This article is the second part of my series on Deere & Company (NYSE:DE); the first part analyzes debt and maintenance capital expenditures. The aim of the second part is to assess the potential impact of the risk factors listed in Deere's 10-K. Although the list is not exhaustive, I believe that it covers all risks material to the company, perhaps with an exception of fraudulent behavior of executives. (I know of no indications of such behavior; Deere's management seems to be open, honest and very shareholder-friendly.)
The word "risk" is hard to define and has multiple meanings. In addition, the interpretation of a particular risk factor depends on the investor. For instance, volatility is positive for someone investing regularly every month for 30 years, but negative for a lump-sum investor needing his money in 5 years. I will evaluate the risk factors as an owner of Deere's business, whose purpose is to maximize his future consumption by converting investment returns into products having some basic consumption utility (food, gasoline etc.). I believe that this is the position most investors take. Notably, there is a difference from goals like maximizing total returns or dividend income: if grain prices rise significantly, then John Deere will likely thrive as an investment; however, my overall personal impact from such a rise is likely to be negative, because I will have to pay much more for basic groceries.
Another aspect to bear in mind is that the risk factors are not specific to John Deere; almost all of them also affect Deere's competitors. Consequently, the materializing of a risk will hurt John Deere, but it might enhance its competitive position for the long term. (A competitor going bankrupt because of negative economic conditions is definitely a positive for John Deere.)
The impact of a risk factor also depends on the investment horizon. A short-term trader essentially faces risks entirely different from those of a long-term holder. I will evaluate Deere's risks with an investment horizon of at least 20 years, which is suitable both for retirees and people in the accumulation phase. With such a horizon, there is an important aspect playing in John Deere's favor. The average life of a combine or a tractor is about 12 to 15 years and then it has to be replaced because costs of repairs escalate above the price of leasing a new machine. Thus if sales are poor for a few years, the business will flourish in the next several years. The only way how to avoid the replacement of an old combine is to switch into another kind of crop, but then you need new equipment anyway.
Finally, an investor invests in a stock because he thinks that the expected returns outweigh the risks. Almost all risks are worth undertaking if the expected return is high enough (and one can diversify). In Part 3, we will look at the expected returns and determine if they outweigh the risks.
I have split the risk factors into two groups: internal risk factors, where Deere has a material control, and external ones, where Deere has essentially no control over the likelihood of the risk materializing. In many cases, I could not find historical data, so I only used my judgment to estimate financial impacts or likelihoods.
Internal risk factors
1. Failure to understand or meet customers' specific requirements. This risk is very material in certain other industries [Kodak (NYSE:KODK) and Nokia (NYSE:NOK) are among the most prominent examples]. The needs of farmers are well understood and do not change much even over decades: they need reliable and efficient equipment and supportive quick-to-respond dealers offering spare parts and related services. In addition, some of them want the equipment to be computerized and networked nowadays. There is nothing that a competitor can do and John Deere cannot. Moreover, Deere can easily survive a messed-up product from time to time; the company can afford to recall products or pay financial compensations to avoid brand damage. In conclusion, I am not afraid at all of this risk.
2. Availability and prices of raw materials and components. Most of the supplies needed by John Deere are commodities which are sourced from multiple producers. However, there are certain components available from a single supplier which cannot be re-sourced quickly. The management is aware of this, and I believe they have taken appropriate measures to deal with the situation. John Deere produces a very wide range of equipment in a number of factories all over the world; I believe that no supply disruptions will threaten the company as a whole. Deere has demonstrated its pricing power: equipment prices were increased by 3, 4, 3 and 5 percent in 2013, 2012, 2011 and 2009, respectively. (Precise numbers are not reported for 2010 and 2008, but they are close to 4 percent, as can be seen from the comparison of sales increases with physical volume increases.) Note that the poor 2009 results were caused by lower shipment and production volume; pricing was strong, despite the recession. In conclusion, prices of raw materials and/or components are not a material threat.
