AGB 2024.1 - Deere & Co. (DE)

Precision Ag to Combat Cyclical End Markets

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Deere

“Our goal is to develop technologies that are targeted at the greatest problems that our customers have with the end or the outcome being by using John Deere technology, you as the customer will be more profitable because it will minimize your inputs, you're going to be more productive because of the case of autonomy, when we might take somebody out of the cab or other technologies. And you're going to do the jobs you do in a more environmentally sustainable way. That's really good for our business. It's good for our business long-term, regardless of where we are in any given cycle. Customers are going to buy these technologies to improve their profitability.” - Chief Executive Officer, John May on the Q4 2022 earnings call

Deere is the leading producer of agriculture related machinery (60% market share of tractors in North America). Founded in 1837, the company has a long history of providing tractors, combines, pickers and harvesters to farmers around the world. Throughout the years, Deere has spent billions of dollars on R&D and acquisitions so that their end customers can lower their input costs while increasing crop productivity. Many of the recent technology enhancements involve autonomy, connectivity, automation and guidance, which the company has categorized as Precision Agriculture. As of 2022, Deere’s customers had over 500k connected machines and 340M+ engaged acres (ones that connected machines have done work).

The company’s business units are segmented into Production and Precision Agriculture or PPA (45% of revenues and 54% of operating income), Small Agriculture and Turf or SAT (23% of revs and 19% of op inc), Construction and Forestry or CF (25% of revs and 21% of op inc) and Financial Services (8% of revs and 6% of op inc). The PPA segment includes large and mid-sized tractors, combines, harvesters and other tillage equipment. The SAT segment includes compact tractors, foraging equipment, mowers and other lawn equipment. The CF segment includes loaders, dozers, excavators, trucks and road building equipment. The FS segment provides financing solutions for customers to purchase equipment, leases, extended warranties, etc.

Replacement cycles of agriculture equipment are relatively long due to their limited annual operating hours. For example, a combine is used to harvest grains, which are mainly done in the summer and fall seasons. It’s estimated that tractors and combines maintain 70% of their original value in 5 years, which is higher than 30% for trucks and 50% for construction equipment. Because of the longer replacement cycles, the used equipment market and specifically those inventory levels tend to have a large impact on new equipment demand.

For Deere to be able to continually sell new equipment, there needs to be meaningful improvements and additional features to make the ROI worth it for farmers, especially during periods of favorable pricing in the used market. Since the early 2000s, the company has focused on Precision Ag advancements so that the total cost of ownership for new equipment (and thus ROI) is better for customers. This is especially important as cost of labor, fertilizer and other chemicals are increasing. Here is Deere’s CEO explaining the net benefit of Precision Ag at the company’s 2022 Analyst Day.

“The days of abundant resources in farming inputs is over. Labor, fertilizer and crop protection inputs, just to name a few, are all growing in scarcity, and they're increasing in cost. Weather patterns are becoming more volatile. Governments are increasing regulations, and customers are increasingly interested in more sustainably grown food, fiber and fuel. And populations are growing, demanding greater food security, all while embracing a shared imperative to a lower carbon world. All of these factors driving increased volatility in our customer's financial outcomes. Older approaches to increase agricultural output are no longer viable. In the past, we would rely on planting more acres, increasing horsepower and applying more nutrients. In short, we could always do more with more. However, today in agriculture, we must do more with less. And our ambition at John Deere is to help our customers do exactly that.” - Chief Executive Officer, John May, at the 2022 Analyst Day

Given the cyclical nature of its end markets (for both agriculture and construction machinery), a positive view on Deere heavily depends on the success of its Precision Ag pursuits. The company invests most of its capital into R&D specifically for this purpose.

The current 5 most promising Precision Ag features are ExactApply, ExactRate, Combine Advisor, ExactEmerge and See & Spray. Adoption rates for these features have been increasing over the past 5+ years. ExactApply adoption rates have increased from mid-40%s to mid-70%s, ExactRate from mid-teens% to low 20%s, Combine Advisor from low 60%s to now coming standard, ExactEmerge from 20%s to 60%s, and See & Spray just starting in the low teens%.

• ExactApply (introduced in 2017) is a precision spraying technology that allows farmers to accurately control each spray nozzle and adjust for flow, droplet size and pressure. Goldman estimates that there is a 3%-7% reduction in chemical and fertilizer costs. This would imply a $10k in annual costs savings on a 2k acre farm. ExactApply costs ~$50k , which implies an ROI of 20% for the farmer.

