- DE is pioneering the next huge phase of productivity growth in agriculture since the first tractors were brought to the market.
- Tractor autonomy, see and spray technology, drone usage, digitalization, and electrification drive DE's LEAPS ambitions.
- The LEAPS ambitions will reduce DE's cyclical sales cycles, with The Company estimating 10% recurring revenue by 2030.
- While share prices are around all-time highs, remember, DE is still prone to cyclicality.
- Wait until a downturn in demand to buy DE shares.
Deere & Company (NYSE:DE) is historically a cyclical company that experiences swinging sales cycles, depending on demand for equipment from farmers and construction companies. For example, I find that Deere's share price is correlated with farm income and well as operating margins. 2022/2023 is the culmination of farm income, as well as Deere sales and margin expansion. However, to offset future cyclicality the company is implementing its LEAPS strategy in which management expects 10% of 2030 sales to be through incredible autonomous SaaS products. I believe these products will dramatically increase the productivity of farming and will therefore be an immense value-add for farmers and consumers around the world. But, until then, I believe investors should wait until the next few years play out since Deere does not have a good margin of safety for a potential recession at its current $110 billion valuation.
|Sales growth|| |
(Reference: Capital IQ)
Based on a quick overview of two important financial performance indicators, we can see that DE does not experience steady sales growth. Furthermore, when sales decline so do returns on invested capital. The cyclicality arises from the cyclicality in farmer income. If we match DE's data with the following time series of U.S. farmer cash flow and income since 2002, we can see a clear correlation.
Notably, as the farmer's bull market reached an inflection point in 2012 so did DE's capital returns. USDA forecasts that farmer incomes will decline by an inflation-adjusted 18.2%. Although the forecasted decline will leave farmer incomes above the long-term average, the trend should be alarming for investors who are considering buying shares in DE today. The unprecedented increase in returns as well as sales for DE is expected to continue throughout 2023, but investors should be wary about a market slowdown that could lead DE to miss its target guidance of $8.75 - $9.25 billion of net income for FY 2023. Furthermore, although the outlook for DE's 2023 is still strong, The Company could experience an even larger slowdown in 2024 and/or forward. I believe that an eventual slowdown in farmer income and John Deere's main operations are the perfect chance for investors to buy into The Company's long-term LEAPS ambitions.
The overarching theme of the LEAPS ambitions is "Do more with less".
The most exciting of the ambitions is Deere's fully autonomous tractor. Economically, this innovation should vastly increase farmer productivity for several reasons. First, the farmer will not need to be present for certain parts and eventually all parts of the production process - giving the farmer the chance to perform other value-added activities while the tractor farms. Second, the tractor will be able to operate for longer hours - even in the dark, the fully autonomous can perform tasks that the farmer would not be able to complete. Third, the cost of seasonal labor should decrease over time thus improving the farmer's margins. If The Company can successfully drive customer adoption, then the autonomous tractor will be one of the century's most essential innovations. As of recent announcements, Deere is planning to offer the autonomous driving feature as a usage-based subscription service. This product will most likely be the largest component of Deere's eventual subscription revenue going forward. In my opinion, substantial revenues from this product will most likely not come to fruition closer to the year 2028 as farmers' digital adoption will likely be slow.
A product, though, that is taking a substantial share already is See & Spray. The Company sells a boom that sprays only weeds and other unwanted plants in the field, which has the power to significantly decrease the farmer's input cost. The Company is also testing alternative spraying devices that reduce the pressure and weight released onto farmland due to large ag. products. These products come in the form of The Company's, joint venture produced, Volocopter drone, signature John Deere drone, as well as... what do you call this thing?