3. Pension plans deficits. Pension and post-retirement benefits are openly discussed in Note 7 in the 10-K. The total cost of pensions is recognized in other comprehensive income. It was -1.6, 0.9, 0.8, 0.2, 2.2 and 0.9 billions of U.S. dollars in 2013, 2012, 2011, 2010, 2009 and 2008, respectively. The expected long-term rate of return is 7.5%, which I find realistic; a significant portion of the pension plan assets is in equities and a significant one in bonds. Over the last three years, the pension fund losses and gains evened out; however, a year like 2009 could result in a significant shortfall. Overall, the pension fund is in good shape, and it is very unlikely it will become a major drag on performance.
External risk factors
4. Trade laws and government farm policies. This is a real risk; for instance, Russia's aggression towards the Ukraine could lead to various restrictions on international trade, which will hurt John Deere. However, most of Deere's business is still done in the U.S., which will provide a strong base for earnings even if the international expansion falters for a few years. Farmers usually have powerful lobbyists and many supporters among the masses, so governments are unlikely to cut their farm subsidies quickly and profoundly. Deere can do very little to mitigate this risk, and thus it's up to the investors. I consider this risk small, and thus do not require a particularly high-risk premium.
5. Banking, monetary and fiscal policies. John Deere's Financial Services are dependent on access to cheap and easily obtainable financing. Inability to obtain the financing (due to government restrictions or for other reasons) would lead to a decline in customer lending, which would hurt John Deere's sales in turn. Experience shows that regulators of financial markets are prone to err on the side of leeway, not caution. In addition, John Deere's financing business is simple, straightforward and conservative, thus I do not expect any regulations having a strong impact on Financial Services.
6. Worldwide demand for food and bioenergy and its effect on prices of farm commodities. Agricultural commodities as a group serve as a prime example of inflexible demand. That is, irrelevant of the price, there will be a lot of demand. Maybe you can substitute rice for wheat or change the proportion of meat in your diet, but you have to eat something. Both demographic and consumer trends are working in Deere's favor: there are more and more people and they are eating more and more meat. Meat requires much more resources to produce than grains. However, farmland is a limited resource, thus increased productivity is needed --- and that is what John Deere's equipment provides. The company will operate with strong tailwinds for decades to come.
7. International expansion changes dynamics of competition, customer base and product offerings. John Deere has already shown it is capable of international expansion. The company's marketing is tailored to the needs of a particular country, and as their customer base and experience grows, they are ready to offer an increasingly diverse array of products. Although it is true that local competitors may emerge in certain countries and perhaps slow Deere's expansion, I do not fear they would pose a real threat to Deere.
8. John Deere operates in highly competitive markets. This is perhaps the most important risk factor; I have postponed the discussion into a separate section following the list of risk factors.
9. Negative economic conditions weakening demand. John Deere's business definitely shows cyclical characteristics. Recessions will come and go, interspersed with periods of boom or quiet slow growth. I think that a proper way to account for this risk is to look at earnings over a longer period containing both a peak and a trough and then avoid overpaying. We will do this in detail in Part 3.
10. Currency translation risk. If emerging market currencies depreciate against the U.S. dollar, John Deere will suffer currency translation losses on its assets and profits in developing countries. This is actually a risk I welcome: I am a consumer of a lot of goods imported in part or in whole from Asia and other developing countries, hence the possible currency translation losses will be more than offset by price declines of the imported goods I am buying.
11. Interest rate risks. In Part 1 of this series, we have demonstrated that rising interest rates pose only a very small threat to John Deere's financial condition. The problem with rising interest rates is that Deere's customers will be less willing to buy equipment if borrowing rates are higher. However, there are three factors playing in Deere's favor. First, Financial Services have borrowed money for a period much longer than was needed to finance current receivables. Since the interest rates of those borrowings are fixed, Deere can forgo some profit in FS and support equipment sales instead. Second, economical life of farming equipment is somewhere between 10 and 20 years, so while farmers can postpone replacing old machines with new ones, they cannot do it for too long. Third, in certain countries (e.g. Brazil), farmers' borrowing is subsidized by the government. Finally, rates will rise only gradually, if at all (they are actually declining in the eurozone). Nevertheless, to maintain a conservative approach, it would be better to avoid relying on record earnings of the last few years; I will cut them by 10% in the calculation of average owner earnings.
