We're Bullish on Deere

John Deere pioneered the use of the steel plow when he fashioned one out of a saw blade in 1837. Farmers quickly saw the benefits of this invention and adopted the technology, subsequently ushering in the era of mechanized farming in the early 1900s. Now in the 21st century, wide-moat

In a global agricultural equipment marketplace, John Deere stands out as one of the world’s most valuable brands. Unlike its ag equipment competitors, Deere focuses its marketing efforts on a single brand. Most of Deere’s growth has been organic, but in 2017 the company made a key acquisition of road building equipment vendor Wirtgen, which improves its position in global infrastructure and urbanization trends.

As a modern industrial powerhouse, Deere provides a complete suite of agriculture equipment including tractors, planting equipment, sprayers, harvesters, and a host of other implements. It also manufactures construction equipment, which accounts for 30% of company revenue. Its most complex pieces of equipment such as combines are effectively factories on wheels that can cost more than $500,000. These machines must be created with durability in mind. Hence, the quality associated with the John Deere brand is critical to the company’s success.

In the developed world, margins from farming are quite low, which allows Deere to sell farmers on efficiency gains through continuous product innovation in what has become an agricultural arms race. The growth of precision farming has led to a dramatic increase in on-board software, processing, and sensor technology, which are being developed by Deere’s Intelligent Solutions Group.

One of Deere’s great strengths is the robustness of its dealer network, which includes approximately 1,500 dealers in the United States and 3,700 globally. Deere’s strong dealer network provides a one-stop shop for parts, service, equipment, and financing. Approximately 55% of Deere’s revenue originates from sales to customers in the U.S. and Canada, with the remainder distributed across every continent except Antarctica.

Brand Strength and Dealer Network Dig Wide Moat Over the past 10 years, Deere has generated an average return on invested capital of 24%, significantly greater than its cost of capital of 8.5%. Deere's wide moat rests heavily on its intangible assets, which includes the strength of its brand and extensive global dealer network. Interbrand has ranked John Deere as the 92nd most valuable brand, worth $4.7 billion. The strength of the brand leads to consistently high resale values of Deere equipment and what appears to be a slight price premium. Further strength of the brand is evidenced by the sale of Deere consumer lawncare equipment through mainstream retail outlets. Other informative data points came from a survey conducted by Farm Equipment magazine in 2017. First, 75% of farmers who responded described themselves as brand loyal. More important for Deere is that 77% of Deere customers, who were 60% of the respondents, described themselves as brand loyal.

To a lesser extent, highly specific intellectual property enhances the moat. This comes in two forms: (1) Deere’s ability to manufacture the highest-quality agricultural equipment and (2) its ability to innovate. As farming in the developed world is highly competitive, a veritable arms race has emerged. With razor-thin margins, farmers are constantly seeking ways to cut costs and increase yields. Hence, quality must be engineered into the products from the design stage. Innovation is also essential as higher yields can have a dramatic effect on profitability. Deere’s efforts to continuously advance precision farming is key. We anticipate greater automation and even autonomous equipment will reduce labor costs. The need to innovate partially explains why Deere was granted 328 patents in 2017, ranking it 111th among organizations awarded patents by the U.S. Patent and Trademark Office.

One of Deere’s great strengths is the coverage of its dealer network, especially in North America, as farmers tend to develop long-term relationships with their local dealers. These relationships grow stronger over time, which increases switching costs. Deere has approximately 1,500 dealers in the U.S. and 3,700 worldwide. Because machine reliability is so important, having a highly robust support structure is critical. This criticality is enhanced by the finite periods in the season that farmers can plant and harvest crops, which can be as short as two weeks. The support structure enables rapid access to parts and service that minimizes downtime. With millions of pieces of equipment in service, this provides a nice stream of parts revenue, which accounts for approximately 21% of equipment sales.

As technology solutions become a larger element of farming and a bigger fraction of equipment cost, switching costs are further enhanced. Farmers gain familiarity with the Deere technology platform and ultimately rely more on integrated solutions that combine real-time equipment use and offline planning. The same issues exist with construction and forestry equipment. These too have become technologically advanced, with customers adopting Deere’s WorkSight and ForestSight solutions to optimize equipment usage and minimize equipment downtime.

Cyclical End Markets and Government Policy Are Risks Deere caters to two cyclical industries: agriculture and construction. Farmers tend to purchase equipment when earnings are highest, so Deere's short-term fortunes are tied to farm income. The Food and Agriculture Organization of the United Nations forecasts aggregate global food consumption to increase for several decades. In North America, the U.S. Department of Agriculture forecasts production to be relatively flat for the next decade, growing slightly with population. Adverse climatic conditions, crop failures, and other exogenous factors can affect aggregate farm output and farm income.

Government can directly affect many dimensions of Deere’s business. Legislation can affect how Deere’s equipment is engineered and manufactured. Environmental regulations have evolved in recent years and become increasingly more stringent. Vagaries in any legislation related to equipment design can drive up costs but also encourage customers to delay purchases.

Government can also indirectly affect the demand for Deere’s equipment and how it is used. Government spending on farm subsidies and biofuel mandates affect farm income, while investment in infrastructure development can impact the demand for construction equipment. New-home construction can be affected by available financing and hence interest rates. Global trade trends and tariff disputes can affect the input costs and demand for export crops.

The financial services segment is doubly exposed as an economic downturn could lead to both fewer units of equipment being financed and increased defaults on contractual obligations, including leases and loans. Additionally, the success of the financial services segment depends on access to capital, which can be limited during times of financial distress. Interest-rate risk is a potential problem as rates can affect the desire to use financing and hence overall demand for equipment.

Financially Solid With Exemplary Management Deere maintains a strong cash and liquidity position. On its consolidated balance sheet, it has approximately $4 billion in cash and $42 billion in debt. Of this debt, $36 billion is held by its captive finance arm, which is a critical component of Deere's financial strength and overall strategy. As of the fiscal third quarter, it had nearly $31 billion in receivables and another $5 billion of equipment on operating leases. Historically, it has provided financing for Deere equipment but now has expanded into short-term credit for crop supplies such as seeds, chemicals, and fertilizer. The finance arm has not had a single annual loss in the past 30 years. It generates significant profit for Deere directly, $477 million in net income in 2017, while providing a convenient financing vehicle for farmers to acquire Deere's equipment. We expect Deere's financial position to strengthen over the next five years as it produces significant cash flow.

Deere historically has had strong governance policies in place. Management has strong incentives to align capital allocation with shareholder value. Significant components of executive compensation rest on shareholder value added and total shareholder return, which focuses on a three-year period of profitable growth and equity appreciation. Executives are expected to hold a multiple of their salaries in company stock. This alignment with shareholder value has served investors well, as returns on invested capital have averaged nearly 24% over the past decade, and we give management an Exemplary stewardship rating.