Deere Plows Ahead

We modestly reduced our 2016 earnings forecast for

Deere's second-quarter industrial sales were down a modest 4% compared with the prior year as agricultural and turf sales were flat, while construction and forestry sales declined 16%. Serious headwinds remain in both the agricultural and construction end markets, but quarterly sales were somewhat aided by order timing issues and a move to increase production runs to improve cost absorption in the period. All told, the industrial operating margin contracted 180 basis points to 9.7% in the quarter, with heavy sales incentives in construction and forestry hampering margins.

Although Deere's financial services business continues to perform well, with loss provisions still trending below the 15-year and 10-year averages, the weak market for used agriculture equipment caused the company to face some losses on off-lease equipment sales. In response, Deere raised loss provisions for remaining short-term leases. The company has increased dealers' responsibility for short-term lease losses and anticipates that these can be kept to a minimum going forward. Despite pushing greater lease risk to dealers, the shortfall caused Deere to reduce its 2016 financial services income outlook to $480 million from $525 million.

North American Leader Looks Overseas for Growth Founded in 1837 as a blacksmith's shop, Deere's brand name is synonymous with agricultural equipment. It generates 80% of sales from agricultural equipment and greater than 50% of sales from the North American farm equipment market. The brand is built on industry-leading agricultural research and development spending and an unmatched North American agricultural dealer network. Outside North America, Deere's brand is weaker, although it is aggressively deploying resources into markets like Brazil, where it has grown to 20% of the new tractor sales from 8% over the past decade. Growth has come from a combination of an improved dealer network and Deere's push to expand its product portfolio to be more suited to the Brazilian market. While the company clearly benefited from the U.S. and Europe biofuel mandates and robust farm capital expenditures, we believe it has smartly diversified its business into new geographies including Brazil, Russia, India, and China. In these newer markets, Deere has capitalized on a consumer base that demands higher caloric intake and needs the local agricultural economy to produce more.

While Deere is closely affiliated with agricultural equipment, its brand and assets are also active in consumer, construction, and forestry applications. These markets make up 16% of Deere's manufacturing revenue. While they offer incremental diversification away from the large agriculture-oriented business, they also allow the company to spread its R&D costs across more units. We think this has been an attractive cost-absorption opportunity, especially as the cadence of emissions regulations has accelerated over the past decade and peers have been forced to purchase equipment from third parties rather than develop their own technology.

Valuable Brand, Network Effect Dig Wide Moat We believe Deere has carved a wide economic moat based on a combination of intangible assets and a network effect. Over the past 5 and 10 years, these two moat sources have generated 21% and 25% average returns on invested capital, respectively--highly attractive relative to our 9.2% weighted average cost of capital estimate.

Most Americans are familiar with John Deere's green and yellow leaping deer logo, and multiple generations of North American farmers view the brand as a symbol of high quality and prestige. In

Forbes

' 2015 list of most valuable brands, it was ranked 70th among global brands.

Farm Equipment

's January 2014 issue, in which 18% of John Deere customers described themselves as less loyal than five years ago. This compares with Case and AGCO, where 20%-33% of customers described themselves as less loyal than five years ago. We only think 18% of Deere's customers are less loyal because recent emissions technology regulations over the past five years have driven equipment prices 15% higher and any prudent customer would explore other options. Excluding the price impact of emissions changes, Deere's brand intangible asset has created a pricing premium that John Deere receives upon initial sale and in the used equipment market.

The second source of Deere's moat comes from its network effect. Throughout North America, Deere has 1,539 agricultural equipment dealers. In contrast,

Financing Business Is Another Advantage We also think that Deere's captive financing entity is an intangible asset that supports a wide moat. Although it does not enjoy a bank's debt financing costs, its scale in agricultural equipment loans is unmatched by stand-alone banks. We believe this offers superior insights into analyzing borrowers and pricing loans relative to a borrower's creditworthiness. If Deere has to recover equipment, we think it has a superior position in organizing logistics to acquire defaulted equipment. Additionally, it has an advantage for selling equipment through its dealer network rather than through third-party auctions, which will reduce a stand-alone bank's loan recoveries to 90% of the equipment's value. The combination of these factors gives Deere a cost structure at least in line with stand-alone banks. While we think Deere can make money in this business, we also think it is a strategic advantage for Deere's manufacturing business.