12. Negative conditions in the financial industry would impact Financial services which provide financing for a significant portion of Deere's sales. We have discussed this already under point 5. The company uses derivative contracts to hedge interest rates and cross-currency cash flows and thus carries counterparty default risks. The maximum loss incurred if all counterparties fail to meet their obligations would be $394 and $637 million in 2013 and 2012, respectively. Thus there is no extensive damage to be afraid of here.
13. Increasingly stringent engine emission standards. Research and development expenses ranged from $1 billion to $1.5 billion in the last five years. A few hundred millions of this was probably devoted to diesel engine improvements. This effort has been successful; John Deere's diesel engines are among the few which allow to use pure diesel without specialty additives, reducing emissions. Deere's advantage is that the development costs are spread over a large number of engines sold. [As an illustration, Deere's revenues of $37B are larger than the sum of revenues of all its competitors shown by Google Finance, with the exception of Caterpillar (NYSE:CAT), with revenues of $55B.] More stringent regulations can actually lead to margin improvements versus smaller competitors. Deere's engines are also used by other agricultural equipment manufacturers, e.g. by Claas, the favorite combine brand in Slovakia. Apart from R&D expenses, there are some necessary plant upgrades; it is likely that such upgrades are recurring every few years. I think the best way to account for this is to count most of capital expenditures as maintenance, exactly as we have done in Part 1.
14. Emission regulation laws affecting suppliers, customers and Deere's manufacturing. I believe that emission reduction laws will help to improve sales of Deere's top-quality diesel engines.
15. Weather risk. Weather can have a significant impact on demand for John Deere's products in any given year. However, extreme events like hurricanes or large-scale droughts are rather rare, with some of them helping the business. Over a 20-year period, this is not a major threat to the company. One can account for the weather risk by considering average earnings and not overpaying.
16. Environmental, health and safety regulation. Such regulations are significant only for companies dealing with dangerous substances, like miners, oil and chemical producers, or nuclear operators. Indirectly, this affects everyone, but John Deere is not affected more than its competitors; perhaps it even has some scale advantage. Anyway, it is very unlikely that such regulations would cost the company more than a few tens of millions a year, which will only marginally affect profits.
17. Security breaches, IT disruptions. This is a risk threatening every large business nowadays. Deere does not operate with much personal data or strictly-guarded supplier/customer information, and a security breach causing a loss of customer's data will not lead to extensive negative publicity damaging the brand. I am willing to bear this risk without being paid a particular risk premium.
18. The Dodd-Frank reform impact. Additional regulations of financial services are being implemented under this reform, however, until they are finalized, no precise impact can be calculated. Deere's Financial Services is a very large organization (almost $40 billion in assets) and as such, it should have no problem implementing the new regulations in a cost-efficient way.
19. Extensive anti-corruption laws. Compliance with such laws will cost a million here or there, but John Deere does not derive a significant portion of its revenue directly from governments, so this is not material.
20. Reallocation of GPS frequency ranges. For a few millions, Deere's technicians and programmers will have no problem dealing with this.
Highly competitive markets
The principal competitive factors for agricultural, forestry and construction equipment are product performance, innovation and quality, distribution and customer service, price, and brands. There is little doubt that John Deere's products are of top quality. Thanks to its size, John Deere is also able to invest more than its competitors in research and development, ca. $1.4B annually, compared with $350M at Agco Corporation (NYSE:AGCO) and $930M at CNH Industrial (NYSE:CNHI), of which only $540M is relevant for this comparison. Products of AGCO, CNHI and a few other competitors are far from junk, too, so what makes a difference is price, dealers and brand image.
