During the early 19th century, farmers in Midwest America struggled with their cast-iron plows. Most of the plows were made in Northeast America and it didn’t suit the sticky Midwest soil. The dirt from the soil caked on their plows and the farmers ended up spending most of their time cleaning the mud from plows. In 1836, John Deere a black smith from Illinois, came to know about this problem. He came up with an innovative solution by curving a steel sawmill blade and designed a self-scouring steel plow. This dramatically improved the efficiency of farmers and an agricultural equipment manufacturing company named John Deere was born.
1. Business
The John Deere enterprise has manufactured agricultural machinery since 1837. It manufactures and distributes a broad range of machines and service parts used in agriculture, turf, construction, and forestry related activites. It’s business operations can be categorized into three major segments. They are (1) agriculture and turf (2) construction and forestry (3) financial services. The products and services produced by the segments are marketed primarily through independent retail dealer networks and major retail outlets.
Around 78% of sales and operating profit comes from US & Canadian markets. And the remaining 22% of sales and operating profit comes from rest of the world. Each business segment of John Deere has unique characteristics and we need to study them separately in order to gain better understanding.
1.1 Agriculture & Turf
The main steps involved in growing and harvesting a crop are preparation of soil, sowing, adding manure and fertilizers, irrigation, harvesting, and storage. And these steps remained the same for thousands of years. But the overall productivity and output has increased leaps and bounds over these years. In 1790 around 90% of American population was engaged in farming. As of today only 2% of the population does farming. Over the same period productivity went up by a lot. How is that possible?
Free market economies incentivized smart people to innovate by deeply specializing on few things. And this led to the invention of internal combustion engines and better machineries which does 1000x more work by using the same set of inputs. John Deere has been innovating for the last 179 years.
The focus on innovation allows John Deere to be a leader, helping its customers find more productivity. In 1837, this meant manufacturing a plow that kept sticky soil from clinging to its sides. In 1960, this meant building a tractor that combined more power, comfort, and style than farmers had seen before. In 2005, this means producing a combine that uses such advanced technology as global satellite positioning to guide the equipment on the most productive path, while enabling farmers to better control input costs and yields through its state-of-the-art systems… If we reduce the time a farmer spends driving in the field and increase the information about the crop available to the farmer in the cab, he can put more of his effort into increasing his profitability. – The John Deere Way
John Deere’s agriculture and turf segment equipment is consolidated into five product platforms. In the mind map shown below I have captured one equipment in each platform to get a feel for its products.
Very few companies in the agriculture equipment industry has survived intact over two decades. But John Deere has thrived for 179 years. So it should be doing something correct. What is that? In order to answer the question let us look at one important metric return-on-invested-capital (ROIC). From the chart given below you can see that agriculture & turf segment is cranking out a healthy ROIC of 31.30%. It achieved this by generating a decent operating margins and a high asset turn over.
A sharp eye would notice that sales and operating profits dipped during 2009 and 2014. This should not be surprising as agriculture industry is cyclical in nature. The next question is what makes John Deere to crank out high ROIC? I can think of three reasons (1) vast dealer network (2) brand appeal (3) research and development. Pat Dorsey did a fantastic job in explaining the power of its vast dealer network.
The key, as it turns out, is Deere’s vast dealer network, which is much more extensive in North America than those of competitors. Dealers can quickly source parts and complete repairs on Deere equipment, which minimizes downtime during critical planting and harvesting seasons. The ability to get broken equipment up and running in short order is critical given that Deere’s customers are extremely time-sensitive—a farmer might use a $300,000 combine for only a few weeks out of the year, but the machine absolutely, positively has to be running smoothly during those few weeks. – The Little Book That Builds Wealth
Large proportion of its sales in North America comes from the sale of large size agricultural equipments. These equipments generate higher gross margins for the company. If you search for ‘price realization of’, you will find it in its last five annual reports. The company has been able to increase the price by 2%, 3%, 4%, 3%, and 5% without affecting its volume. When will this happen? This will happen when the customers have a brand appeal on its products. Also the company spends a lot of money on research and development to ensure that it provides the best equipment to its customers. This creates a feedback loop of high price <-> better quality.
