This article is the first part of a three-part series aiming at understanding and evaluating John Deere's (NYSE:DE) business. Deere manufactures farming equipment and other large machinery; we will thoroughly look into its financial statements in order to judge risks (Part 2) and estimate returns (Part 3).
Psychologists have in many studies shown that information does not equal knowledge and that while having more information increases confidence, it rarely increases accuracy. This supports my view of the purpose of security analysis (inspired by Ben Graham): to digest the available information, distill facts influencing valuation, and then forget all the rest, at least for a few years. I will try to stay away from forecasts since people tend to perform very poorly at forecasting. (Check this great material for more on irrationality and faults of human behavior)
We start with a few interesting facts about John Deere's business.
- John Deere offers the most complete line of forestry machines and attachments available in the world.
- Large-size agricultural equipment comprises a large proportion of sales in North America and a growing proportion in other markets; such equipment commands higher gross margins regardless of region.
- In many international markets, the demand for small equipment is greater; this partially explains much lower gross margins achieved in those markets compared to the US.
- In the U.S. and many other markets, there are typically several used equipment transactions for every sale of a new piece of equipment.
- The company increased prices of equipment by 3 to 5 percent in each of the last six years (even in 2009).
- The completion of several new factories in key markets in 2013 means that the existing manufacturing capacity is adequate to meet current demand (sales are forecasted to decline in 2014).
- GAAP earnings are overstated because the company has to spend millions on plant upgrades just to maintain its competitive position.
- At the first glance, total debt looks very high compared with equity or earnings.
Google Finance reports that Deere's debt stands at 336% of equity. This immediately raises a few questions.
Q1. What has caused such apparently high debt levels, much higher compared to competitors AGCO (NYSE:AGCO), Kubota (OTCPK:KUBTY) etc.? Does the management have a good reason to impose this debt burden on the company?
Q2. Is it true that interest payments are eating out a large portion of operating profits? What will happen if interest rates go up?
Q3. Is this high debt level, combined with cyclicality of Deere's business, the main reason why the company trades at only 10 times earnings?
To summarize the answers given later, debt is not a problem for John Deere. The debt's presence in the balance sheet is essential for Financial Services, an operating segment that borrows billions at low rates and uses them to finance retail equipment sales, earning a profit on the interest spread.
The best way how to understand the role of debt is to look at the company as two separate entities: Equipment Operations, which manufacture agriculture, turf, construction and forestry equipment, and Financial Services, which provide retail financing for equipment sales. John Deere offers this split view in the last note to its financial statements (Note 31 in the 2013 AR). We will start with Equipment Operations; the basic important data are summarized in the following table (source: annual reports and 10-K forms available on the company website).
Q4. How to explain the significant jump in equity between 2012 and 2013? What does it mean for the reported ROE values?
To keep it short, equity has jumped because of the positive performance of the pension fund and because of actuarial gains. Those items are included in Other comprehensive income and discussed in detail in notes to the 2013 financial statements. The takeaway is that equity is jumping up and down because of changes in the pension fund deficit and those jumps directly translate into the reported ROE values. Consequently, precise values of ROE are of little importance; it would be better to use other measures of profitability for DE. Later, we will use operating returns on operating assets.
The purpose of Financial Services is to facilitate sales of equipment. They add some profits and risks, but the future of John Deere depends on its Equipment Operations. Therefore, the key point of any valuation attempt is to estimate the owner earnings of Equipment Operations.
First, we estimate maintenance capital expenditures. In page 33 of the annual report, we find that "expenditures for maintenance, repairs and minor renewals are charged to expense as incurred."
Thus only larger renewals are capitalized. For 2014, "capital expenditures will relate primarily to the modernization and restructuring of key manufacturing facilities, U.S. Tier 4 emission requirements, the construction of new manufacturing facilities and the development of new products." Deere has to continuously upgrade its products and plants just to stay competitive, thus most of Deere's capex can be categorized as maintenance (emission-related expenditures are a typical representative of that, together with certain new products replacing obsolete products). Thus earnings indeed are overstated. In the following table, I have decided to count 140% of D&A as maintenance capex; this roughly means that in trough years like 2009 almost all capex is just maintenance, while in years like 2012 more than one third of capex goes into growth. I consider this estimate realistic and conservative; during 2012 and 2013, seven new factories were completed, which explains the spike in capex.
