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Deere: Unveiling The Path To $15 In EPS

About: Deere & Company (DE)
by: Opal Investment Research
Opal Investment Research
Long only, value, growth at reasonable price, contrarian

Deere's analyst day event highlights the path from the current ~12.5% mid-cycle margin profile to an aspirational 15% margin profile by 2022.

The near-term outlook is mixed, but a focused margin expansion strategy positions the company well for mid-to-longer term growth.

The improved margin profile implies a materially increased normalized earnings power at ~$15.

Improved earnings power does not appear to be captured by the current share price, offering substantial room for upside.

Deere & Company (DE) recently held its annual sell-side meeting with analysts and hosted booth tours at CES showcasing its precision ag tractor, spraying technologies, and crop production systems solutions. Of particular importance was management's showcase of the path toward achieving a targeted ~15.0% 'normalized' margin profile by 2022, highlighting that its immediate priorities include a focus on capital allocation in areas of greatest potential differentiation and profitability, along with cost structure reorientation.

DE was also upbeat around Phase II of its Combine EOP, suggesting that demand is normalizing faster than what the prior guidance had contemplated. With signs of a recovery in the higher-margin North American large agriculture market, in line with increasing replacement demand, cycle-over-cycle margin benefits should begin to filter through to earnings. With the FY20 targets looking very achievable, I anticipate positive guidance revisions ahead.

Additionally, I believe long-term demand in global agricultural markets will pick up gradually, and along with the company's targeted structural improvements in cost structure and cost synergies from Wirtgen acquisition, DE looks set to materially increase its normalized earnings power, which I do not think is being captured at the current price. Continued shareholder-friendly capital allocation policies, e.g., share buybacks and higher dividends, should also unlock further value for shareholders going forward.

Analyst Day Revives the Bull Case

While management highlighted some of the broader company initiatives and mid-to-long term financial aspirations at the analyst event, the focus at this year's event was more on precision agriculture.

Intensified Precision Ag Investments: Management highlighted that one of the two top immediate priorities is to allocate capital in areas of greatest potential differentiation and profitability. This entails intensified investments into precision ag and a reorienting of the product development process around the crop production cycle (tillage, planting, growing, harvesting), where the economics are shifting from the acre-level to crop-level. To this effect, the company has identified a "3-pronged" approach which includes:

  • Automation to autonomy - A proactive tech-driven approach where "forward perception" is being integrated across the product portfolio and production systems. A few examples of this are predictive feed rate control, adjustments to the speed of combines for field conditions, and the optimization of the equipment path before entering a field.
  • Insights to intelligence - Provide access to better data to farmers to empower them to make better farming decisions. DE's John Deere operations center is the largest precision ag platform, with 165 million engaged acres globally.
  • Anywhere management - Leveraging connectivity across the cloud to enable the management of the farm from anywhere.

Source: Company Presentation

Commercialization of See & Spray - the largest herbicide application: An initial version of the See & Spray will now be available in the market by 2021. The application uses computer vision and advanced algorithms to distinguish between crops and weeds, and selectively spray weeds only. The initial use case will be limited to spraying fallow fields to cut herbicide use by 40-50%, but the next generation will be used on crops, which could result in a significant 90% reduction in herbicide use. Similar technology could also be rolled out on the fertilizer side, though management provided no timeframe or productive enhancement data on this front. It is expected that the continuous need to update algorithms on this product could open up new business models such as subscriptions.

Source: Company Presentation

8R tractor and other products: DE also showcased its new 8R tractor, which is equipped with precision ag technology such as E-IVT, an electro-mechanical transmission capable of generating 10x more power than a bolt-on generator providing electrification of a full range of farm implements. Other products highlighted by the management include Auto-Turn and Predictive Feed Rate Control on the combine side, which senses crop condition and density and then decides the optimal harvesting speed.

Prioritized investments for Increased Penetration in Aftermarket and Retrofit Markets: DE's current aftermarket parts capture is ~15-20% of sales, which the company aims to increase. While DE typically retains a high market share with the first owner after the initial sale, its penetration drops throughout the latter years of the machine's life. To mitigate this, the company has made critical investments in all makes and remanufactured parts to promote tiered solutions for second and third-tier purchasers and enhanced e-commerce capabilities (acquisition of Unimil, a family-owned business with robust aftermarket solutions for Brazilian sugar market).

Also highlighted was the precision retrofit market, which represents a significant opportunity over the next few years as the installed base market size is much larger than the new equipment units, making retrofit solutions the fastest way to increase precision agriculture. Specifically, the opportunity is large in high-speed planters (annual market of a few thousand new units vs. installed base of 70,000 planters consisting of 2 million row units) and sprayers (ExactApply technology). The company has recently built out a dedicated internal organization and increased dealership incentives to increase penetration in this market.

Source: Company Presentation

Cost Structure Realignment: DE will conduct a comprehensive assessment of its organizational structure and has plans to shift resources within the company and offer voluntary separation to resources that do not align with the structure to give greater levels of autonomy, empowerment, and accountability to business owners. Additionally, the company is beginning an enterprise assessment to streamline its overseas operations as certain markets have matured differently than expected. These initiatives are set to drive significant run-rate savings in 2022.

Source: Company Presentation

FY20 Expectations: The industry forecast for 2020 remains muted, and company guidance is for FY20 top-line to be down by 5%-10%. The Agriculture and Turf division net-sales is expected to be under 90% of mid-cycle volumes with North American large agriculture net-sales at ~80%. For the Construction & Forestry division, overall net sales guidance is down 10% to 15% and complements the mid-single-digit decline in retail sales. Meanwhile, Construction & Forestry is set to reach ~95% of mid-cycle, with Equipment Operations revenues guided toward slightly less than 90% of mid-cycle volume for FY20.

Source: Company Presentation

Path toward 15% mid-cycle margins by 2022: Penetration of precision technologies in both North America and other international markets will contribute at least 100 bps, increased performance of aftermarket business will add 50 bps, and execution of cost initiatives and Wirtgen acquisition synergies will add another ~65bps ($260 million) to managements' aspiration of mid-cycle 15% margin by 2022 from the current estimated potential of ~12.5%. Global market share, footprint consolidation, and lower SG&A initiatives are expected to drive the shortfall of ~35bps to the target. Notably, with DE's strategic review of overseas operations, some facilities consolidation will likely occur over the next 12-18 months.

Source: Company Presentation

Current Valuation Offers Significant Upside

Though there is execution risk ahead, I believe the DE story has become quite compelling with an outlined path toward 15% margins. If DE is able to achieve its target in 2022, the company should be able to generate ~$15 in EPS based on the current run-rate, and thus, should trade at least at its historical mid-teens multiple, in my view. Given the improved earnings power at ~$15, a ~18x P/E on FY22 EPS would yield a valuation of $270 (~55% upside). Note that this valuation is in line with the broader market multiple, as well as DE's historical average relative multiple.

That said, there are risks to the investment case, namely industry-wide risk such as a decline in agricultural commodity prices, which would result in machinery sales weakness and lower earnings, putting downward pressure on farm machinery stocks like Deere. Additionally, weakness in the North American construction equipment market could also negatively impact Deere's earnings potential and its stock price going forward.

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.