- Deere & Co. (DE) is undervalued and Caterpillar (CAT) is overvalued.
- The performance spreads of DE are superior to the ones of CAT.
- The market value of total capital of DE comes mainly from its current operating value whereas the one of CAT comes from its future growth value and thus, is riskier.
- The economic value added per share of DE has grown regularly from $0.56 to $2.75 in the last four years.
- We prefer DE to CAT using our proprietary data and our own valuation methodology based on the integration of the economics of strategy and the principles of modern corporate finance.
Deere & Company (NYSE:DE) is a noteworthy value creator and enjoys a sustainable competitive advantage. Deere is not alone in the farm and construction equipment industry. Its close competitors are Caterpillar Inc (NYSE:CAT) and AGCO Corp. (NYSE:AGCO). DE and CAT are two value creators. AGCO is just marginally one. In the following analysis, we will show why we prefer DE to CAT using our proprietary data and our own valuation methodology based on the integration of the economics of strategy and the principles of modern corporate finance.
Briefly, DE is undervalued and CAT is overvalued. The performance spreads of DE are superior to the ones of CAT. The market value of total capital of DE comes mainly from its current operating value, whereas the one of CAT comes from its future growth value, and thus, is riskier. The economic value added per share of DE has grown regularly from $0.56, to $2.75 in the last four years, while CAT has declined from minus $0.38 to minus $2.98 with to two positive peaks in between.
Deere & Co
Close behind apple pie and the Fourth of July in recognizable symbols of Americana runs a golden deer. In the 175 years since it was founded, John Deere & Company has worked its way to becoming one of the most recognized, respected and trusted of American brands.
Deere & Company operates in three segments: agriculture and turf, construction and forestry and financial services. The company's equipment operations generate revenues and cash primarily from the sale of equipment to John Deere dealers and distributors.
The equipment operations manufacture and distribute a full line of agricultural equipment, a variety of commercial, consumer and landscapes equipment and products, and a broad range of equipment for construction and forestry. The company's financial services primarily provide credit services, which mainly finance sales and leases of equipment by John Deere dealers and trade receivables purchased from equipment operations. In addition, financial services offer crop risk mitigation products and extended equipment warranties.
The company views its operations as consisting of two geographic areas, the U.S. and Canada, and outside the U.S. and Canada. Deere & Company, as brand name John Deere, has permeated the agricultural equipment industry for 175 years, and is one of the largest manufacturers of agricultural machinery in the world. A strong dealer network supports its high-quality products. Net sales and revenues for the year 2013: $37.795 billion.
With 2013 sales and revenues of $55.656 billion, Caterpillar is the world's leading manufacturer of construction and mining equipment, diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. The company principally operates through its three product segments: Resource Industries, Construction Industries, and Power Systems. It also provides financing and related services through its Financial Products segment. Deere is a lesser construction player compared with Caterpillar. CAT enjoys many of the competitive advantages Deere's enjoys in its agriculture segment.
The John Deere Strategy
Its ambition is to realize sustainable growth through global expansion. And, it knows what "sustainable growth" means. For DE, it signifies a sustainable "shareholder value added" growth that is delivered by distinctively serving its customers, employees and investors.
Shareholder Value Added as used by Deere is essentially the difference between operating profit and pretax cost of capital. It is a metric used by John Deere to evaluate business results and measure sustainable performance. This metric is highly consistent with our own measures of economic profit that we use in our analysis below.
To arrive at SVA at Deere, each equipment segment is assessed a pretax cost of assets (generally 12% of average identifiable operating assets with inventory at standard cost (believed to more closely approximate the current cost of inventory and the company's related investment). The financial services segment is assessed a cost of average equity (approximately 15% pretax). The amount of SVA is determined by deducting the asset or equity charge from operating profit.
Creating value takes more than acceptance of value maximization as the organizational objective. All companies affirm to do this but that is not always true. The choice of value maximization as the corporate objective must be complemented by a corporate vision, strategy and tactics that unite participants in the organization in its struggle for dominance in its competitive arena. At Deere, its metrics reflect strategic direction: "Performance" metrics that align compensation to strategy, and "Health" metrics introduced to monitor underlying factors (e.g., market share, quality) to ensure that the performance is sustainable.
How does an investor determine if a company is creating value or not? The creation or destruction of value is measured by calculating the change in market value added over the past periods. Market value added will increase if value expands by more than the amount of new capital committed to the business, and vice versa.
This behavior should give you assurance that the alpha you expect to obtain in investing in a particular stock will persist.