• ExactRate (introduced in 2021) allows the farmer to apply fertilizer during the planting phase. This alleviates the farmer from making a separate pass to apply fertilizer, which is sometimes done months apart from planting. This also makes the application of fertilizer more efficient, reducing nitrogen usage by 5%-10%. Deere estimates that nitrogen and fertilizer represents 35% of the variable cost structure of a farm.

• Combine Advisor (introduced in 2016) optimizes harvesting operations of grains. Combine Advisor can be adjusted manually depending on how the farmer determines the grain quality using cameras on the combine. Once the grain quality targets are met, the farmer can then rely on Combine Advisor to make necessary adjustments to maintain quality levels even as external conditions change. Deere estimates that Combine Advisor reduces losses and improves yield by 1%.

• ExactEmerge (introduced in 2014) allows farmers to plant seeds to much higher accuracy (exact spacing between seeds, depth in the soil and fewer duplicative seeds) while being able to drive across the field at 40% greater speeds. Deere estimates that yields improve by 5%-10% and require 5%+ fewer seeds. The faster speeds also allow for reductions in labor, fuel and other costs. Goldman estimates that one ExactEmerge planter would generate $67k additional revenue and reduce seed costs by $11k, while the planter costs $150k. This implies an ROI of 52%.

• See & Spray (introduced in 2023) allows farmers to target weeds when applying herbicides to a quarter inch accuracy. Cameras on the unit capture images of each plant and the unit only sprays herbicide if the image matches against the database of weeds. The technology has shown to reduce herbicide use by 90% for cotton and 30% for corn and soybeans. See & Spray is priced as a subscription with varying prices depending on the crop.

The company has sold these new features based on customer value and measurable returns on invested capital. When adoption rates reach close to 80% for a certain feature, it’s Deere’s plan to move that feature to the base model of the new machinery. This comes with a price increase in addition to the annual price increases of 2%-3%. The latest feature to go standard is Combine Advisor.

Certain Precision Ag features can be retrofitted to existing Deere equipment as well. ExactEmerge, ExactRate and ExactApply can be added to existing equipment for a price. This goes hand in hand with the company’s effort to capture more share of the aftermarket parts market. As of 2020, Deere commanded just 15%-20% of the aftermarkets parts market. The company stated that the 2^nd or 3^rd owner of equipment typically goes with other suppliers for aftermarket parts, so the company is working to fix that. With Precision Ag retrofit capabilities, Deere is hoping that the company will be able to increase share among these ownership cohorts. As we’ve seen with TransDigm, aftermarkets parts typically command higher margins and have decent returns (though the end market structures are different).

What’s also interesting about Precision Ag is that pricing terms are moving more towards subscription vs. the traditional equipment sale model. This started with the Gen 4 Universal Display and software suite that was introduced in 2015. This came with an annual renewable license vs. a one time upfront payment. As of 2021, this feature had a 80% renewal rate (not as high as enterprise subscription software).

Deere’s See & Spray is also priced in a subscription model because the software’s accuracy varies depending on the type of crop and the database of weeds continues to grow, which presumably will make the feature more accurate over time. The company currently generates less than 1% of its revenue from subscriptions. The company has put out soft guidance targets of 10% contribution from subscription services by 2030. Future releases in Precision Ag related to automation will also be priced in subscription model.

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Why is it a good business?

As the largest producer of agriculture machinery and equipment, Deere benefits from intangible assets and switching costs. Intangible asset benefits come in the form of brand recognition, with most customers making repeat purchases of Deere products over their work lifetime. Brand loyalty also means that newer features that are introduced like Precision Ag may benefit from higher and steeper adoption curves. Higher adoption rates of certain features lead to these features becoming standard on new machinery, like recently with Combine Advisor.

The brand also helps Deere establish one of the largest dealer networks. The company has over 2k dealer locations in North America and another 1.7k internationally. Many of these dealers are large networks of locations that exclusively sell Deere products. Dealers also do a lot of the machine servicing, retrofits and repairs. Having an extensive network of dealers allows for less down-time for customers during servicing and repairs. Dealers are compensated on units sold and bonuses are awarded based on volume and incentive programs.

Precision Ag features can be retrofitted to older equipment (planters back to 2005 and sprayers back to 2014) and many of these services are completed at the dealer locations. The company has stated that it may one day allow some features to be retrofitted onto machinery from other companies, but that may be much further into the future and the features they allow to be retrofitted may not be at the leading edge.

