Coverage of Deere (DE) is nearly universally bullish and Wall Street, while rightly cautious, still has a $176/share consensus target sitting out there on the firm. Peruse most professional analyst models of the company and the outlook looks darn good: fiscal 2021 EBITDA estimates are around $7,200mm, up 35% from realized fiscal 2018 levels. However, there is more to the story.
Those assumptions are built off of solid growth from 2018 (mid to high single digits) but most importantly are also built off some aggressive margin expansion expectations – so much so that margin is expected to recover all the way back to peak levels realized in several years ago. This is unlikely to happen as 2012-2014 were a once in a lifetime event for farmers. The likelihood of margin expansion appears even lower given trends in raw material pricing (steel) and sky-high implied incremental margin expectations.
Both the sell-side and retail investors have a knack for underestimating how long cyclicals can remain below “mid-cycle” levels and utilizing the wrong periods for coming to mid-cycle estimates. That looks to be the case today. For the better part of the past decade, Deere benefited from a surge in equipment sales fueled by cheap and easy credit, above average crop prices, and increasing farmland values. By comparison, the future does not look promising. While other agricultural equipment OEs and suppliers (AGCO Corporation (AGCO), CNH Industrial (CNHI)) have rolled over this year on justifiably weaker future outlook, Deere has held up relatively firm. This will break and I see downside back down to $100/share.
Addressing The Bull Case
*Source: Deere Corporation, December Strategy Overview, Slide 20
Much of the bull case around Deere revolves around its shareholder value added (“SVA”) program, a metric it adopted nearly two decades ago. The program was the brainchild of prior CEO Bob Lane, set in place to address what he felt was an overly capital-intensive business. This was true; Deere at the time was asset heavy (inventory, receivables) and reported decent margins only during the good times. Once SVA was rolled out as a company-wide metric, the rules of the game for internal managers was simple: Either meet the company’s pre-tax cost of asset hurdle (initially and still set at 12%) or the business would get cut. There was a lot of pain early on (indicative on the above chart).
So what exactly is SVA? SVA is defined as adjusted operating profit before taxes less the pretax cost of assets (that prior 12% number). Management will point to the clear improvement seen in the above slide as a sign that:
- It has become more adept at managing the agricultural cycle
- It has become a leaner, more efficient organization.
That is not the case. What SVA does not control for is the massive growth within its financing book. That 12% hurdle is focused on so-called “average identifiable assets”, a number that was reported at $14,825mm in 2018 inclusive of inventories (excluding the Witgen acquisition). That figure is primarily made up of property and equipment, inventories, and receivables. It does not include financing assets. Don’t just take my word for it; the terms of the Mid-Term Incentive Bonus Plan for Deere managers control for this by utilizing a cost of equity (Source: 8-K Filing) versus assets when measuring returns.
To reinforce, let us compare two years:
- $17,700mm in net equipment sales
- $7,477mmm average identifiable assets at standard cost
- $466mm in operating profit within its Credit business on $12,530mm in financing receivables and operating leases
- $30,324mm in net equipment sales
- $14,825mm in average identifiable assets at standard cost
- $792mm in operating profit in its Credit business on $38,241mm in financing receivables and operating leases
Since 2004, John Deere has grown its equipment sales at a 3.9% compound annual growth rate; barely above the rate of inflation. By comparison, the asset base has increased much more quickly. That average identifiable asset figure jump that I suspect many readers noticed has been entirely driven by a ballooning in net property and equipment on balance sheet ($3,706mm) and inventories ($4,150mm). So much for reducing asset intensity.
But the number one thing to take away from this data is that amazingly, despite tripling its outstanding receivables business, operating profit within its Financial Services business has only increased marginally. Deere has taken on tens of billions of dollars in additional risk by tripling its credit book (albeit collateralized risk) to only incrementally boost its operating profit within financing by 70%.
Why the lack of profitability in financing? Giving better deals to customers. Write-offs have not been bad due to still stringent underwriting standards (10-30% down payments), so the difference between 2004 and 2018 is the credit spread: the rate at which Deere loans out money and the rate that it borrows. Given the growth in the loan book, it is pretty clear that many more sales to buyers today are financed – not cash paid. With farm income under stress and interest coverage at multi-year lows, farmers need a little help to make equipment purchases. This can also be seen in the massive growth in operating leases versus capital leases that are moved off balance sheet (done on shorter terms).
