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 2nd or 3rd 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.