Reports Of John Deere's Death Are Greatly Exaggerated

| About: Deere & (DE)

Summary

DE’s strong brand recognition in the agricultural industry indicates that sales will return to normal within three years.

There is a very real need for their products now and in the future.

Management is reducing current costs and investing in future products.

My valuation: $92 per share.

Top Agriculture Equipment Manufacturer:

John Deere Most of John Deere's (NYSE:DE) money is made by its Agriculture and Turf segment. This division makes large agricultural equipment such as tractors, combines, and harvesters. It also includes parts and services the equipment needs. The Construction and Forestry segment is smaller and has more competition from Caterpillar (NYSE:CAT) and other construction equipment companies.

Many people like to use Caterpillar as a comparable because both companies make construction equipment, but I think this glosses over the dominance that John Deere has in the farm sector. Try to think of a different brand of tractor besides Deere. Caterpillar doesn't come to mind.

Two year sales decline:

Overall sales have been declining for the past two years mostly due to lower agricultural commodity prices. This is cyclical and is expected in the farming industry. However, as long as farmers are not getting high prices for their crops they will not spend a lot of money on a new tractor.

This is creating a lot of used John Deere equipment on the market now. Many analysts are worried because those used tractors compete with newer tractors but John Deere does not see any of those sales. I believe this is a temporary problem. If your product has a high resale value that means people need and value it. It is not a bad problem to have in the long run. Eventually crop prices will go up due to increasing incomes or simply population growth. The Agriculture Equipment industry just has to wait it out.

Prudent financial management:

You can tell that management expected the current downturn in sales because inventory and production capacity decreased every year as sales decreased. This keeps costs low in lean years. If they hadn't done this, we would have seen the gross margin decrease. Instead it stayed steady.

Year

2011

2012

2013

2014

2015

Sales

32,013

36,157

37,795

36,067

28,863

Inventory

4,371

5,170

4,935

4,210

3,817

Property

6,502

7,540

8,619

9,593

5,181

Gross Margin

31.17%

30.50%

31.71%

30.89%

29.66%

Click to enlarge

At the same time, management has not cut money for new product research. Research and development spending is stable at $1.4 million. This is necessary to keep quality up so farmers will buy new equipment when crop prices improve. You might think that agriculture equipment doesn't change much from year to year, but that's not true. Every year new features get added to keep up with customer requests.

Many people associate self driving cars with Google (NASDAQ:GOOG). John Deere has autonomous equipment working on farms right now. In fact, they are the largest seller of autonomous vehicles in the world. I found that fact hard to believe at first since they were founded before the Civil War.

Enterprise life and earnings growth:

Past performance is no guarantee of future return. But it is a good indicator. Few companies last longer than a hundred years, let alone 178. For the purposes of this estimation I assume that they will continue to grow at their current rate for another 20 years, and then level off at a slower 4% growth rate for another 10 years.

Determining the current growth rate is hard for cyclical industries. Depending on when you measure income growth, you can make it look amazingly successful or despondently flat. Here is a graph of earnings per share for the past 20 years, including the company's $4.17 estimate for 2016:

Click to enlarge

You could have justified growth rates from 2% to 18% based on this data. The average line on the graph calculates it at 9.9%. I'll use 6% to keep the estimate reasonable. In cases like this I try to be conservative but practical.

Discount rate:

John Deere's earnings may be down but they are high quality. If management was inflating earnings we would see signs like higher receivables, sharp rises or falls in inventory, and changing discretionary expenses. These telltale signs aren't here when earnings are down, so we can conclude management isn't hiding anything from us.

Year 2011 2012 2013 2014 2015
Sales 32,013 36,157 37,795 36,067 28,863
Receivables 3,295 3,799 3,758 3,278 3,051
Inventory

4,371

5,170

4,935

4,210

3,817

R&D 1,226 1,434 1,477 1,452 1,425
SG&A 3,362 3,662 3,810 3,608 3,056
Click to enlarge

Based on that, plus its long history of market leadership and plans for the future, I'll use a low discount rate for this valuation. 8% might seem too low but I think it is better justified than the 9.5% rate that its Beta (1) would predict. 8% is approximately the average US Treasury rate (4.9%) plus an equity premium. This implies a reduced Beta of 0.67.

Valuation:

Management Predicted 2016 EPS= 4.17

Years= 20

Growth rate= 6%

Terminal growth rate= 4%

Years of terminal growth= 10

Discount rate= 8%

Value= $92

Conclusion:

John Deere is an historic leader in the agricultural equipment space and will increase earnings within three years. An investment in them should have a time horizon of 3 to 6 years, hopefully more. At the current range ($72-$79) they are around 20% undervalued.

Please leave comments below. If you think John Deere will not pull out of its sales slump, please say why.

Disclosure: I am/we are 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.