Unfazed By Market Turbulence: Is Deere’s Sideways Action A Golden Opportunity? (NYSE:DE)

Investment Thesis

Background

Deere & Company (NYSE:DE) has built one of the most recognizable brands in the world, leading to strong customer loyalty. The company also boasts one of the most diverse and advanced portfolios of products in the agriculture and construction industries.

Despite being one of the largest players in the industry and consistently providing customers with high-quality, reliable products at fair prices, Deere’s stock has remained largely flat over the past three years. Since March 2021, the stock has only risen by 7%, while the S&P 500 has gained 25%.

Of course, this stagnant period comes after the stock’s remarkable run-up of over 100% between March 2020 and March 2021. However, after lagging the market for the past few years, Deere’s current valuation and resilience (not fully dropping back to pre-pandemic levels) make it appear quite appealing.

Long-term, DE has a proven track record of shareholder value creation through their internal metric SVA, demonstrating their strong positioning for future growth. While the stock price may not have reflected this yet, I believe it’s only a matter of time.

Investment Thesis

At just 13.8x 2024 P/E, Deere’s stock looks exceptionally appealing, especially considering its five-year average P/E of over 17x and the sector median above 18x. This undervaluation, coupled with record cash flow generation ($11.9 billion in 2023), presents a compelling opportunity for investors.

Deere’s substantial cash generation enables them to outspend competitors in R&D while still returning adequate capital to shareholders. Their disciplined capital allocation process allows for investments in future products and innovation, while also ensuring shareholder rewards.

Management’s disciplined approach to capital allocation excites me for several reasons:

1. We can expect them to invest in and develop leading-edge agricultural and construction equipment, fully integrating technology and AI to their maximum potential.
2. The balance sheet will remain robustly managed, avoiding excessive leverage. They will continue to target an appropriate dividend payout ratio, balancing dividend growth with capital for internal investments.
3. Share repurchases will likely continue to boost EPS and shareholder value. Shares outstanding have decreased by 32.7% over the past decade, demonstrating commitment to shareholder returns.

Long-term, I expect Deere to continue producing the best machinery for farmers and land developers. Their machines have consistently increased in profitability and benefit to users.

I view Deere’s recent price stagnation as a valuable opportunity for further investment. The upcoming $1.2 trillion infrastructure bill in the U.S. promises positive tailwinds for the company over the next few years, as renewed focus on infrastructure improvement aligns perfectly with Deere’s strengths. Beyond this specific catalyst, they boast vast addressable markets across diverse industries and sub-categories, offering significant long-term growth potential. Moreover, their commitment to continuous self-investment ensures they remain at the forefront of innovation and development, consistently delivering best-in-class products year after year.

Deere & Company’s global brand recognition and reputation for quality make it a compelling long-term investment. Ranked among the world’s most valuable brands, Deere plays a crucial role in fueling civilization’s development through its contributions to infrastructure and agriculture. Though short-term fluctuations are inevitable, I believe DE is a solid contender for investors seeking both income and capital growth.

Fundamentals

While a significant portion of Deere’s revenue stems from agricultural products and the U.S. market, their commitment to diversifying their revenue and product portfolio is a major draw for me. They’re actively growing their smaller business segments, adding stability and resilience to their overall performance.

The stock and farming industry are indeed cyclical, and Deere’s machines have long lifespans. However, despite analyst expecting a near 14% decline in sales for 2024 due to waning demand, it’s important to highlight their impressive track record. Deere has achieved a 5-year CAGR of 10.4%, showcasing their ability to grow even in challenging environments.

In my opinion, Deere’s combination of industry dominance, customer loyalty, and diversified portfolio provides a strong foundation for navigating cyclical downturns. This diversity can mitigate the impact of any single market or product segment experiencing a slow period, offering greater stability and long-term potential regardless of consumer location or the current stage of the cycle.

Even if sales were to plateau for a year or two, Deere’s management has demonstrated an impressive ability to generate cash and enhance profitability. They’ve consistently expanded margins over the past few years, exceeding the company’s 5-year averages. This margin improvement translates to increased cash flow, positioning Deere for significant growth when demand and the cycle inevitably turn upward. In essence, the current plateau could set the stage for even greater profitability once the market rebounds.

Deere’s strong cash flow provides robust support for its dividend, making it one of the most attractive dividend growth stocks in the market. While their dividend track record spans 34 consecutive years, COVID temporarily slowed growth. However, the past five years have seen impressive momentum, with a 14% annualized dividend increase alongside a conservative payout ratio below 15%. I expect this measured approach to dividend growth to continue, offering reliable income in addition to the potential for significant capital appreciation over the long term.

The low payout ratio for the dividend provides Deere’s management with flexibility to allocate capital elsewhere. They’ve demonstrated this skill by efficiently managing R&D expenses, keeping them below 4% of revenue. This prudent approach still allows them to invest billions in technological advancements and operational upgrades, strengthening their competitive edge. This strategic investment will likely bolster their industry moat against smaller players and startups aiming to enter the market.

