A lot of industrial companies posted better than expected margins this quarter, but I believe Deere‘s (DE) strength will prove more durable, as the company is seeing some meaningful benefits from structural changes that have been years in the making. On top of that, Deere has drivers that go beyond traditional drivers like commodity prices, farmer balance sheets, and fleet age, with technology-driven precision ag offerings that deliver demonstrated benefits to farmers.
Up about 10% from the fiscal third quarter earnings release, and up almost 40% over the past year, well ahead of peers/rivals like AGCO (AGCO), Caterpillar (CAT), and CNH Industrial (CNHI), these positive drivers are not exactly a secret or meaningfully underappreciated by the Street. That makes valuation tough; the return potential is okay, and I like the momentum in the business and the prospect for more beat-and-raise quarters, but this isn’t a value pick.
Impressive Margins Drive A Big Quarterly Beat
In a quarter where many machinery companies did well, Deere took it to a new level, at least relative to sell-side expectations. Equipment revenue was far ahead of expectations, with Ag & Turf beating by 11% and Construction & Forestry beating by 43%, driving a total equipment revenue beat of 22%. Profits were also exceptionally strong relative to expectations, with A&T beating by 112% at the segment profit level (120% on an adjusted basis) and C&F beating by $182 million on a revenue base of $2.2 billion.
To be sure, it was still a challenging quarter, with Deere hurt by weaker demand across the business. Total revenue declined 11%, with net equipment revenue down 12% and down closer to 11% in organic terms. Ag & Turf revenue declined about 3% in organic terms despite a 4% price improvement, with weakness in large and small ag offset by growth in the small turf business. In Construction and Forestry, revenue declined about 26% in organic terms, with weakness across the board.
Equipment gross margin improved 230bp from the year-ago period, which was a rare performance in the machinery space even with some material tailwinds. Equipment operating income improved 16%, with margin improving 360bp, with Ag & Turf up 54% (margin up 630bp as reported) and Construction & Forestry down 46% (margin down 310bp).
Tech Is The Sizzle, But The Ag Cycle Can Still Offer Some Steak
Arguably the key driver for Deere now is the company’s precision agriculture business, a business that could generate $3 billion or more in revenue in a few years versus about $1.2 billion last year. Management reported that engaged acres have tripled over the last 18 months, and improved 11% from the prior quarter. ExactEmerge adoption has improved into the low-40%’s (from around 40% last year) and ExactApply has seen adoption grow from the high 30%’s a year ago to the high 40%’s.
So far, precision GPS (AutoTrac Guidance) has been one of the bigger offerings, with users seeing 20% more reductions in fertilizer costs. Precision planting (ExactEmerge) and precision spraying/chemical app (See & Spray, ExactApply) are likely to become bigger in the relatively near future.
Deere’s precision planting offering helps drive yield improvement (5% or better) and lower costs (5% to 15% savings), but also allows farmers to plant much more quickly (an average speed of closer to 10mph versus 5mph – 7mph); the ideal planting time for crops is typically a short window, and there has historically been a trade-off between speed and accuracy/quality of planting. Precision spraying is largely about reducing the use of chemicals – management expects the first version of See & Spray to come out next year primarily for burn-down, and it should allow for a 95% reduction in chemical usage in this application, as farmers will only need to spray actual weeds rather than essentially coating the field.
Although precision agriculture offers high-margin growth, it’s not the only positive driver in the ag business. The North American ag fleet is as old as it has been in over a decade, and the sale of new combines and tractors has fallen about 60% from its last peak. With used equipment inventories down significant and pricing starting to improve, I believe we will start seeing a fleet refresh cycle, particularly as there is now new technology available that can drive real savings for farmers over the life of the machinery.
Infrastructure Is Dicey
I’m not generally bullish on construction now, particularly given what I see as a weak outlook for non-resi construction over the next couple of years. Roadbuilding has generally remained healthy so far, though, and this is an area where Deere is more leveraged. I’m definitely concerned about state and local budgets in 2021 and the impact that will have on road construction, but Deere would definitely have leverage to a federal infrastructure stimulus program, were one to make it through Congress and be signed into law.
I expect healthy equipment revenue growth over the next three years, and this quarter certainly adds confidence to the idea of mid-teens operating margins, healthy cash flows, and strong ROICs. Longer term, I see Deere as a low-to-mid single-digit revenue growth story, with margin and FCF leverage driving high single-digit EBITDA growth and double-digit FCF growth.
The Bottom Line
Deere is not particularly cheap on cash flow or EV/EBITDA, but I wouldn’t expect it to be given the recent performance and the positive drivers in place (and the likelihood that this is the start of a positive cycle in ag). I do see a better than average likelihood of beat-and-raise quarters, though, and I’d be hesitant to jump out of a strong story just because the near-term valuation is a little rich. On the other hand, for investors who don’t own the shares, this is more of an upward revision/momentum story now, and that’s not every investor’s cup of tea, but if the market were to sell-off in a meaningful way, this would definitely be a name to look at again.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.