting this is the type of stock Warren Buffett would buy. While I cannot speak for the Oracle of Omaha, I agree with Barron's that Deere is a strong buy at current levels.
In many ways, Deere is a better version of Caterpillar (CAT), though CAT has a premium 16x multiple. Caterpillar has been crushed by the dramatic slowdown in mining as commodities like copper and gold have seen dramatic price declines. Deere is not exposed to mining, instead 83% of revenues are related to agriculture while the remaining 17% are related to construction and forestry. I expect these sectors to remain comparatively strong in 2014 and beyond. We are beginning to see signs of life in the U.S. housing market, and so long as rates don't go out of control (which I do not foresee), we should see continued strength in the new home market, which will support Deere's construction business.
I continue to believe that the long-term fundamentals in the agriculture business are fantastic. As emerging markets continue to develop and millions enter the middle class, demand for food will continue to rise, which will support prices going forward. Moreover in the United States, we have seen several droughts, which have limited supply, a positive for prices. At the same time, the weather has not been so bad as to limit farmer's profitability. Farms continue to make more money than ever, and while mild price declines and lower ethanol requirements may lead to a less strong 2014, it will be a good year by historical standards:
With farmers making more than $350 billion, we should continue to see strong machinery purchases, which is a positive for Deere. Farm land remains the ultimate commodity, and as the emerging markets continue to develop, we will see incremental demand outstripping additional supply in 2015 and beyond, which is why I expect strong profits for farmers beyond 2014. A strong farming industry means strong orders for Deere equipment.
2013 has been a fantastic year for Deere with over $35 billion in sales and $9 in earnings. As a consequence, 2013 will be a tough comp for 2014, which is why I expect a mild decline to about $34 billion in sales and $8.50 in earnings before returning to growth in 2015. Given its exposure to the strong agricultural business, I think Deere is an excellent buy at 10x earnings. With strong end markets, Deere should at least trade at the same mutliple at Caterpillar, which would suggest a stock price of at least $120.
In addition to strong fundamentals, Deere has become increasingly shareholder friendly over the past decade, returning about 58% of net cash to shareholders. This has been an accelerating trend with an 82% increase in the dividend since 2010. The company just last week added $8 billion to its existing share buyback program (release here). The previous program had $1 billion left, giving the company a total authorization of $9 billion. The last program was initiated in 2008, though repurchases did not really begin until 2009, due to the financial crisis. As a consequence, I would look for this plan to be executed over 4-5 years.
I would expect the company to repurchase about $2 billion in shares every year, or 6% of its current market capitalization. This plan will provide support for the share price and hasten the pace of EPS growth noticeably with an ever lower share count. Even if you assumed an average purchase price 25% above current levels, Deere will be repurchasing over 21% of outstanding shares over the next 4-5 years, which will provide tremendous value for existing shareholders. With a solid 2.4% dividend yield and accelerating share buybacks, Deere is an excellent buy on capital returns alone.
Therefore, I am in agreement with Barron's over its recommendation to buy shares of John Deere. With a focus on agriculture, Deere will outpace fellow equipment makers like Caterpillar, which are exposed to metals and mining. I expect Deere to earn $8.50 next year and $8.75-$9.00 in 2015, giving the company a very reasonable 10x multiple. Moreover, shareholder friendly management will keep returning cash to shareholders, which will increase share appreciation. Deere has at least 30% upside from here and is a great addition to your portfolio in 2014.