Deere Has Taken Care Of Its Investors (NYSE:DE)

In May 2020, I believed that Deere & Company (NYSE:DE) was fairly valued in a challenging environment. At the time, Deere was preparing for a fall in sales as the large financial business and financial book of Deere raised some questions as well. Despite being a great steward of long term capital, and trading at a reasonable valuation, I unfortunately remained on the sidelines, with shares trading around the $150 mark at the time.

What followed has been a boom in the share price and while shares are down nearly a third from recent highs, the current level at $312 per share makes that shares have doubled from the levels seen just two years ago, marking a very decent outperformance. As it turned out, the equipment maker which allows those who take care of the land, has taken care of its investors too.

Back To 2020

Deere closely follows the agricultural cycle, even as the company has been diversifying somewhat away from agriculture by focusing more on forestry and construction markets, in part through M&A. After sales peaked at $35 billion in 2013, on which operating earnings were posted at $5.8 billion, sales fell to just $24 billion in 2016, with operating earnings down to $2.3 billion.

Ever since, shares recovered again as in 2019 the company was back to posting $39 billion in sales again. These sales were comprised out of more than $23 billion agriculture & turf equipment sales, more than $11 billion in construction sales and nearly $4 billion in financial revenues. Operating profits recovered to $4.4 billion, a strong absolute number, but margins still came in below the 2013 peak as earnings were posted at $10 per share. At the time, net debt stood at $40 billion, although the company had some $34 billion financing receivables as well. While leverage was limited if we factor in these receivables and net for them, the company essentially ran a big bank during a period of great turmoil, creating some risks.

With shares trading at 15 times earnings in 2019, while 2020 was becoming a more challenging year, I failed to see great appeal, albeit that the pandemic actually boosted demand for agricultural products (with a lag), to be followed by inflationary pressures (including in soft commodities) in 2021 and certainly in the first part of 2022.

That neutral stance, albeit in a very uncertain period of time, has obviously been too cautious with the benefit of hindsight, as inflationary pressures, demand for food, the capital spending cycle and continued focus on automation of the agricultural sector have been drivers behind continued growth in Deere´s business.

Steady As She Goes

As it turned out, the pandemic only had a small impact as full year sales fell just 9% to $35 billion and change, all while operating earnings fell slightly to just $4.3 billion, as growth in earnings was seen in the fourth quarter already. With net earnings down from $3.3 billion to $2.8 billion amidst higher tax rates, it was the 2021 guidance was quite strong, calling for net earnings between $3.6 and $4.0 billion.

2021 sales recovered and rose 24% to $44 billion, a new high. Operating earnings essentially doubled to $7.6 billion, as earnings rose to $19 per share, or $6.0 billion in dollar terms. More so, net debt was equal to $40 billion, including financing liabilities of the financing unit, this time backed up by $38 billion in financing receivables. Momentum was set to continue in 2022 with net earnings seen at $6.5-$7.0 billion as great operating momentum translated into 17% margins in 2021, historically a very high number.

It were these strong results which drove shares to a range of $350-$400 early in 2022, which looked reasonable with the strong balance sheet being apparent, as earnings of $19 per share translated into a roughly 20 times earnings multiple.

With shares peaking at $446 per share in April of this year, it has been (concerns) on lower demand, inflation and supply chain disruptions which triggered quite a big pullback to $312 per share now. In May, Deere posted its second quarter results, with revenues up 8% to $23 billion so far this year, as operating profits were down from $4.1 billion to $3.9 billion, while net earnings were flat at $3.0 billion.

Amidst a roughly 2% reduction in the share count, earnings per share improved modestly to $9.72 per share, all while net debt inched up a bit to $44 billion following some smaller M&A and share buyback. For the year, the company now sees sales at $7.0-$7.4 billion which looks very strong, but includes a one-time gain of $220 million. Even if we adjust for that, a midpoint of $7.0 billion is simply very strong.

What Now?

With earnings power still seen at $22 per share this year, albeit that there are some inflationary and demand risks to that, the valuations have been reset in a major way. Even if earnings only come in at $20 per share, the valuation is still only seen at 15-16 times earnings, while the balance sheet is in solid shape and the company has continued to be an excellent steward of capital, even while running an internal bank.

Of course the impact of Russia and Ukraine is key, as Ukraine is such an important agricultural country, yet sales in both countries run at just 2% in total, with exposure seen less than half a billion. There are risks to this, yet the reality is that the event/war probably induced more demand elsewhere, creating a bigger boost than Deere´s direct exposure to the conflict.

While the overall picture look solid, we have to take a further step back. As sales could surpass $45 billion this year with margins seeing in the high-teens, there are risks to this amidst softer soft commodity prices as we arguably find ourselves at a very good point in the agriculture cycle. Hence, the picture could look a bit different if things normalize and sales could easily fall back to $40 billion, with margins seen between the historical 10-18% range, let´s say at 14%.

In that case operating earnings would come in at $5.6 billion, leaving net earnings just north of $4.0 billion, or about $13-14 per share in earnings power. In such a case, multiples still come in at 22-23 times earnings here. This still feels a bit rich despite the low current multiple, and while I think that Deere is rapidly getting more compelling, I am just waiting for a slightly larger pullback.