Deere: Incredible Company, But Still A Cyclical

Summary

• 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.

Wirestock/iStock Editorial via Getty Images

Investment Thesis

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.

History

Year	2012	2013	2014	2015	2016	2017	2018	2019	2020
Sales growth	12.9%	4.5%	(4.6%)	(20.2%)	(7.8%)	9.5%	28.4%	5.1%	(9.5%)
ROIC	44.9%	41.3%	32.7%	24.5%	22.9%	26.8%	22.7%	28.7%	22.6%

Click to enlarge

(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.

Farmer Income (USDA)

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.

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?

Autonomous Sprayer (Deere.co.uk)

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.

The Author

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

Data by YCharts

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.

Conclusion

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.

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.

Comments

[The Stock Stooge]

While farm incomes are pointing down from the 2022 peak, expected farm incomes this year are still really great and support farmer purchases of DE equipment sufficient for $30 EPS. I don't see farmer incomes dropping much further considering low global grain stocks that need to be replenished. In fact, farmer incomes could increase due to lower fertilizer and shipping costs.

[Philip Eriksson]

@The Stock Stooge very interesting perspective, thank you! You are right that incomes will still be high over the next year. But the question is rather about 2,3,4 years from now?

[foxtown]

Deere up 5.24%. Agco up 6.97%. United Rentals up 6.57%. Caterpillar up 8.39%. Economy looking better after job report today. Also,congress agreed to settlement on debt fiasco. So,that is another worry off the table for the economy. Is it a beginning to an upside in the industrial sector? Time will tell! Many AI companies had a down day today! Valuation concerns? Perhaps its the beginning to a sector turnaround! When the dust clears, profitable companies stock price will eventually go up. Fundamentals matter in the long term! Technical and momentum trading matters in the short term! Your not going to get rich off of Deere stock unless you invest much money but it has been a steady performer over the years. Much better than Verizon or AT@T! 5 year return for Deere stock is up 136%. Verizon minus 30%. AT@T minus 40%! What good is a 5-6 percent dividend when you keep having stock losses! Deere stock might not be as sexy as Nvidia or Amd, but its much less volatile.

[Philip Eriksson]

@foxtown Agreed! And it may be even more sexy than Nvidia & AMD when it releases fully autonomous products ;)

[foxtown]

Yes, I will look up autonomous products coming up from Deere. The big thing is cost. If they can keep the cost down, it could be very profitable for Deere. Of course another thing is reliability.

[Philip Eriksson]

@foxtown yes great point! 👌

[foxtown]

I don't know how Deere can be classified as overvalued when revenue has been up 30-40 percent for the past three quarters. Also,their EPS has gone up big time compared to historic averages. If you look at the stocks Agco,United Rentals, and Caterpillar they been under the slow bleed for the past few months. Very similar stock charts. All these stocks have also been very good in terms of their profitability but their stock price does not reflect that. It seems like it is just a sector downturn and in the long term these stocks will rebound. On the opposite side, the AI craze has been nuts. There are companies that are rising big time though they are not very profitable now. Its all based on speculation of what they possibly can make! It seems like these industrials are being dragged down by the speculation of a future recession. If a recession does happen next year, Deere should still be OK. The basic need for people is food. The problem it seems is that Deere is in a bad sector right now. Profitable companies can still go down in a bad sector. Non profitable companies can still go up in a good sector. Lately that's been the tech sector!

[Philip Eriksson]

@foxtown Yes I agree with you, it has been crazy following the market in the past few weeks! And Deere will be doing really well in the long-term and don't have a problem if we enter a recession. But, they are definitely not as immune to the downturn as they might be in 5-10 years. I'm looking forward to them rolling out consumption based AI features (See & Spray + Autonomous driving) which will lower the cyclicality since farmers plant every year regardless of the price of crops.

[Paul.Y]

Nah, they ll be pumping Deere to 500, just need some Ai powered tractor 🚜.