Regarding brand loyalty, John Deere beats its competitors by a huge margin. You can find many details in this survey from 2010. I will quote just a few facts: farmers' brand loyalty has slightly increased between 2005 and 2010; John Deere owns 66% of the midwest market; 77% of Deere's customers are brand loyal, compared with just 25% for AGCO, 35% of Case IH, and 45% for New Holland. More than 88% of John Deere's customers feel that their brand loyalty has increased or stayed the same in the last 5 years. Combines are particularly tough to crack: more than 85% farmers told that they have not purchased a combine of a brand different from their favorite one in the last 5 years.
Perhaps the most intense competition in agricultural equipment is going on in Brazil, where John Deere is increasing its market share at the expense of AGCO and CNHI. According to AGCO's claims, Deere is using lower prices to gain market share. (More details on Brazil can be found in various SA articles, e.g. this one and also here; both Deere and AGCO expect sales to fall by 10% in 2014.) So John Deere does not come out as a loser in direct competition. As Deere is becoming more and more established, economies of scale are slowly but steadily working in its favor. I believe that after the John Deere brand gains wider acceptance, its market share is unlikely to deteriorate.
A useful exercise would be to compare dealer networks which are of utmost importance in gaining and maintaining market share. However, companies do not disclose enough data to do this in a meaningful way. This is what I have managed to find, scattered through various reports and presentations available on company websites:
- DE has 2438 dealer locations in North America, of which 1539 sell agricultural equipment;
- AGCO has 1300 dealers in North America, but who knows how many dealer locations;
- AGCO has 340 dealers in South America, 1160 in Europe, Africa and Middle East, and 300 in Asia and Pacific;
- DE Construction and Forestry has 29 dealers with 114 locations in Latin America;
- the number of John Deere's dealers doubled in Brazil since 2007.
Another useful exercise would be to compare margins. The problem is that to make this comparison meaningful, one has to account for the size of the equipment sold: according to a Deere's presentation, margins are higher on larger equipment independent of geography. Relevant data are unfortunately not disclosed. Therefore, I will focus on something different instead: how much of the gross margin is translated into the operating margin? This would allow us to compare how economies of scale help to save on SG&A and R&D expenses.
I will use the term conversion ratio for the ratio of operating margin to gross margin. The ratio is equal to the ratio of operating profit to gross profit. In the next table, I have used CNHI's data from its latest 20-F form. Note that gross margins could be significantly impacted by the method used for inventory accounting. All of the companies in question use a combination of different methods depending on the inventory type; Deere uses mostly LIFO while AGCO and CNHI use mostly FIFO. Consequently, Deere's gross profit is probably slightly understated compared to the other two companies.
As we can see, John Deere's operating margins are about twice as large as AGCO's and CNHI's margins. A half of this difference is explained by Deere's higher gross margins, the other half by a better conversion ratio. Deere's higher gross margin is caused by a larger proportion of large equipment sold and a larger contribution from its Financial Services segment for which a very large part of the revenue flows directly into profit. (AGCO also offers retail financing, but on a smaller scale than John Deere.)
Another thing to note in the table is that John Deere's operating margin showed more resiliency in the 2009 recession. (CNHI's operating profit was close to zero in 2009.) In my opinion, John Deere is a clear winner in this comparison.
Among the 20 listed risk factors, I consider only the following important:
- a significant risk of rising interest rates which could affect sales and profits for a period of several years; however, equipment has to be replaced eventually and that will boost profits in the following years;
- a significant risk of prices getting suppressed by intense competition; however, a price war is likely to be more harmful to competitors than to Deere because Deere has higher margins;
- a moderate risk of governments cutting farm subsidies or imposing restrictions on trade/financial markets; however, changes in the existing policies are likely to be slow and gradual;
- a moderate risk of pension plan deficits during recessions; this is certain to materialize from time to time, but the average annual impact is small.
There are four other notable points:
- earnings are cyclical and we need to average them over a longer period;
- Deere possesses pricing power, evidenced by consistent 3 to 5 percent annual price increases --- even during recessions;
- Deere has wider gross, operating and net margins than its competitors, and the difference increases during recessions;
- John Deere is miles ahead of its competitors in customers' brand loyalty.
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.