The Implications of an Autonomous Subscription Model
John Deere projected that 10% of total revenues will be made through subscription services in 2030 (Leaps Unlocked). The company briefly mentioned this but has not given any concrete guidance as to how its go-to-market strategy will change with this new business model. This makes it difficult to estimate revenue projections into 2030. For example, with the subscription service, will John Deere own the fleet of tractors that the farmer operates and only charge the farmer for leasing as well as autonomous-based consumption? Or will Deere sell and finance the tractors like they are doing now and simply charge an extra fee for the autonomous-based consumption of the vehicles? I believe that we will continue seeing the original, latter strategy over the next decade but with a new focus in mind. During the Leaps Unlocked presentation, Deputy Financial Officer Joshua Jepsen highlighted that "We're not simply focused on driving units, but instead on increasing the value each machine delivers over its lifetime... [through this Deere's] goal is to achieve an average of 20% throughput margins by 2030 [throughout the cycle]". Deere, as a matter of fact, is already implementing this business model with the See & Spray product today. The purchase of the machine is made at the point of sale whilst the AI-enabled pesticide sprayer is charged on a per-acre usage basis. In the coming years, Deere will equip all of its tractors with autonomous functionalities which will be available for any farmer to use on a subscription basis. This means that tractor and tractor equipment sales will not be lower at the expense of the SaaS model.
Below is a revenue projection model with three sensitivity levels for Deere's Production and Precision Ag business unit. Since 2020, the company began reporting this as a separate unit which was before aggregated into a unit called "Worldwide Agriculture and Turf" (Q1 2019). This business has an expected revenue CAGR from 2020-2023 of 27% with an incredible margin expansion that will result in around a 48% operating profit CAGR over the same period. These results have been incredible in part due to a low baseline (pandemic year) and high pent-up demand due to record high farmer income during 2022/2023. For this reason, I do not believe the CAGRs can be used for a forward-looking projection for the six years following 2023. Because of the uncertainty going forward, the sensitivity model can be used to gain some perspective. 2023 sales for Deere's Production and Precision Ag business will also be at record highs, therefore it will be difficult for the company to generate a high sales CAGR going forward. Therefore I believe the CAGR will lie somewhere between the pessimistic and neutral case where we can expect slightly below a doubling of equipment sales by 2030. Furthermore, I have included SaaS sales to be 10% of equipment sales in each scenario which yields a meaningful bump in sales.
One important implication of SaaS revenues is that operating margins on these offerings should be high. In the best-case scenario, this should lead to an even stronger margin expansion. Since John Deere is still an incredibly cyclical company, the scenario which comes to fruition will be heavily dependent upon the broad macro-economic environment, farm income, farm subsidies, inflation, and more. Nonetheless, if Deere lands in the neutral to optimistic case then a corresponding stock appreciation will follow.
The Implications of Cyclicality for Deere Shares
John Deere's share price and its operating margin tightly follow each other. Furthermore, I would like to point back to the beginning of this article showing a graph of farm income. The Great Financial Crisis in 2008 was followed by an extreme growth in farm incomes, which also correlates well with this graph. Then, farm incomes fell steeply in 2014 and remained at low levels until 2019. And finally, we can see that recently rising farm incomes and operating margins for Deere have led to an incredible share price appreciation. The implication of lower farm incomes is henceforth a lower demand for Ag Equipment and slower sales growth. Moreover, as inflation continues to ease Deere will not be able to continue raising prices so substantially as they have been doing during the previous years and, therefore, we can expect to see a retreat in operating margins. This will most likely culminate in a share price reduction during the short to medium term.
In conclusion, John Deere's historical performance has been closely tied to the cyclical nature of the farming industry, resulting in fluctuating sales growth, operating margins, and returns on invested capital. While the company is currently experiencing a period of growth and margin expansion, I am concerned about the company's vulnerability to potential market slowdowns and a decline in farmer income. Therefore, I consider DE a hold until it can be purchased for a higher margin of safety especially considering that Deere stock was flat between 2012 and 2017 due to depressed farm incomes and lower operating margins/ROIC. John Deere is addressing the cyclicality of its business by creating incredible products such as See & Spray, precision planting (ExactEmerge & ExactRate), and completely autonomous farming vehicles. I believe that this set of products will be the most revolutionary since the tractor replaced horse-driven farming and therefore want to emphasize my belief that DE stock is a strong buy over the long term.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of DE either through stock ownership, options, or other derivatives. 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.
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