[HPBunker]

@Paul.Y

Already exists, though it's not widespread yet. See & Spray is widely available, though. AI-controlled herbicide spraying.

[Philip Eriksson]

@Paul.Y should be coming with higher adoption in the coming years!

[HPBunker]

I see the value in See & Spray. If you're going to use herbicides, you might as well use less of them. That saves money and has environmental benefits as well. But I'm not sure about autonomous tractors. Growing row crops like corn and soybeans is already extremely labor-efficient. It seems like the area where automation would be a huge labor saver in agriculture is with tasks like picking fruit and vegetables. Does Deere have any plans in the works to address that aspect of farming?

[Philip Eriksson]

@HPBunker I see what you mean there. But, one thing is that autonomous tractor allows farmers to work longer hours with the help of autonomy (for ex. the tractors can run at night). Fruit picking & vegetables would be huge, I agree. I can't find anything concrete on it right now, but I have seen that Deere has a joint venture with a company providing autonomous vehicles for fruit farmers.

[Philip Eriksson]

@HPBunker fruitgrowersnews.com/...
here it is. Not picking fruit yet, but spraying.

[HPBunker]

@Philip Eriksson

Interesting. Thanks for the link.

[Robin Heiderscheit]

Really good piece, thank you, I learned alot.

Which is actually troubling because I started buying yesterday!

[Philip Eriksson]

@Robin Heiderscheit hehe well thank you for the read! It could be good to purchase a little bit at a time with Deere. I still think your investment will do well long term!

[Trevor42]

I love the idea of holding Deere for the long haul, but it doesn't generate enough FCF to justify this valuation, imo. I can't bring myself to pay a massive premium for a company so sensitive to interest rates and commodity prices.

[ding dong]

My rough estimate, the stock needs to be close to 200 (+/-) to be a fair price.

[Trevor42]

@ding dong That seems pretty fair. I was thinking a little higher but not much. At that valuation, they would still have cash flow concerns but some of that cyclicality risk is taken out.

[ding dong]

DE was an OK stock until 2020, when it went parabolic. In 2020 the deranged Fed threw so much money into the economy that stocks went up.

DE is not very expensive based on their PE ratio, but as you point out it is highly dependent on farm income and I suspect the farm income will fall over the next few years and DE's EPS will also fall, thus DE may end up being expensive on forward earnings (classic cyclical pattern.)

[Philip Eriksson]

@ding dong yep agree, and its easy to ignore or 'forget' when times are as good as they are now for DE.

[duinmd]

You state in your summary that share prices are around all-time highs. The 52 week high was $448.40, now trading at $363.55-am I missing something?

[joelav]

@duinmd I was going to write the same thing - It is ~ 20% off it’s high. Thanks

[Integr8byDarts]

@duinmd Correct, it is down 18% from its ATH. Zooming out to >5 year time horizon, though, the author probably views this as essentially at ATH and a much larger correction due. (I'm not agreeing or disagreeing)

[Philip Eriksson]

@Integr8byDarts @joelav @duinmd Hey good point, you are all right about that. I wasn't so precise with my wording there, and I just meant it to say over the long term it is around all-time highs. As @ding dong mentioned above, Deere went 'parabolic' after 2020. But, i do believe the stock price growth is merited since DE's margins have grown, sales have grown like crazy, and new product launches have been impressive. Thanks for the feedback :)

[slam stocks]

DE is cyclical and regretted selling years ago. Bought at $13 and later sold for $95. It was a huge mistake and repurchased recently on the dips at $387.

There is so many reasons the stock is a buy. Growing population, global warming, decline crop yield, smaller workforce, fertilizer costs, Ukraine etc. Automation and efficiency to feed the world will depend on companies like DE.

It was a huge mistake selling years ago and will continue adding shares on further weakness.

