Deep Analysis on Deer & Co (DE)
Deere
& Co (NYSE: $DE)
is a company I came across twice in recent weeks – once as an investment made
by Berkshire Hathaway as reflected in their annual report and again in
this
article
. The author of the 2nd article points out some appealing
characteristics of Deere & Co and then asks some very good questions
regarding potentially “not so nice” characteristics about the company. These
questions require further analysis, which I aim to answer followed by my sense
of value.
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Readers Note:
Refer to leehillequity.com
to download the Excel file containing data referenced below as
well as the valuation model.
Deere
& Co
(NYSE:
DE
) is a company I came across twice
in recent weeks
– once
as an investment made
by
Berkshire Hathaway
as reflected in their annual report
and
again in
this article
. The author of the 2
nd
article points out some appealing characteristics of D
eere & Co
and then asks some very good questions
regarding potentially “not so nice” characteristics
about the company
. These questions require further
analysis, which I aim to answer followed by my sense of value. Of the questions posed from the linked
article, I’ll focus on what I co
nsider to be the most important; refer to the
article for a complete list of
the author’s questions
. Here is an
excerpt:
“...we can also see quickly a few
“not so nice” things at Deere:
– pension
/health liabilities (health –
how to value ? 6bn uncovered. Very critical,
healthcare sunk GM, not pension (EV multiples
need to be adjusted for this)
– lower sales but higher financing receivables ? Channel stuffing ?
– comprehensive income to net income
volatility
– cyclical business. current profit margins still above historical average
”
Pension & OPEB Plans
Regarding the first question, t
here are a couple of ways to sanity check pension and other post
-
employment benefit (OPEB) assumptions
. One way is
to
analyze these assumptions over time and
the
other
to compare with
peers.
As the author in the above linked article noted, pension net liabilities
total
ed
$0.8B while OPEB net liabilities totaled
$5.1B for a total underfunded amount of $5.9B
as of
10/31/
14
(DE’s fiscal year-
end is 10/31)
. Throughout this article all data and quotations are from DE’s
10-
K and 10
-Q reports unless otherwise noted. Based on the below pension and OPEB
charts there are
a
few items to note.
(Source: DE’s 10
-K reports)
1
(Sou
rce: DE’s 10
-K reports)
•
The discount rates use
d to calculate the present value of the pos
tretirement obligation balance
“were based on hypothetical AA yield curves represented by a series of annualized individual
discount rates. These discount rates
represent the rates at which the company’s benefit
obligations could effectively be settled at the October 31 measurement dates.” The higher the
yield curves (see
the black line’s data point in
’08), the higher the discount rate and the lower
the obligatio
n. The 2009 10
-K states “The increase in the pension and OPEB net liabilities in 2009
vs. 2008
was primarily due to the decrease in the discount rates for the liabilities.” As you can
see
, the
gross
obligation
(and
gross obligation / total assets)
pops in
’09
for both the pension
and OPEB liabilities by a combined $4.7
B as a result of a lower discount rate.
•
In addition to an increase in the obligation amount from ’08 to ’09,
DE’s accumulated other
comprehensive income (
OCI
) decreased by $2.7B, net of tax, largely as a result of the increased
retirement obligation balance.
With anything complex, I always try to simplify. As liabilities
increase, and
holding
assets
constant
, equity must decrease to maintain the accounting truth
that A = L + E.
Low interest rates
were and continue to be
a significant contributing factor to
increased net liabilit
ies and reduction in OCI which reduces
total shareholders’ equity.
•
Depending
on your view, the increase in liabilities and decrease to shareholders’ equity from a
lower
discount rate
will be limited in the future dependent upon
how low you think interest
rates can go.
If interest rates returned to ’08 levels of
8%,
about $4.8B of the $5.9B underfunded
post
-retirement obligation
(as of 10/31/14)
would be eliminated bas
ed
on my math,
simply from
discounting the obligation at a higher rate
. Stepping back to see the big picture, increased
interest rates would reduce the benefit obligation but
would
likely
hurt business overall since a
significant portion of
the large ticket i
tems DE sells are financed
. Low
rates improve affordability
for customers
increasing the volume of product sold
. The interest rate sensitivity impact to
retirement plan’s net liabilities
is located in the Critical Accounting Policies section of the 10
-K
(also shown below).