Deere also benefits from their customers’ increasing switching costs. Once a customer has Deere equipment on their farm, it’s likely that the next set of equipment will also come from Deere. And with the largest installed based of agriculture machinery, the company can more easily sell new Precision Ag features. Specifically with the newer features, the company’s increasing database of imaging data for See & Spray is an example where the customer will see higher switching costs over time.

Deere’s size also allows the company to use its balance sheet to help customers find financing for their equipment purchases. Through its subsidiary, John Deer Capital Corp, Deere can help customers purchase equipment on installment plans or leases. This segment also provides wholesale financing to dealers to finance their inventories. While customers can find financing from a third party, having the financing arm does stabilize the availability of capital, especially during weaker credit markets. In certain international markets like India, having the financial services segment is critical to sales operations.

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Returns on incremental capital?

Over the past 10 years, Deere has spent 29% of its capital on capex, 51% on R&D and 20% on acquisitions. Capex is related to production of machinery and equipment for all three operating segments. The company has heavily invested in digitally connecting its factories to improve efficiency. The company also re-manufactures many used engines and other components that are resold to customers and dealers for maintenance and repair purposes.

R&D is Deere’s largest capital expense ranging between 3.5%-4.5% of revenues over the past 10 years. The majority of that spend is related to innovation and advancements in Precision Ag. The company typically develops technologies specific to a single product first and then leverages that advancement into other new products.

Deere’s newer products have increasingly more compute power directly on the machine. Because connectivity is sometimes scarce in rural environments, the compute power of the hardware needs to be good enough to process some of the data intense applications. For example, most of the image processing is done on the machine itself vs. in the cloud for Combine Advisor and See & Spray. Specifically for See & Spray, there is a custom NVIDIA GPU embedded on the machine that can process over 3B pixels of imaging data to determine what is a weed vs. a crop.  

For M&A, most of Deere’s acquisitions have been technology related. They typically are dilutive to returns because the multiples are implied to be high (usually not disclosed) but they are necessary when advancing the company’s initiatives in Precision Ag. And because the company is spending so much on its own product development through its own R&D efforts many of these acquisitions are complementary to existing technology.

Here are some notable technology acquisitions by Deere:

• NavCom (acquired in 1999) allowed the company to implement satellite guidance for their machinery. From that acquisition, Deere was able to develop applications like AutoTrac, Section Control and AutoPath.

• Blue River Technology (acquired in 2017) allowed the company to apply computer vision to its machinery. In 2021, Deere released See & Spray based on this technology.

• Bear Flag (acquired in 2021) allowed the company to advance in autonomous tractor operations. The acquisition helped with adding autonomous features on Deere’s 8R tractors released in 2022.

The other notable deal over the past decade is Wirtgen in 2017. This was not a technology acquisition to advance Precision Ag, but rather a scaled operation that increased Deere’s footprint and market share in its Construction and Forestry segment. Deere acquired Wirtgen for $5.2B, which implies an EV/EBITDA multiple of 9.5x, or 10.5% return on capital. Deere identified synergies of 100M Euros over 5 years, which would imply a lower EV/EBITDA multiple of 7.9x. Wirtgen was known for its road building business, which complemented Deere’s existing earth moving business. This acquisition put Deere as the number 3 player in construction market after Caterpillar and Komatsu.

We estimate that Deere has generated returns on incremental capital between 15%-35% over the past 5 years in the company’s operating segments. Due to the cyclical nature of the company’s business, the range of outcomes is wider than other companies we have studied. We would also like to point out that this calculation is without the impact of the financial services segment (the company nicely separates the operating segments from the financial services segment), which has its own set of returns that tend to exhibit more volatility.

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Reinvestment potential?

Deere estimates that its incremental addressable market opportunity is over $150B by 2030. This is different from the traditional definition of TAM because included in the estimate is customer value capture, which includes cost advantages from the use of Deere’s Precision Ag technology. Deere looked at every job that a customer does and calculated the total increase in yield or a decrease in cost. Then they applied that to the number of connected acres of its customers to arrive at its incremental TAM estimate. The example the company gives is with See & Spray. Customers that use this technology will typically see a reduction in the amount of herbicide required to grow crops.