[ding dong]

387 may have been too soon. I think on a trend line from 2010 to 2020 projected in the future when the EPS reaches the trend and the PE is about its average PE from 2010 to 2020 is when it will be a good buy.

[Philip Eriksson]

@slam stocks Ah man, well you got a good upside at least. This time, don't sell! Deere might just be worth holding for 20-30 years especially with their LEAPs ambitions.

[Robin Heiderscheit]

@slam stocks well I can top you for stupidity, having bought DE at $37 in I believe 2001 and sold at $39 the same year!

[Skih20]

Thanks for sharing your insights. There are tens of thousands small farmers that keep chugging along. Companies like DE are going to change that (over time) by giving the big/more sophisticated farmers the ability to offer landlord $100+ more per acre than the mom & pops. The bigs will be able to do that via technology (think DE) wholesale pricing of inputs, less labor/acre, etc. I agree with your current thesis, but I’m looking for the day (maybe 5-6 years out) when DE is able to expand its market due to this massive shift I see coming.

[Philip Eriksson]

@Skih20 Interesting idea. So to clarify, do you think that big farmers will expand their acreage share over time since they better/ more efficient technology?

[Sugar Charlie]

I am a very happy long-term investor in DE with a cost-basis about 30.50, and I have no inclination to sell,-- even aside from the tax liability on disposition. The major concern I have currently is with the "right to repair": www.cnn.com/... 'The memorandum of understanding with the American Farm Bureau Federation (AFBF) gives farmers access to the same Deere documentation, data and diagnostic tools used by the company’s authorized repair shops. Farmers will be able to diagnose and fix broken down equipment on their own or by choosing an independent repair facility, which will also have access to the proprietary tools and data on the same fair and reasonable terms, according to the MOU.'

[Philip Eriksson]

@Sugar Charlie great point. I agree with you on this, it certainly is a risk. The question though is, how much of Deere's revenue & profit is based upon repair?

[Sugar Charlie]

@Philip Eriksson Services are a steady and reliable source of revenue for companies which sell capital goods. This will tend to depress the growth of such revenues, though how much cannot reasonably be estimated. Aside from volume of services sold, DE will have to keep its rates down so as to avoid farmers' doing their own servicing, One issue is what position DE can take when the farmers try to service themselves, and do so in a faulty manner, and then look for help.

[Investor_JR]

Thank you for a good article.
DE's business is definitely cyclical. But that concern seems overblown. This stock has been locked in Valuetrap for 2 years and 2 months. Until this year, the order has already been set. From 2024, sales over the next five years are unlikely to decline significantly. The adoption of AI technologies has greatly expanded the added value. In addition, the industry is changing from a simple machinery business to a technology monopoly business. Similar to ISRG, it can be given multiples. I don't think there is a significant downside to the share price. It is likely to be supported at around $300 per share. Upside is over 100%.
1. Healthy balance sheet
2. Long-term annual average cash flow of $10B
3. Multiple for FCF of 30x.
The stock has a fair value of over $800.

[Philip Eriksson]

@Lion capital Thanks! And great comment. I have been contemplating when to continue purchasing shares. But, time and patience are on our side to purchase little by little at favorable prices.

[Seeking ROI]

Given your "hold" recommendation, do you consider AGCO a better alternative at this point. I believe AGCO has some excellent SaaS capability. What are your thoughts?

[Philip Eriksson]

@Seeking ROI hey good question. I've looked a bit into AGCO in the past as well as now recently. From what I understand, they are focused on digital farm-management tools & precision agriculture (similar to John Deere), but from what I understand AGCO has not released an autonomous tractor (as Deere has). Deere has actually already launched a fully autonomous working tractor that is being used in pilot projects, which is incredible, while AGCO has some autonomous robots (www.futurefarming.com/...). Another thing i would like to mention about the companies is that Deere had operating margins of around 24% last quarter (expecting 25-26% FY) whereas AGCO had 11-12%. I believe DE's high margins are a reflection of there incredible products and strong brand name.