(Full disclosure: my clients and I own shares of Deere (DE))
John Deere faces significant opportunities and risks that must be considered before a proper valuation can be done.
The biggest opportunity John Deere faces is booming growth for food in developing and emerging markets. This subject has been covered significantly by others, but I’d like to put a couple of data points out there for consideration. Middle class growth over the next 15 years from places like China, India, Indonesia, Brazil, Pakistan, Mexico, the Philippines, Vietnam, Bangladesh, Nigeria, etc. will be staggering. That middle class is expected to go from 29% of world population in 2008 to 50% by 2030 (Goldman Sachs, 2008). That larger middle class will lead to higher crop production over time and the need for higher efficiency farm equipment like Deere produces. Higher incomes will also lead to higher protein consumption in the form of meat like beef, pork, chicken, fish, etc. (as it has for every country that has achieved middle class income). It takes 2-6 times the pounds of crops to produce an equal pound of meat (Wikipedia, feed conversion ratio). The shift in middle class diets towards more meat consumption will also lead to the need for higher and more efficient crop production the world over.
A second opportunity for Deere is to boost the lower productivity of many farmers in the world. In corn production, Canada is the second most efficient producer to the U.S. at 96% and Nigeria is only 18% as efficient (looking at production relative to acres harvested, USDA data on Deere’s website). With soybeans, Brazil is the most efficient producer, 3% more efficient than the U.S., with Canada at 98% U.S. efficiency and India at 33%. With wheat, the E.U., China, Canada and Ukraine are more efficient than the U.S., but Kazakhstan is only 34% as efficient. The rest of the world can benefit from Deere’s high efficiency farming equipment in order to produce the growing demand for more food.
Although Deere dominates in manufacturing large tractors and combines for row crop production, they also have the opportunity to grow share and efficiency in building equipment for other crops, such as cotton, sugarcane, rice, etc. It may take time to build such expertise, but the returns for such effort, especially over the rest of the world, are great.
John Deere isn’t just a farm equipment manufacturer, they also make construction and forestry equipment. That division has been in a major slump as both the U.S. and the rest of the world has cut back dramatically on construction and forestry markets. But, the good news for Deere is that such markets are coming back and will come back to a normalized level over time. This recovery will, no doubt, come in fits and starts, but Deere has the opportunity to profit from significantly higher revenues and profit margins as those markets recover.
A more defensive opportunity for Deere comes from its finance arm. Although this business is likely to decline over time (see risks below), it will decline more slowly than new equipment sales, and that will dampen earnings volatility over the full cycle.
Finally, Deere’s businesses have a significant service parts business. Although this is a smaller part of Deere’s business, it is profitable and much more stable than selling original equipment.
An understanding of Deere’s opportunities must be balanced against a solid understanding of its risks. Most of these risks relate to the long cyclical boom of farming over the last 5-10 years.
The ethanol production boom has led to great mal-investment over the last 5-10 years. By mal-investment, I’m referring to the Austrian economics term for investment that results from government manipulation of markets. Much more corn has been planted and harvested in order to meet government demands for ethanol production. That artificial demand has led more farmers to buy more equipment than they otherwise would have. Although Deere has benefited from that over the last 5-10 years (and you can see it in their volumes, margins and returns on capital over that time), they have also necessarily overbuilt production capabilities and pulled demand from the future. The boozy boom of the last decade is likely to turn into a nasty hangover over the next decade.
This long boom will take years to work out and for Deere to re-achieve economic equilibrium and then restore normalized growth. That means production will likely need to be cut significantly with a resultant decline in volumes, margins and returns on capital.
The long boom has also resulted in one of the youngest, most productive tractor and combine fleets in history. Farmers making less money (due to lower crop prices caused by supply getting ahead of underlying demand) will be reluctant to replace or even repair such young equipment. This will create the same headwind referred to in the two paragraphs above.
The farm equipment market depends heavily on government financing, especially in places like Brazil. Another risk to Deere is that such funding dries up as many emerging, developing and developed market governments try to right their own fiscal problems. This could create an additional headwind to production volumes and profitability.
John Deere also specializes in large, hyper-efficient farm equipment that most of the developing world is not as willing or ready to purchase. It will take Deere time to build up profitability of smaller tractors and harvesters and and adapt them to new local markets. Added to this, Deere doesn’t possess the same advantages in smaller scale farm equipment that they possess in large equipment, thus under-cutting one of their key competitive advantages.
Although Deere’s finance arm dampens earnings volatility over the full cycle, it will also become a headwind over time as less new equipment is financed (thus shrinking the earning portfolio) and less profitable farmers default on their financing. Added to this, such problems will generate more used equipment to compete with Deere’s new equipment. Financing equipment sales is a double-edged sword that will be considered an increasing risk over time (until, that is, market equilibrium is restored).
Reviewing the opportunities above, you can see there are mostly secular growth opportunities offsetting cyclical decline risks. How these two forces play against each other is another risk for Deere. Will secular growth overcome the downturn due to mal-investment and a return to normalized economics? Or will it take time for secular growth to overcome the cyclical headwinds of over-production? I don’t know the answer, but I know it is a risk for Deere as an investment. I would expect the cyclical headwind to prevail over the short to intermediate term and for the secular tailwind to assert itself over the intermediate to long term.
Next week, I will take a hack at Deere’s valuation, keeping in mind the risk and opportunities highlighted above.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.