“The eighties were particularly tough,” Lawson said. ” We would go to product review meetings and the chairman and all the top executives were there to participate. We needed to cut costs, but engineering was always supported. And I don’t remember a time when Deere delayed the next generation of product… John Lawson was with the company for 44 years and never remembers members a time anyone suggested cutting back on research and development spending, even in the toughest times… In 2003, for example, the John Deere Agricultural Equipment division invested 4 percent of its net sales in research and development, almost two times what its largest competitors spent. This focus on innovation allows John Deere to be a leader, helping its customers find more productivity. – The John Deere Way
In life everything is relative and this applies to business as well. Let us compare John Deere’s R & D expenses with one of its main competitor AGCO. In the last five years John Deere on average spent 4.23% of sales in R & D compared to AGCO’s 3.47%. This difference might appear miniscule. But when we look at the quantum of money spent then John Deere spent 4.4x more on R & D than AGCO ($6.6 billion vs $1.5 billion). Also John Deere has scale advantages over AGCO which lets it generate higher operating margins. Take a look at the chart which shows John Deere’s scale advantage over AGCO. All of these makes John Deere the largest agriculture machinery company in the world.
1.2 Construction & Forestry
John Deere provides a broad line of construction equipment and the most complete line of forestry machines and attachments available in the world. It started the construction equipment business 45 years ago when it noticed a small-equipment niche overlooked by Caterpillar and others that were manufacturing construction equipments. I have mind mapped some of the construction and forestry equipments to get a feel for its products.
Let us look at the ROIC for construction and forestry segment. From the chart given below you can see that it generated a subpar ROIC averaging 11%. This is very low compared to its agriculture and turf segment ROIC of 31.30%. Also during 2009 recession its profits got wiped out completely. Caterpillar, world leader in construction equipment, cranked out a similar ROIC averaging around 11%. So we can conclude that John Deere is doing a decent job in this segment.
1.3 Financial Services
John Deere’s financial service (FS) segment is responsible for lending money to dealers and customers so that they can purchase the equipment. After making a sale the equipment operations immediately sells the receivables to FS segment. For this the equipment operations pays interest compensation to FS at market rates. The equipment is used as a collateral and it expects the customer to make a minimum downpayment of 10 to 30 percent.
This segment also offers retail leases to customers in North America. Leases are usually written for the periods of 4 to 60 months. And it typically contains an option permitting the customer to purchase the equipment at the end of the lease term. Also this segment securitizes some of its financing receivables. From the chart given below you can see that FS on average generated an ROE of 18.68%. These are fantastic returns.
In the game of financing it is easy to generate high returns on equity (ROE). But it’s very hard to maintain high ROE along with a quality loan portfolio. In order to measure the quality of loan portfolio let us look at provisioning and write offs. Take a look at the charts which I got from company’s presentation. Even during 2009 recession the provisions and write offs were below 1% of loan portfolio. This is a formidable achievement. From this we can safely conclude that FS has a high quality loan portfolio.
Take a look at the pie charts which I got from company’s presentation. Majority of the loans are given to agriculture and turf equipments in the US. Compared to construction segment the write offs in agriculture segment is very low. As most of the loans are in US the currency risk is minimized.
FS segment is run under the name Capital Corporation. In 2014, it had a total liability of $37.97 billion and a total equity of $4.81 billion. What happens if Capital Corporation defaults on its debt payments? John Deere the parent company’s only responsibility is to make sure that Capital Corporation earnings to fixed charges ratio is at least 1.05. If you are interested in learning how earnings to fixed charge ratio is calculated then go here. If this ratio falls below 1.05 then the parent company needs to fund the deficit. And the parent company isn’t responsible if Capital Corporation defaults on its debt. The chart given below clearly shows that earnings to fixed charges ratio was maintained even during 2009 recession. Overall the FS segment is exceptionally well managed. If you’re a shareholder then you can sleep peacefully.
2. Management
In the last 179 years, John Deere had nine CEOs. On average a CEO stayed at his role for 20 years. I have not come across this statistic in any other company. Even today the company is run based on four basic tenets set by the founder in 1837. The tenets are quality, innovation, integrity, and commitment. I learnt a lot about the culture and management of the company by reading the book The John Deere Way. I extracted few key points from the book which can be found here.
On of the best ways to asses the quality of management is to see what they did with cash generated from operations. From 2004 to 2014 it generated $29,480 million as cash flows from operations including few divestitures. It returned 58% back to shareholders in the form of dividends and share repurchases. And retained 34% for capital expenditure and the balance for retiring some of its debt. In the last ten years dividend per share went up from $0.60 to $2.22. This represents a CAGR of around 14%. Take a look at the chart which shows the total shares outstanding going down.