2
(Source: DE’s 10
-K reports)
•
If the actual return on plan assets is less than the expected return on
plan assets, the difference
would
be recorded in OCI and amortized through net income over time. For the pension plan,
the actual
return
on plan assets
exceeded the
long
-term expected return for 7 of 10 years
. For
the OPEB plan, the actual return exceeded the expected return for
6 of
10 years. Both plans’
actual return experienced significant losses in ’08 coincident with the financ
ial crisis. The data
and chart for the OPEB actual vs. expected ret
urn is in
cluded in
the model
. Although the long-
term expected rates of return seemed aggressive
at first glance
, the below chart illustrates the
company has been able to consistently achiev
e those returns with the exception of
a few years
including the outlier year
2008.
Although past performance on plan assets is no guarantee of
future performance, at least we know underperformance in the past has
not been a recurring
issue
with more years beating performance objectives than not
.
(Source: DE’s 10
-K reports)
3
•
The discount rate
and the expected long
-term rate of return on plan assets should be consistent,
and that appears to be the case ov
er the long run, save fluctuations in the discount r
ate
in ’08
due to the financial crisis
.
Another critical accounting assumption for the OPEB plan is the health care cost trend rate, or medical
expense inflation
shown in the chart below by year.
(Source: DE’s 10
-K reports)
As noted in the 10
-K, “The annual rates of increase in the per capita cost of covered health care benefits
(the health care cost trend rates) used to determine accumulated postretirement benefit obligations
were based on the trends for medical and prescrip
tion drug claims for pre
- and post
-65 age groups due
to the effects of Medicare.”
•
The starting point for health care costs is lower
(more aggressive)
in 2015 (pink line) than it was
in 2007 (blue line) while the decline in costs for future years to a steady state rate of cost
increase
s equal to 5% is more gradual
in ’15 (more conservative)
. When compared to a couple of
peers, CNHI and AGCO, the trends
were similar. CNHI’s ‘15
initial weighted average cost increase
was about 6.8% decreasing to 5% and AGCO’s
‘15
initial cost increase was about 7% decreasing
to 5%. The health care
inflationary assumptions for
AGCO’s Brazilian plan were
significantly
higher
in line with the country’s inflationary environment.
Additional pension and OPEB assumptions are in the chart below. More conservative accounting uses
lower discount rates, higher rates of compensation increases, and lower expected long
-term rates of
ret
urn.
•
AGCO and CNHI use more conservative discount rates,
•
DE and AGCO use relatively more conservative compensation increase assumptions, and
4
•
CNHI uses the most conservative expected return on plan assets.
(Source: DE’s 10
-K reports)
I don’t have to
o much concern regarding DE’s pension or OPEB liabilities.
They are viewed
essentially as
loans from em
ployees;
compensation earned in past and
current periods and paid out post
-retirement. I
believe the low interest rate environment caused much of the inc
rease to the
present value
post
-
retirement obligations and losses recognized in OCI. While these are very real impacts, it’s not unique to
DE and the gross obligations as a percentage of total assets have actually decreased over time. I’d value
the post
-retirement obligations as the 10/31/14
underfu
nded amount of $5.9B or about 15
% of total
debt
.
The EV multiple adjustment refers
to the
post
-retirement
obligations being supported by non
-operating
plan assets of $11.4B as of 10/31/14. Normally
a company’s debt will be repaid by cash flows from
operating assets with the residual cash flows paid out to equityholders. In this case, the plan assets are
“maintained in a separate account in the company’s pension plan trust” so these assets are protected
from
both
bondholders and equityholders.
The plan assets are simply meant to cover the defined
benefit obligations.
Sales & Financing Receivables
The author’s 2
nd
point addresses the concerns of lower sales and higher financing receivables.
The
company warns of l
ower sales in 2015 in the 2014 10
-K and provides quite a bit of detail about the
outlook.
•
Agriculture and turf equipment expected to decrease 20% in ’15 due to “weaker conditions in
the global farm economy. Lower commodity prices and falling farm incomes are putting
pressure on demand for agricultural machinery, especially for larger models.”
DE’s view of s
ales
for
the
agriculture and turf industry is
expected to perform worse relative to DE’s
company
-
specific forecast
.
Benefit plan assumptions related to the
obligations
2012
2013
2014
DE
Discount rates
3.8%
4.5%
4.0%
Rate of compensation increase
3.9%
3.8%
3.8%
Expected LT rates of return
8.0%
7.8%
7.5%
AGCO
Discount rates
4.3%
4.4%
3.5%
Rate of compensation increase
3.5%
3.8%
3.8%
Expected LT rates of return
7.0%
6.8%
7.0%
CNHI
Discount rates
n/a
4.1%
3.2%
Rate of compensation increase
3.4%
3.3%
Expected LT rates of return
6.8%
6.0%
5.9%
5
•
Weakness in the agriculture and turf
business segment is expected to be partially offset by
strength in the Construction &
Forestry segment. From the 10
-K, “sales of construction and
forestry equipment are forecast to increase by about 5 percent for 2015. The gain reflects
further economic recovery and higher housing starts in the U.S. as well as sales increases
outside the U.S. and Canada.” Global forestry is expected to be flat YOY.
