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Stock Strategist

Weak Farm Equipment Outlook No Shock

Our wide moat rating for Deere is unchanged after the Farm Progress Show.

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We recently attended the Farm Progress Show in Decatur, Illinois, the largest farm equipment show in North America. After meeting with  AGCO (AGCO),  Deere (DE), and  CNH Industrial (CNHI), we think overall sentiment is on par with recent company reports of oversupply in the farm equipment market. In North America, new and used equipment inventories remain high, and an anticipated sales decline of 25%-30% in 2015 is likely to weigh on 2016 sales unless there is a weather abnormality that improves farm economics. South American industry conditions remain under severe pressure because of fiscal austerity policies in Brazil. Europe appears to be the sole bright spot, although most operators are highlighting the fact that from a cyclical perspective, low sales volume over the past five years should spur an equipment cycle refresh during the next two years. Europe's trends are in stark contrast to North and South America, where sales were relatively strong through 2013. With most of its business tied to the North American agricultural outlook, Deere's revenue trends will be under the most pressure in coming months, although we expect share repurchases to limit declines in earnings per share. We are maintaining our $89 fair value estimate and wide moat rating for Deere.

The major manufacturers highlighted three major trends this year. First, everyone appears to be making substantial telematics investments, albeit no one could quantify the expected economic benefit. Second, with the global market remaining fairly depressed, there was less emphasis on expensive high-horsepower equipment and more emphasis on value-oriented and flexible-use products at the 2015 show. Third, reducing dealer and manufacturer inventory levels remains a key priority. During our meetings, all manufacturers reminded investors that their current production levels are below retail sales volume as they attempt to liquidate excess inventory and improve free cash flow.

Telematics remains a key area of investment for the major tractor makers. In a recent earnings call, we were surprised when Deere revealed that its telematics research and development spending is equivalent to what it is spending on large-tractor R&D. This is noteworthy, as Deere's large tractors are traditionally its highest-margin products. Additionally, market share leaders like Deere and Case appear to be pursuing strategies that are more proprietary in an attempt to keep incumbent product buyers in their product ecosystems. AGCO, the global number-three player, is more heavily emphasizing an open solution in an attempt to latch on to more brand-agnostic buyers. It is also emphasizing grain storage and processing technologies as it is the only global tractor maker that is also highly active in those markets. Longer term, we believe equipment buyers will embrace telematics and the Big Data approach to creating crop production efficiencies.

Near term, cost-conscious buyers were able to see many value-oriented products at this year's show. Most operators highlighted that they have launched certified used equipment programs in the past 12-18 months to help reduce excess used inventory at dealers. The show spotlighted middle-of-the-line equipment or multiuse equipment, acknowledging that in an environment of largely depressed farm economics, farmers are less focused on buying top-of-line and highly specialized equipment unless it offers a compelling value trade-off. All of the manufacturers made it clear that their dealers had a product for price-sensitive buyers.

New equipment manufacturing levels remain below forecast end-market demand. The three largest tractor manufacturers continued to emphasize that they've reduced production volume below end-market demand to improve their 2015 free cash flow outlook as well as to reduce overall dealer inventory levels. In another bid to improve dealer inventory levels, CNH Industrial mentioned that traditional dealer incentives that were 15% dedicated to used products have now grown to 50% of incentives in the current marketplace.

Diversifying Geographically and by Business
Founded in 1837 as a blacksmith's shop, Deere has a brand name synonymous with agricultural equipment. It generates 80% of sales from agricultural equipment and greater than 50% of sales from the North American farm equipment market. The brand is built on industry-leading agricultural R&D spending and an unmatched North American agricultural dealer network. Outside North America, Deere's brand is weaker, although it is aggressively deploying resources into markets such as Brazil, where it has grown to 20% of the new tractor sales from 8% over the past decade. Growth has come from a combination of an improved dealer network and Deere's push to expand its product portfolio to be more suitable to the Brazilian market. While the company clearly benefited from the U.S. and Europe biofuel mandates and robust farm capital expenditures, we believe it has smartly diversified its business into new geographies including Brazil, Russia, India, and China. In these newer markets, Deere has capitalized on a consumer base that demands higher caloric intake and needs the local agricultural economy to produce more output.

