By The Valuentum Team
Deere's (NYSE:DE) strong brand name and extensive dealer network are key competitive advantages and are core drivers of the firm's attractive fundamentals. It has been focused on productivity improvements through the course of its history, and net-sales-per employee has grown at a ~5% CAGR over the past 30 years, from just over $100k in 1986 to more than $600k in 2014 before retreating slightly in 2015. The company is tied to the ups and downs of the economic cycle, and demand for its equipment is dependent on agricultural and other commodity prices. Its financial services arm adds credit risk to its operations as well.
Deere's dividend prospects are not as strong as in the past due in part to its large debt load, in our opinion. As of the end of the second quarter of fiscal 2016, the firm had more than $24.6 billion in long-term borrowings on the balance sheet, compared to cash, cash equivalents and marketable securities of more than $4.6 billion. We like management's priority chain for use-of-cash, as it lands dividend as the third priority behind maintaining an investment grade credit rating and funding operations and growth needs. However, debt is something that can come back to bite a cyclical entity tied to agricultural crop fluctuations with a finance arm to boot. Worst-case scenarios can get pretty bad for Deere.
Now all of this being sad, free cash flow generation at Deere has averaged more than $2.5 billion per year from fiscal 2013-2015 and has covered average annual cash dividend obligations of ~$785 million in the same period multiple times over. Management is committed to consistently and moderately raising the dividend while targeting a 25%-35% payout ratio of mid-cycle earnings. The firm's shares offer a compelling ~3.1% yield, and its Dividend Cushion ratio of 1.1 could be worse. However, we'd like to see a more healthy balance sheet from such a cyclical operator. Why not just become a debt-free entity? Under that scenario, nothing would stop Deere from running!
Image Source: Valuentum, Deere's stock landing page
Deere's Investment Considerations
• Deere operates in three business segments. Its agricultural/turf segment makes tractors, loaders, combines, and harvesters. Its construction/forestry segment produces earthmoving 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 ups and downs 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 Industrial (NYSE:CNHI), Kubota (OTCPK:OTCPK:KUBTY), and Toro (NYSE:TTC). The construction/forestry segment is also highly competitive, and Deere bumps heads in this market with Caterpillar (NYSE:CAT), Komatsu (OTCPK:OTCPK:KMTUY), and Volvo (OTCPK:OTCPK:VLVLY), 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 has reduced its fiscal 2016 sales outlook. The firm now expects net sales to be down ~9%, compared to previous guidance of ~8% due to the revision of its expectation of the negative impact of currency translation of ~2%.
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 31.6%, which is above the estimate of its cost of capital of 9.4%. 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.
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 -2.9% 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 19% from levels registered two years ago, while capital expenditures expanded about 19% over the same time period.
We think Deere is worth $93 per share with a fair value range of $74-$112.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of -1.3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -7.2%.
Our model reflects a 5-year projected average operating margin of 9.7%, which is above Deere's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of -5.7% for the next 15 years and 3% in perpetuity. For Deere, we use a 9.4% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
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 were 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.
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.