John Deere has long been known for its great products. But its stock was going through a roller coaster ride. Investors will buy the stock at the bottom of the agriculture cycle and sell it at the peak. The returns for a long term shareholder was lousy. In 2000 Robert Lane got appointed as CEO and he changed how John Deere’s performance was measured.
He introduced shareholder value added (SVA) and it measures what shareholders are earning with John Deere in comparison to what they could earn by investing elsewhere at similar risk. For example if a business earns $200 with $1,000 as invested capital then at 10% cost-of-capital SVA comes to $100 [$200 – ($1,000 * 0.1) ]. Even today this how John Deere measures its performance and part of executive compensation depends on this. Take a look at the chart which I got from company’s presentation that will tell you the impact created by SVA. Overall I believe that John Deere’s management is able and shareholder friendly.
3. Valuation
Equipment (agriculture and construction) operations business is very cyclical in nature. One needs to be careful and not overpay based on peak earnings. Take a look at the operating income of equipment operations business. In 2 out of 7 years operating income went down. Taking an average over an entire cycle gives a reasonable estimate of operating income. The average operating income of equipment operations comes to $3.54 billion. After paying taxes at 35% the net income comes to $2.3 billion. At 10% cost-of-capital no growth valuation for equipment operations should be $23 billion.
Finance business got immensely benefited by very low borrowing rates; average interest rate of 1.2% in 2013 and 2014. Its interest expense went down by more than 50% as shown in the chart. To avoid the effect of low interest rates let us value the business based on book instead of operating income. For an exceptionally well run financing business its reasonable to pay one time book which comes to $4.8 billion.
Adding the value for equipment operations and finance business, zero growth valuation of John Deere comes to $27.8 billion. As of this writing the market capitalization of John Deere is $32 billion. At this price Mr. Market is expecting John Deere to grow its earnings at 1.5%. I believe that John Deere can grow its earnings more than 1.5% and the stock appears to be a bargain. The next question is from where does the future growth going to come from? Given below are few areas where growth can come from.
(1) In US and Canada every farmer owns a fleet of agriculture equipments. Growth can only happen by replacing the old machines with the new one. Farm equipments runs smoothly without much issues for 7 to 10 years. After that maintenance cost shoots up and its cheaper to buy a new equipment instead of maintaing an old one. Take a look at the chart which I got from company’s presentation. As of 2011 around 85% of the combine equipments in the US are older than 5 years. So we can expect a lot of replacement demand for many years to come.
(2) Around 40% of the world population live in India, China, and Brazil and agriculture represents 18, 10, and 6% of their GDP. Agriculture in these economies use a lot of manual labor and demand for mechanization is on the rise. On top of this world population is on the rise and expected to reach 9.5 billion by 2050. Many countries are coming out of poverty and this will increase per capita consumption. Since 1995, global corn consumption has risen every year, by over 80 percent in all. Soybean demand has more than doubled over this time. The only way to meet all this demand is to increase productivity through the use of machineries.
(3) In the last 5 years John Deere was able to increase the price of its equipments on average by 3.5%. Some of its costs like R & D and SG & A are fixed in nature. Increase in sales will not result in proportional increase in costs. This creates operating leverage and it will result more growth in net income. In the last 10 years John Deere grew its sales by 5.46%, operating income by 8.38%, net income by 8.13%, and EPS by 11.36%. This shows the effects of operating leverage and the power of share buybacks.
The company set itself a target of acheiving $50 billion in sales and 12% operating margins by 2018. After paying taxes at 35% the net income comes to $3.9 billion. Also the company is aggressively buyback shares. If it retires 4% of outstanding shares ever year then by 2018 it will have around 310 million outstanding shares. This translates to per share earnings of $12.66. If the market pays 12 times earnings then the stock should sell for $151 by 2018. This translates to a compounded return of 12.3%. To this add dividend yield of 2.53% and you would get a total return of around 15%. Not bad at all in the current low interest rate environment.
But the ride is not going to be smooth and John Deere faces few risks. Read this excellent post and the author has done a fantastic job in capturing all the risks faced by John Deere. The competitive advantage of John Deere comes from quality products and its dealer network. In today’s interconnected world we can safely assume that quality is taken for granted. No company can survive without delivering quality products. This means that the strength of any equipment manufacturer depends on its dealer network. And the first mover definitely has an advantage over the late entrant. John Deere has to compete for market share with local and international players with first mover advantage.
Disclosure: As of this writing I don’t own any shares of John Deere.