To execute to this target, Deere is targeting 500M engaged acres by 2026. Remember that Deere is at 340M as of 2022. In the SAT segment, the company aims to have all new equipment connected and introduce a fully autonomous tractor to market by 2026. By then, Deere’s goal is to have 1.5M connected machines, up from 500k in 2022. Within the CF segment, the company aims to have precision road-building solutions and electric and hybrid products available for customers.

Subscription revenues are expected to reach 10% of product revenues, which we can conservatively estimate is >$6B by 2030. A lot of that will depend on the company’s new product innovations and the adoption of existing subscription offerings like See & Spray. Near full adoption, See & Spray alone has the potential to contribute $2.5B in annual subscription revenues but this may be unreachable by 2030. Instead, Deere will likely have to rely on future innovation like automation to reach its subscription revenue target.

The John Deer Operations Center also can contribute to subscription revenues. Customers subscribe to the service to monitor and analyze their operations. Customers can keep tabs on the health, usage and efficiency of their equipment to adjust their operations if they need to. They can also analyze their operations to the crop level and take recommendations based on data that’s been collected across the customers’ engaged acres. There are also third party software developers (over 250 as of 2022) on the platform that can provide customized solutions for customers.

For the CF segment, Deere is the #3 player in the construction equipment market with 5.5% share behind Caterpillar (16.5%) and Komatsu (11%). With the Wirtgen acquisition, the company has a strong position in road construction equipment. Similar to Vulcan Materials, this segment should benefit from the $1.2T IIJA infrastructure bill signed in 2021. The Federal Highway Program is the largest part of that bill.

With a reinvestment rate between 35%-60% and a return on incremental capital between 15%-35%, we estimate that Deere has increased its intrinsic value between 9%-12% over the past 5 years. The reinvestment rates are relatively consistent since the company’s largest capital expense is R&D. However, with the Wirtgen acquisition in 2017, the reinvestment rate was elevated for a few years while returns were somewhat muted.

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What else is important?

Concerns about the 2024 Outlook

Deere’s outlook for 2024 isn’t very rosy with overall demand expected to decline in 2024. The PPA and SAT segments are expected to decline -10%-15% and -5%-10% in North America, respectively. Europe and the rest of the world range between -5% and -10% expected declines. The CF segment is expected to be down -5%-10% for construction equipment, -10% for forestry and flat for road building.

Some of that has to do with the hangover from the past 3 years related to increased demand and higher than normal price increases. Price increases in the PPA segment have been +8%, +13% and +14% over the past 3 years. And volume increases in that segment have been +7%, +9% and +3% over the same time period. Deere expects to moderate its price increases in 2024 to +1%+1.5%. They also expect that dealer inventory may rise a bit with some restocking this year if market demand is as expected.

Future prospects for the company depends on whether 2023 was a cyclical peak or if 2024 is just a small step back in across a longer cycle. Deere expects that 2024 will be closer to midcycle, implying that with the revenue decline, margins will also contract. The company expects that its earnings will be 2.5x the size of the last time they were at midcycle levels in 2019 implying operating margins close to 17.5% in 2024.

So Where are We in the cycle?

When owning a company that participates in highly cyclical end markets, it’s necessary to take a view on where we are in the cycle. The last cyclical bottom was in 2015/2016 and there was a short lived decline in 2020 due to Covid.

Deere believed that they were at 90% of midcycle for PPA and just over midcycle for SAT at the end of 2020. And then 110%-115% of mid-cycle in 2021 and at 120% for 2022. For 2024, the company estimates that end market demand will be close to midcycle. Deere considers a cycle peak to be 120%-140% of midcycle. By many measures (although pricing was much higher than normal due to inflation) 2023 could have been a peak cycle year.

Knowing where you are compared to the midcycle is important because it also has a strong impact on the margin profile of the company. At the company’s 2020 Analyst Day, it was estimated that 15% operating margins would be achievable at midcycle (up from the previous target of 12.5%). Deere was able to achieve 17.3% operating margins the very next year when the company was just over midcycle at 110%-115%. In 2021, the company was expecting to achieve 15.5%-16.5% margins based on 30%-35% incremental margins. At the company’s 2022 analyst day, Deere announced that midcycle margins could improve from 15% to 20%, due to the increasing contribution from subscription revenues and aftermarkets business.

Optionality

M&A is likely the highest chance for upside optionality. We know that the company has to meet its subscription revenue target with either internally developed new products or acquire an outside technologies. Deere has the balance sheet to make these acquisitions, especially since its leverage ratios are low. Excluding the financial services segment, the company had a net debt/EBITDA of 0.2x in 2023.

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