While the Deere story is closely affiliated with agricultural equipment, its brand and assets are also active in consumer, construction, and forestry applications. These markets make up 16% of Deere's manufacturing revenue. While they offer incremental diversification away from the large agriculture-oriented business, they have also allowed the company to spread its R&D costs across more units. We think this has been an attractive cost-absorption opportunity, especially as the cadence of emissions regulations has accelerated over the past decade and peers have been forced to purchase equipment from third parties rather than develop their own technology.

Powerful Brand and Dealer Network Provide Wide Moat
We believe John Deere has carved a wide economic moat. Deere's moat is based on a combination of intangible assets and a network effect. Over the past 5 and 10 years, these two moat sources have generated 21% and 25% average returns on invested capital, respectively, which is highly attractive relative to our 9.2% weighted average cost of capital estimate.

While most Americans are familiar with John Deere's green and yellow leaping deer logo, multiple generations of North American farmers view the brand as a symbol of high quality and prestige. The Forbes 2015 Most Valuable Brands list ranked Deere 70th among global brands. Caterpillar (57th) was the only heavy equipment manufacturer to outrank it. An even more interesting reflection of the brand strength comes from Farm Equipment's January 2014 issue, in which 18% of John Deere customers described themselves as less loyal than five years ago. This compares with Case and AGCO, where 20%-33% customers described themselves as less loyal than five years ago. We think 18% of Deere's customers are less loyal only because recent emissions technology regulations have driven equipment prices 15% higher and any prudent customer would explore other options. Excluding the price impact of emissions changes, the company's brand intangible asset has created a pricing premium that John Deere receives upon initial sale and in the used equipment market.

The second source of Deere's moat is its network effect. Throughout North America, Deere has 1,539 agricultural equipment dealers. In contrast, AGCO has 1,300 that are selling a combination of one or more of its Challenger, AGCO, Massey-Ferguson, or Valtra tractors. From a practical standpoint, any one brand is only represented by 600 distributors at most. CNH Industrial has an undisclosed number of North American dealers, but we believe its dealer network quality is weak. The strength of the dealer network is important for three reasons: new equipment sales, continuing product service, and used equipment resale. Deere's strong brand means that customers have the confidence to run the equipment longer than comparable products. Customers prefer buying equipment that they are confident can be serviced within a short time frame. When a customer buys Deere equipment but relies on a Deere competitor's service facilities, there is a higher risk of equipment downtime. Additionally, when a non-Deere repair shop services the equipment, the customer's experience is no longer under Deere's control. Being the North American market share leader means Deere has more dealer outlets and Deere customers have a better service experience. When a user is done with equipment, there is an ample secondary market of used equipment buyers. Smaller competitors CNH Industrial and AGCO have some benefits from a network effect, but by operating smaller dealer networks and having less market share, they are unable to capitalize on this moat source and unable to create a premium-priced product.

We also think Deere's captive financing entity is an intangible asset that supports its moat. Although it does not enjoy a bank's debt financing costs, its scale in agricultural equipment loans is unmatched by stand-alone banks. We believe this offers superior insights into analyzing borrowers and pricing loans relative to a borrower's creditworthiness. If Deere has to recover equipment, we think it has a superior position in organizing logistics to acquire defaulted equipment. Additionally, it has an advantage for selling equipment through its dealer network rather than through third-party auctions, which will reduce a stand-alone bank's loan recoveries to 90% of the equipment's value. The combination of these factors gives Deere a cost structure at least in line with stand-alone banks. While we think the company can make money in this business, we also think it is a strategic advantage for Deere's manufacturing business.