The Macro Environment For Farmers
*Source: Author-Created Graphic, USDA, Net Farm Income Data Adjusted For Inflation
It is quite remarkable how stable net farm income is once inflation adjusted and it is a stark reminder on why investors need to be careful about extrapolating trends from data reported in nominal dollars. If farming is a mature, zero growth industry when it comes to inflation-adjusted profits, then by extension Deere is a supplier to a low growth industry. Additional value can only be created by taking market share or driving savings at the bottom line.
2012-2014, which have formed a key basis for Deere and other agricultural firms within mid-cycle forecasts, were once in a lifetime years for farmers. The money made in those years, in particular, spurred substantial new equipment sales and drove investment from farmers that were previously highly cash-strapped. Remember that margin expectations for 2019 and 2020 are at those levels (see Credit Suisse projections below):
*Source: Credit Suisse
This is a tough sell for me, particularly as most investment bank coverage continues to try to paint Deere as a company as within a cyclical trough versus actually being mid-cycle. The Congressional Research Service, in its U.S. Farm Income Outlook, is a bit more rational in its language:
Commodity prices are under pressure from a record soybean and near-record corn harvest and from diminished export prospects due to an ongoing trade dispute with China. U.S. farm income experienced a golden period during 2011 through 2014 due to strong commodity prices and robust agricultural exports. Most crops and livestock product prices remain significantly below the average for 2011-2014, when prices for many major commodities attained record or near-record highs.
Deere, in response to weak crop pricing and falling exports, tends to point to farm balance sheet data to make its case that farmers are in decent enough shape to borrow. See the below from one of its more recent presentations:
*Source: Deere Corporation, CEO Strategy Presentation, Slide 20
Measures of health like debt to equity or debt to assets are reliant on a farm’s asset values, not its income-generating power. For farmers, much of their asset value is tied up in their land. Since 2004, average farm real estate values have rallied significantly from $1,340 per acre in 2004 to $3,140 per acre in 2018; this is an increase of 134%. Underlying crop prices have not changed materially since then; farmers were getting similar price per bushel of corn in 2004 as they were in 2018.
This is a hot topic of debate among farmers. I’ve been personally surprised to see acreage hold up as it has in recent years, but this is more of a reflection of the group who, as older Americans on average (the average farmer is in his/her late 50s), has seen acreage prices do nothing but head north for years. They continue to see cropland as a multigenerational long-term investment despite the fundamental lack of underlying profitability. After all, that is all they have ever known. However, at the end of the day, acreage prices are going to adjust to reflect underlying earnings power of the asset sooner or later. For cropland in Nebraska, that means farming or nothing at all. In fact, acreage pricing is already starting to come down and if this trend continues, these “Farm Balance Sheet” slides will look much worse. For a different look, consider interest coverage (also sourced from the USDA):
*Source: Author-Created Graphic, USDA, EBIT Coverage
This does not fit the Deere narrative, certainly not over the past ten years. Actual farm cash income to cover debt is now the lowest it has been in two decades. Outside of levering up and mortgaging land assets to buy equipment, farmers have little wiggle room. Keep in mind that this interest coverage is also built off of a low interest rate environment. As we head into a potential upswing in lender-demanded interest rates, refinancing could pressure farmers when it comes to interest coverage as well.
Given the glut of new equipment sitting out there bought between 2012-2014, future sales growth is tough. Farm equipment, such as combines and tractors, have average useful lives in the fifteen to twenty-year range. While data is slow in this space – the Census of Agriculture is only run every five years (2017 set to be released in February 2019) – I expect 2019 reporting to show just how new the fleet of equipment is for farmers, particularly domestically.
Going forward, I expect the hangover from the boom years to continue. Equipment inventories remain elevated, farm credit is likely to tighten, and there is quite a bit of unutilized manufacturing capacity within the Deere footprint. While not addressed directly above, what is true of the United States is also true of most of the foreign countries in which Deere operates. This is a global problem.
I think Deere at least recognizes some of these risks as well: the Wirtgen deal is a major shift to strategy. This is not a company known for deal-making. If Agricultural equipment was truly at a cyclical bottom, why not deploy capital to make a big purchase in agriculture or turf? There were much better targets out there and the deal seemed stretched given the synergy targets. With time, I expect fiscal year 2019 and 2020 estimates to move down – and that means pressure on the share price. I’d view any strength in the name as an opportunity to further bolster a short position.
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Disclosure: I am/we are short DE. 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.