(Source: DE’s 10
-K reports)
•
As you can see, the decline in net sales discussed in the 10
-K is reflected in 1Q15
(period ended
1/31/15)
and 2Q15
(period ended 4/30/15)
. Typically, based on
historical trends, net sales are
lowest in Q1, peaks in Q2 and remains strong in Q3 and Q4, albeit lower than Q2. This is the
normal seasonality baked into the business mod
el. For example, “
retail demand for turf and
utility equipment is normally higher in the s
econd and third fiscal quarters.”
The lower sales
in
’15
– at least in my view
– are not
a function of accounting irregularities so much as it
is management’s acknowledgement of a weaker business environment
, even after accounting for
seasonality weakness in
Q1
. The financing receivables, as you can see from the black line in the chart,
are b
eginning to decline in line with lower sales. If channel stuffing
were an issue, I would expect net
sales to increase instead of decrease.
Comprehensive Income / Net Income Volatility
Compre
hensive income does not impact net income or EPS but it does capture items that impact
shareholders’ equity. The first chart below is from my model and since only historical periods are
shown,
the numbers are directly from the 10
-K balance sheet with the a
ccumulated OCI balances reflected
. The
second
chart
from the 10
-K shows the components of accumulated OCI.
6
(Source: DE’s 10
-K reports)
(Source: DE’s 10
-K reports)
Since the retirement benefits adjustment has already been discussed, and since unre
alized gains/(losses)
on derivatives and investments are immaterial, the focus here will be on
the other OCI element,
cumulative translation adjustment. DE is headquartered in Moline, IL but does
business in well over 20
countries. About 35% of total reven
ues and more than 20% of EBIT is generated from business outside
the U.S. Stepping back again for a moment, what these percentages tell us about lower profitability in
international markets is consistent with the qualitative operating challenges described
by management.
Such challenges in foreign markets include reduced brand value, trade restrictions, and
challenging
access to raw materials.
2012
2013
2014
Assets
Stockholders' Equity
Common stock, $1 par value (authorized –
1,200,000,000 shares; issued – 536,431,204
shares in 2014 and 2013), at paid-in amount
$3,352.2
$3,524.2
$3,675.3
Common stock in treasury, 190,926,805 shares in
2014 and 162,628,440 shares in 2013, at cost
(8,813.8)
(10,210.9)
(12,834.2)
Retained earnings
16,875.2
19,645.6
22,004.4
Accumulated other comprehensive income (loss)
(4,571.5)
(2,693.1)
(3,783.0)
Total Deere & Company stockholders’ equity
$6,842.1
$10,265.8
$9,062.5
Noncontrolling interests
19.9
1.9
2.9
Total stockholders’ equity
6,862.0
10,267.7
9,065.4
Total Liabilities and Stockholders’ Equity
$56,265.8
$59,521.3
$61,336.3
7
Due to DE’s international operations
, converting foreign activity to
U.S. dollars (USD)
requires foreign
exchange (FX) translation
s that flow through OCI on the income statement and accumulated OCI on the
balance sheet (since the current method of translation is used
vs. the temporal method
). Without
getting into the nitty gritty of FX accou
nting, what’s important to know from an analytical point of view
is how a strengthening or weakening of the USD
will
impact
DE’s
equity. Under the current rate method
of translating local to parent financials, a stronger domestic currency (the USD in this case) will decrease
revenues, assets, liabilities, net income, and shareholders’ equity (a negative translation adjustment will
be made in OCI). W
hen valuing DE, as you will see in the model, I do not forecast OCI simply because I’m
not certain what discou
nt rates, return on plan assets, or FX will do. It’s important however to
understand how the variable
s move and to be able to understand
the impa
ct of real
-time movements in
market
variables
to a company’s value. A strong USD will hurt foreign
-based
revenu
es, net income, and
equity
when translated to USD
.
Valuation
(P/E ratios) for a Cyclical Business
The last question
has to do with the cyclicality of a business. The author of the blog was referring to
what Vitaliy Katsenelson
explains here
so well. Investors
are told low P/E ratios are indicative
of “value.”
