By The Valuentum Team
Deere's Investment Considerations
• Deere (NYSE:DE) operates in three business segments. Its agricultural/turf segment makes tractors, loaders, combines, and harvesters. Its construction/forestry segment produces earth moving machines, loaders and excavators, while its financial operation supports its dealer network via wholesale financing. The company was founded in 1837 and is based in Illinois.
• Though Deere investors will feel the up's and down's of the economic cycle, the firm's strong brand name and extensive dealer network are key competitive strengths. We like the company's fundamentals.
• The market for agricultural/turf equipment is competitive and includes rivals such as AGCO (NYSE:AGCO) , CNH Global (NYSE:CNHI), Kubota, and Toro. The construction/forestry segment is also highly competitive, and Deere bumps heads in this market with Caterpillar, Komatsu, and Volvo, among others. Its financial services operation adds a degree of credit risk to its operations, as well.
• Deere is tied to the changing worldwide demand for farm outputs that are required to meet the population's growing food and bio-energy needs. Fluctuating agricultural commodity prices directly impact sales of Deere's equipment and are largely responsible for the cyclical tendencies of its operations.
• Deere recently agreed to acquire a majority stake in Hagie Manufacturing, the market leader in high-clearance sprayers in the US. High-clearance sprayers allow farmers to apply pesticides and fertilizers to their fields later in the growing season, and Deere does not produce such a sprayer at the moment. This could be a sign of consolidation in the US farming industry as it continues to face a prolonged downturn in its business cycle. Deere could play a key role in such consolidation moving forward, and its approach will be more strategic than opportunistic.
• Deere has reduced its fiscal 2016 sales outlook. The firm now expects net sales to be down ~10%, compared to previous guidance of ~8% due to the revision of its expectation of the negative impact of currency translation from ~2% to ~4%.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Deere's 3-year historical return on invested capital (without goodwill) is 63.6%, which is above the estimate of its cost of capital of 8.8%. As such, we assign the firm a ValueCreation rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often solid free cash flow generators, and this also lends itself to dividend strength. Deere's Dividend Cushion ratio, a forward-looking measure that takes into account our projections of future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is a solid 1.4 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Deere's free cash flow margin has averaged about 0% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Deere, cash flow from operations increased about 208% from levels registered two years ago, while capital expenditures expanded about 25% over the same time period.
In the first quarter of fiscal 2016, Deere reported cash used in operating activities of ~$780 million and capital expenditures of $140 million, resulting in negative free cash flow generation of nearly $920 million. This is a decrease of more than 32%.
This is the most important portion of our analysis, so let's plow ahead as we plant our valuation assumptions and unearth a fair value estimate for shares.
Our discounted cash flow model indicates that Deere's shares are worth between $74-$112 each. Shares are currently trading at ~$80, in the bottom half of our fair value range. This indicates that we feel there is more upside potential than downside risk at the moment.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $93 per share represents a price-to-earnings (P/E) ratio of about 12.1 times last year's earnings and an implied EV/EBITDA multiple of about 7.2 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of -5.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 4.1%. Our model reflects a 5-year projected average operating margin of 11.1%, which is below Deere's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of -3.8% for the next 15 years and 3% in perpetuity. For Deere, we use a 8.8% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $93 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Deere. We think the firm is attractive below $74 per share (the green line), but quite expensive above $112 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Deere's fair value at this point in time to be about $93 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Deere's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $117 per share in Year 3 represents our existing fair value per share of $93 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
Deere's strong brand name and extensive dealer network are attractive attributes, and we remain fans of the firm's fundamentals. However, the current trough in the company's business due in part to weak agricultural commodity prices has suppressed demand for agriculture equipment. The reduction in its sales outlook could suggest that management doesn't have the best handle on its business' outlook at the moment, and currency headwinds will continue to negatively impact results. Consolidation in the US farm industry may begin to heat up, and Deere may very well be an active player. We like Deere's Dividend Cushion ratio, which remains solid at 1.4, and the firm offers a competitive dividend yield of ~3%. However, we're not comfortable with exposure to the cyclical nature of Deere's business model at current prices. The firm currently registers a 6 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.