The other interesting aspect of Deere's financing business is how it is tied into the dealer network. Deere's agricultural equipment is sold in small, agriculture-oriented towns, where its dealers are strong members of the local business community. To cement the dealer's role in the community, in North America, Deere deposits 1% of every customer's financing payment into a dealer forbearance account. If a customer is late on a loan or a loan has to be restructured, the local dealer is able to allocate funds from this account to make the loan payment or to reduce the loan's balance. In the current environment, where Deere is creating loss reserves that are less than 0.5% of loan balances, this feature of the business model is underappreciated. However, in more trying times in the farm economy, especially the early 1980s and the early 2000s, farmers' businesses and livelihoods were based on how confident the Deere dealer was in their business. If a Deere dealer correctly provided funds to pay a customer's loan payment or to reduce their loan balance, it would generate a customer for life who shares the positive experience with everyone in the community. If the dealer incorrectly assists a farmer, the dealer loses the ability to assist other customers as the forbearance account is fully depleted. Deere's competitors tend to have weak dealer networks that don't have the scale to know their customers and their communities well enough to provide this degree of service. Deere has recreated this element of the dealer model in Brazil, and we think that as it embarks on a 10-year plan to upgrade its European dealer network, it can build similar brand loyalty and a competitive advantage over its peers.

We don't think the construction and forestry business (16% of revenue) has moat sources as strong as Deere's agricultural business. The business' 10-year average 8.3% operating margin is 350 basis points lower than that of agricultural division. Over the past five years, the division's 4.2% operating margin was almost 1,000 basis points lower than that of the agricultural division. While the business is not tremendously strong, we are encouraged by the decision to partner with Hitachi on a global basis to share manufacturing and product development costs. We think this gives the company greater scales of economy. In India, which is known for being extremely protective of local manufacturers, Deere has smartly formed a joint venture with Ashok Leyland. Aside from simply understanding products that work for the local market, we think the partnership will dramatically narrow the cultural and business gaps that an American company like Deere would have faced had it not partnered with a well-established heavy equipment manufacturer like Ashok Leyland. In both the Hitachi and Ashok Leyland partnerships we believe Deere has gained manufacturing scale and an improved distribution network.

Farm Income a Significant Factor Most of Deere's risk and uncertainty is related to the agricultural equipment business. Anything that affects the underlying health of its customers would pose a risk to our outlook. Farm income is a significant factor in Deere's outlook. The last decade was characterized by a succession of new highs in farm income, but a breakdown in that trend would challenge Deere's sales and profitability. Much of the recent crop income boom was based on higher prices for corn to feed minimum biofuel content mandates in the United States, Europe, and Brazil. Virtually all of these mandates have been capped in recent years. To the extent that any of these mandates are reversed or eliminated, Deere's outlook will be at substantial risk. We are also monitoring the major tax deductibility and finance subsidization programs around the world. In both the U.S. and Europe, equipment buyers have benefited from aggressive tax depreciation programs that are approved in one- and two-year intervals. In Brazil, the government provides loan subsidies to farmers. Recent austerity measures in Brazil have spurred a downward bias in equipment demand in that market.

The construction business is correlated with the trends underpinning construction. Because Deere is more present in small construction equipment, it is more leveraged to residential construction than construction peers like Caterpillar,

Stewardship Is Exemplary CEO Sam Allen is a 41-year Deere veteran who was promoted to the lead role in 2009. His predecessor heavily emphasized metrics like total shareholder value added and operating return on assets. In a continuing emphasis on aligning management and employee incentives, the top 1,000 most senior employees receive stock options, with the top 125 required to hold a minimum multiple of their salary as Deere stock or options.

The company's metrics-driven approach has been successful, demonstrated by the past decade's 19% average return on invested capital. Deere's first priority is maintaining its A credit rating, which is valuable for keeping its financial services business competitive with noncaptive financing outlets and ensuring liquidity over the duration of the business cycle. After ensuring balance sheet health, the company takes on capital-deployment opportunities that exceed its 12% hurdle for return on operating assets. After meeting these two priorities, the company has a 25%-33% dividend payout ratio on midcycle earnings and deploys remaining cash flow via share repurchases. These repurchases have added value and reflect that management has been good at assessing Deere's intrinsic value. Over the past decade, Deere has distributed 58% of its cash flow from operations to shareholders through dividends or buybacks. Deere's ability to execute this capital deployment plan over the past decade supports our Exemplary stewardship rating.