Note that apart from cyclical downturns, ROE stands at about 20% (and is even higher in the present low interest rate environment). Also note the nice growth of owner earnings per share: from the peak 2008 earnings to the peak 2013 earnings we have 15.5% CAGR. In addition, net margins have improved from pre-2009 levels.
The following table captures important ratios related to the debt of Equipment Operations.
Deere has capitalized on the present historically low interest rates and pushed the interest coverage ratio above 9. Total debt is proportional to equity. In years of prosperity, Deere would be able to repay Equipment Operations' debt in three to four years while simultaneously paying dividends. So the debt level could be dangerous only in years like 2009. However, the debt maturity profile extends to 2042 and the debt is payable in chunks manageable even if Deere was not able to borrow anything for a year or two. In conclusion, Equipment Operations' balance sheet is strong. We also have a partial answer to Q2: interest expenses are not eating out a significant portion of earnings of Equipment Operations.
This is where most of Deere's debt resides. I have no experience in evaluating banks and similar operations; the most important aspect of Financial Services (FS) is safety for me. Safety comprises three elements: quality of assets, reasonable debt maturity profile, and asset durations matched with liabilities durations to avoid losses arising from changes in the interest rate curve.
Financial Services provide financing for retail and wholesale sales of John Deere equipment. In particular, Equipment Operations immediately sell receivables to FS and compensate their interest expenses at market rates. FS also provide operating and financial leasing of new and used equipment. Generally, FS retain a security interest in the equipment sold and require a 10-30% down payment. FS operate mostly in the US, which implies little currency risk and a reliable legal framework for debt recovery.
Relevant numbers from financial statements are summarized in the following table.
John Deere is bounded to maintain the ratio of earnings of John Deere Capital Corporation (essentially FS) to fixed charges above 1.05. If the ratio falls below this value in any given quarter, Deere has to fund the shortfall. This is essentially the only obligation of John Deere regarding FS: even if the capital corporation is in default on its debt, the parent company is not liable. (There are some credit lines with additional covenants mentioned in Note 18 in the 2013 AR; however, Equipment Operations have capacity to incur additional $18B of debt under the covenants, about three times the present amount.)
As we can see in the table, the 1.05 ratio has not been much of a concern during the last few years. In the worst quarter of 2009, the ratio was 1.12. I believe it is unlikely to have a meltdown of similar proportions in the near future, though we cannot entirely get rid of such a possibility. Nevertheless, Equipment Operations earned enough even in 2009 to cover a possible shortfall of Financial Services.
The quality of FS assets is demonstrated in the following two figures which do not need further commentary (they are taken from company's presentations available on the website). Less than 1% of financing receivables was past due at the end of 2013.
Most of the FS debt is in medium-term notes due 2014--2023; the average interest rate on these notes is just 1.2%. The debt maturity profile is sufficiently balanced (see Note 20 for more details).
Finally, we need to compare durations of assets and liabilities. Receivables are described in Note 12 to the 2013 AR; generally the maximum terms for retail notes are 5 to 7 years. About a half of the receivables is due within 12 months. We see that John Deere has taken advantage of low interest rates and secured cheap financing for a period longer than the terms of its receivables. The only unfavorable development for Financial Services' net interest margin is if short-term rates go down while long-term rates go up. However, in such a case John Deere can issue short-term notes and use the proceeds to repay the principal due on longer-term notes. In conclusion, changes in interest rates will not harm FS, and favorable moves in interest rates (e.g. an upward movement of short-term rates) will increase their profits.
As the following chart shows, Financial Services produce rather stable and increasing income. It is definitely worth to impose the debt burden on the company.
Most of John Deere's debt is held by Financial Services. Even if FS defaulted on their debt obligations, the parent company is not liable apart from certain quarterly payments which seem very unlikely to be ever needed. Assets of FS enjoyed very low default rates even in 2009. FS essentially pass increases in interest rates to customers and are shielded from interest rate risk.
Equipment Operations have a strong balance sheet and posses both capacity to borrow much more and ability to repay all the debt in three to four years if needed. Overall, John Deere's management of debt is excellent; well in line with their use-of-cash priority No. 1: to support an A credit rating allowing access to low-cost and readily-available funding mechanisms.
Debt is definitely not a reason why DE trades at such a low valuation. In Part 2, we will analyze other risks. Then we return to the valuation of the company in Part 3.
Disclosure: I am long DE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.