We previously discussed Deere’s active share buyback program, and I expect them to continue reducing the share count at a measured pace. This judicious approach allows them to allocate cash flow effectively, fostering growth across various facets of the company.

One key area I’ll be monitoring is Deere’s debt level. While their current 6.9x interest coverage ratio indicates a comfortable ability to service existing debt, it’s worth keeping an eye on future trends. The debt taken on fuels growth and new projects, which I believe Deere’s strong business model and cash flow can handle. However, I’d like to see their debt plateau over the next few years, with potential for gradual reduction over time. While the current leverage isn’t excessive, it’s crucial to ensure long-term financial stability while utilizing debt strategically for growth.

Deere & Company is well-positioned for long-term success. Their diverse product portfolio provides revenue stability, their disciplined capital allocation balances reinvestment with shareholder returns, and they consistently strive to produce the best machinery in the industry. Their robust cash flow generation, reflected in a strong Free Cash Flow (FCF) yield of nearly 4%, is likely to remain respected by the market. Given these factors, I recommend holding or acquiring DE shares, particularly before they potentially exceed $400 per share.

Price Targets

In my analysis, I see 10.5% potential upside to my base case fair value of $428 per share. This calculation considers analyst estimates and the stock’s historical valuation range to produce a 12-month price target scenario with bull, base, and bear case outlooks.

At its current price of $388, Deere offers a highly attractive 3.2x risk-to-reward ratio, indicating a potentially favorable buying opportunity. This translates to potential gains of 30% compared to the bullish scenario while limiting downside risk to just 10% from current levels. In fact, should the stock dip to $350, representing a 10% decline, I would consider it a compelling buying opportunity.

This analysis focuses on the next year or so. Deere’s execution and earnings performance will drive the stock price: strong results could push it towards the higher end of the target range, while significant sales and earnings declines could lead to a downward movement. However, regardless of the short-term fluctuations, I firmly believe Deere & Company is a brand worth owning for the long term.

My bullish long-term perspective on DE is further reflected in my dividend discount growth model, which generates a price target for the next 3-5 years. Continued steady cash flow generation, dividend increases driven by profitability growth, and a gradually rising payout ratio all have the potential to propel the stock further upward as shareholder value and capital return increase.

Deere & Company has cultivated a robust brand and product portfolio poised for long-term sustainability. My conviction in the company’s prospects extends beyond the near term, and I encourage investors to consider acquiring shares before the potential next upward surge. DE enjoys a near-duopoly position alongside Caterpillar (CAT) in its industry, a characteristic I find highly attractive for investment purposes.

Risk

The primary risk for Deere & Company lies in its exposure to the fluctuating commodity environment, particularly its dependence on major crops like soybeans, corn, and grains. Recent weather changes and reduced rainfall have impacted crop yields, leading to a global supply decline. This, coupled with strong demand from China, has driven up crop prices, including corn and soybeans. Higher commodity prices often translate to increased input costs for raw materials and production for Deere, potentially squeezing profit margins.

On the construction side, a global economic slowdown poses a significant risk. DE’s exposure extends beyond the U.S., impacting its performance worldwide. However, the anticipated $1.2 trillion infrastructure bill in the U.S. and expected continued spending from emerging markets offer reason for optimism regarding this segment’s continued steady growth.

Climate change presents another notable risk, affecting farmers and crop seasons. Shorter and less predictable growing periods could further challenge the agricultural industry. Additionally, factors like a potential decline in the number of farmers or a shift towards less weather-dependent technology could impact DE’s long-term prospects. However, given their strong brand, financial resources, and potential role in driving technological advancements, DE is well-positioned to adapt and lead the charge in these changing landscapes. Notably, Builders FirstSource (BLDR), a recent S&P 500 entrant, stands out as another company positioned to benefit from evolving trends in the construction sector.

Conclusion

Deere & Company stands out as a compelling long-term investment for those seeking stability and growth. Their industry dominance stems from a relentless focus on product innovation and customer satisfaction. This success is fueled by management’s ability to actively listen to their customers’ needs and adapt their offerings beyond mere products and services.

The company’s expanding product line generates robust cash flow, allowing management to strategically reinvest in new technologies and products while simultaneously returning capital to shareholders. DE boasts a safe and steadily growing dividend, with ample room for further increases thanks to its low 14.7% payout ratio.

Despite its industry leadership, DE’s stock has been relatively stagnant for the past three years. However, at a current price-to-earnings (P/E) ratio of 13.8, I believe it represents a fantastic entry point. While my base case fair value suggests a 10% upside potential, I see even greater long-term growth possibilities.

This is the type of stock you can confidently hold in your retirement portfolio without a second thought. If you prioritize peace of mind and long-term value, I strongly encourage considering DE for your portfolio.