The other interesting aspect of Deere's financing business is how it is tied into the dealer network. Deere's agricultural equipment is sold in small, agriculture-oriented towns, where its dealers are strong members of the local business community. To cement the dealer's role in the community, in North America, Deere deposits 1% of every customer's financing payment into a dealer forbearance account. If a customer is late on a loan or a loan has to be restructured, the local dealer is able to allocate funds from this account to make the loan payment or to reduce the loan's balance. In the current environment, where Deere is creating loss reserves that are less than 0.5% of loan balances, this feature of the business model is underappreciated. However in more trying times in the farm economy, especially the early 1980s and the early 2000s, farmers' businesses and livelihoods were based on how confident the Deere dealer was in their business. If a Deere dealer correctly provided funds to pay a customer's loan payment or to reduce their loan balance, it would generate a customer for life who shares the positive experience with everyone in the community. If the dealer incorrectly assists a farmer, the dealer loses the ability to assist other customers as the forbearance account is fully depleted. Deere's competitors tend to have weak dealer networks that don't have the scale to know their customers and their communities well enough to provide this degree of service. Deere has recreated this element of the dealer model in Brazil, and we think that as it embarks on a 10-year plan to upgrade its European dealer network, it can build similar brand loyalty and a competitive advantage over its peers.

We don't think the construction and forestry business (16% of revenue) has moat sources as strong as Deere's agricultural business. The business' 10-year average 8.3% operating margin is 350 basis points lower than agricultural division. Over the past five years, the division's 4.2% operating margin was almost 1,000 basis points lower than the agricultural division. While the business is not tremendously strong, we are encouraged by the decision to partner with Hitachi on a global basis to share manufacturing and product development costs. We think this gives the company greater scales of economy. In India, which is known for being extremely protectionist, Deere has smartly formed a joint venture with Ashok Leyland. Aside from simply understanding products that work for the local market, we think the partnership will dramatically narrow the cultural and business gaps that an American company like Deere would have faced had it not partnered with a well-established heavy equipment manufacturer like Ashok Leyland. In both the Hitachi and Ashok Leyland partnerships, we believe Deere has gained manufacturing scale and an improved distribution network.

Farm Income an Important Indicator
Most of Deere's risk and uncertainty is related to the agricultural equipment business. Anything that affects the underlying health of its customers would pose a risk to our outlook. Farm income is a significant factor in Deere's outlook. The past decade has been characterized by a succession of new highs in farm income, but a breakdown in that trend would challenge Deere's sales and profitability. In 2013, Deere's customers saw their first decline, with crop income falling 3.3%. For 2015, the U.S. Department of Agriculture projects farm income will be 40% below its 2013 peak. To the extent our opinion, which is based on the USDA's outlook, is wrong, there is greater risk to Deere's outlook. Much of the recent crop income boom was based on higher prices for corn to feed minimum biofuel content mandates in the U.S., Europe, and Brazil. Virtually all of these mandates have been capped in recent years. To the extent that any of these mandates are reversed or eliminated, Deere's outlook will be at substantial risk. We are also monitoring the major tax deductibility and finance subsidization programs around the world. In both the United States and Europe, equipment buyers have benefited from aggressive tax depreciation programs that are approved in one- and two-year intervals. In Brazil, the government provides loan subsidies to farmers. Recent austerity measures in Brazil have spurred a downward bias in equipment demand in that market.

The construction business is correlated with the trends underpinning construction. Because Deere is more present in small construction equipment it is more leveraged to residential construction than construction peers like Caterpillar, Terex, or Manitowoc. Any structural shift in residential developers' ability to develop new residential lots or consumers' ability to find attractive home financing places our outlook at risk.

Exemplary Stewardship
The company's metrics-driven approach has been successful, demonstrated by the past decade's 19% average return on invested capital. Deere's first priority is maintaining its A credit rating, which is valuable to keeping its financial services business competitive with noncaptive financing outlets and ensuring liquidity over the duration of the business cycle. After ensuring balance sheet health, the company takes on capital deployment opportunities that exceed its 12% return on operating assets hurdle. After meeting these two priorities, the company pays a 25%-33% dividend payout ratio of midcycle earnings and deploys remaining cash flow via share repurchases. These repurchases have added value and reflect that Deere management has been good at assessing Deere's intrinsic value. Over the past decade, Deere has distributed 58% of its cash flow from operations to shareholders through dividends or buybacks. Deere's ability to execute this capital deployment plan over the past decade supports our exemplary stewardship rating.

Kwame Webb does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.