Market Value Added (as of May 13, 2014) (in Millions$)
Market Value of Total Capital
Market Value Added
Companies that are leaders in value creation, like the two fierce competitors Deere and Caterpillar above, bring a different mindset and take a different approach to strategy development. They strive not just to be different from their competitors (which is necessary yet insufficient), but also to be both different from and more profitable than their competitors, like Deere does. They realize that others will seek to copy their success; therefore, they strive to develop capabilities and strategic assets that are hard to match. Creating such distinctive strategies is a difficult challenge, and only a few companies in any given industry, like Deere, are likely to be successful at implementing and sustaining them.
From where the market value added comes from and how do you know that the company will continue to add market value in the future? Simply by looking at the performance spreads (PS) over time. Subject to which we turn now.
Sustainable Competitive Advantage
One of the keys to finding superior long-term investments is to buy companies that will be able to stay one step ahead of their competitors. Companies that have generated returns on their capital higher than their cost of capital for many years of operation usually have a competitive advantage, especially if their returns on capital have also increased over time. This line of reasoning is fundamental. In other words, having an unexpected or a temporary competitive advantage is not enough to be able to declare that a business has a competitive advantage. Simply put, you cannot expect to obtain abnormal return (alpha) as an investor if the business you invest in does not have a sustainable competitive advantage. We define sustainable competitive advantage as the difference (the performance spread PS) between the return on capital and the cost of capital (a difference correctly measured, that is after transforming GAAP numbers into a rigorous computation of economic profit, after deducting the full cost of capital, and eliminating the accounting distortions). The higher the performance spread, the bigger the competitive advantage. In the table that follows we present the performance spreads over time of the three competitors.
Performance Spread (Trailing 12 months)
The data shows the build-up in the performance spreads (PS) of Deere. However, for Caterpillar and AGCO, the PS are mostly negatives with no clear tendency.
As a long-term value investor, you know that, over time, market value and intrinsic value converge. A company with a positive performance spread (PS), that is with a return on its capital greater than its cost of capital, a necessary condition for market value creation, will see it decrease to zero if it is not able maintain or embark on a new strategic value increasing trajectory. Deere with its critical success factors (deep customer understanding, customer value delivery, world-class distribution system and the growing of extraordinary global talent) and its foundational success factors (exceptional operating performance, disciplined shareholder value added growth and aligned high-performance teamwork) is already on a clear strategic trajectory. It is a noteworthy value creator and it enjoys a sustainable competitive advantage in the farm and construction equipment industry
In this competitive landscape, and equipped with the above information on performance spreads and the fact that we are in the presence of competitors that are also value creators, although AGCO only marginally, we have estimated the intrinsic value of those three stocks. They are presented in the following table. It is important to note that the intrinsic values obtained for the three companies are exactly the same whether we use the free cash flows approach, the economic value added approach, or the progress in the value added approach.
The comparison of the intrinsic value with the recent market price shows that Deere is exchanged at a price that is lower than its intrinsic value. The opposite situation prevails for Caterpillar. A superficial knowledge of how prices are established in the capital markets and an over confidence on a point estimate of the intrinsic values would cause some analysts to declare that AGCO is undervalued. We consider it fairly valued. What confidence do we have in our estimations presented so far?
Intrinsic or Fundamental Risk
To answer the question we need to recall that the value of any company (i.e., the market value of total capital) is composed of two parts: the value of assets in place, [Va] or, the value of the current operations (i.e. the discounted value of the current net operating profits), plus the value of the future growth opportunities [Vg]. In the simplify approach that we use here, this second part is just the result of subtracting the first part, (i.e. the value of assets in place) from the market value of total capital [VT].
As you can see in the table below, [Va] plus [Vg] is equal to [VT] or 100%. The connection with the fundamental risk is simple: The greater the market value of the total capital of the corporation is composed of the value of the current operations [Va], the less significant is the value of the most uncertain part of the total value, i.e. the future growth opportunities [Vg]. For Deere, most of the market value comes from current operations, the most confident part of its value. It is not the case for Caterpillar. For Caterpillar you need to put more reliance on the future, the most unpredictable part of your estimation, to arrive at the current market value of total capital. The low value of [Vg] for Deere helps us understand the source of its undervaluation: Because its intrinsic value is much lower that its market price, we can infer that the market underestimates its growth potential. The reverse is true for Caterpillar. AGCO, however, could not benefit from this economic reasoning because it is fairly priced.
Intrinsic Value, Value of Assets in Place, Value of Growth Opportunities
(Trailing 12 months)
First and foremost, invest or stay invested in Deere. This stock is a rock-solid choice for the very risk averse investor. Global macro-trends (global population and income growth in developing nations) will drive increased demand for agricultural output and infrastructure investment.
Second, why not take the opportunity to diversify the farm and construction equipment part of your portfolio in investing in Caterpillar when its market price will have converged to its intrinsic value? The farm and construction equipment part of your global portfolio will leave you sleep at night.