Investors faced with a low P/E ratio have an opportunity to buy when the price is low, assumin
g “E” or
earnings is held constant. That latter assumption though can also get investors into trouble. The danger
is that P/E is low because E has peaked and the ratio will increase not due to future price increases but
due to an E that is on its way to a
trough in the business cycle. There is no price gain to that story, just
earnings lost
yet the P/E ratio expands...
only
for the wrong reason
. As Vitaliy says, “
stuff stocks are likely
to bottom when they’ll look expensive –
their “E’s” will be low or negativ
e.” So where is DE in the cycle?
As reflected in the chart with the last data point using modeled estimates with guidance provided by
management
and my adjustments
, it appears profit margin is
beginning a decline from the peak 2013
profit margin of
9.4%.
Over the past ten fiscal years, the average profit margin has been 7.6%. For 2014
it was 8.8%. In my valuation model I have forecasted a profit
margin of 7.6
%, a YOY decline in net
income
of
27
% and a YOY decline in EPS of
22
% (
EPS declines by less
than net income
as a result of DE’s
continued
share repurchase program
).
8
Here are a
cou
ple more points that are easier to make
with
a graphs
.
•
As you can see, the earnings (green line) are not flat. Thus, the P/E ratio is highly dependent
upon the E co
mponent of the ratio. This seems obvious but when it’s explained I generally
notice the focus is on the P variable. If earnings are heading towards a trough, the P/E ratio
(blue dotted line)
will indeed increase as it has done in the past (see ’09
as P/E i
ncreased but
price dropped significantly
).
•
The P/E ratio as of 7/13/15 is 13.4
, which seems low when compared to the S&P of about 21
.0x
.
What about for DE, is that a low multiple com
pared to its historical trends? When multiplying
DE’s
average ROE over the last 10 years by the book value per share (
BVPS
) as of the last FY
to
calculate normalized EPS
, the adjusted P/E is more like 12.0x. It appears the adjusted
P/E
indicates a somewhat
expensive stock price today vs. the historical trend.
Valuation
To this point I’ve focused more on translating
some of the
accounting components of DE to something
that can be understood from an economic or cash flow perspective
as well as the sales/receivables
relationship and relative valuation from a P/E perspective
. So what’s the PV of the future cash flows?
Based on my assumptions and calculations as reflected in my model, I think DE is worth about $90
-
$110/share. Here are s
ome
points of consideration that significantly impact valuation
.
•
Revenue growth:
I believe DE is in fo
r a rough ‘
15 with revenue declines of about 16% based on
insight from
management’s guidance as well as 1Q15 and 2Q15 numbers. I agree with
management th
at longer term,
the company is “well positioned to earn
solid returns throughout
the business cycle and realize substantial
benefits from the world’s growing need for food,
shelter and
infrastructure.” As I researched this company, I remembered reading “A Farmland
Investment Primer” by GMO in July of last year t
hat is worth a look, specifically page 7 of the
9
report that discusses forecasted global demand
for food
. Long
-term rev
enue growth post
-2015
is about 5
% per year, compared with the past 10 years CAGR
of about 6% annually. The assumed
terminal growth rate is 3.0%
.
•
Cost assumptions:
COS
and o
pex is largely in line with historical trends although R&D is
projected to be about 0.5% higher in future years based on the increased focus on engine
emissions impr
ovements.
•
The
B/S and CF/S accrual ratios
have been relatively constant over time with the exception of
seasonally
-driven peaks (2Q ) and troughs (4Q) so there were few
significant assumptions that
drive sources/(uses) of cash other than profit from conti
nued investment in the business.
The
increase in ’15 forecasted CFO is due to sources of AR and inventory exceeded uses of AP due to
lower overall sales. This source in ’15 will become uses of cash
in ’16 forward as the company is
forecasted to return grow
th mode.
•
The
share repurchase program
communicated was assumed with share buybacks continuing
through 2016.
•
A somewhat sneaky component of value is the
operating lease residual values
and CFI received
from the sale of equipment upon termination of the lease. I modeled $600mm of CFI for my
projections, conservative compared to the last three years but consistent when using a 5
-10
year time horizon.
•
I’d like the
price to drop below $90/s
hare before purchasing shares for my personal portfolio.
The near
-term risks from demand weakness in ’15, an uncertain business environment in
Europe
, and
El
Nino
present enough reasons for me to wait and see what happens. In other
words, I believe the market will overreact to the short
-term risks even thou
gh I think fair value is
somewhere between $90
-$110.
Some may say all this work was a giant waste of time if not
actionable but 1) that presupposes I have interesting hobbies and 2) I now know my entry point
if/when the
price dips below my lower bound so I don’t view my research as a waste of time.
•
Finally, I mentioned
Berkshire Hathaway purchased shares
of DE. For what it’s worth, I calculate
Berkshires average purchase price to be about $88.50. Copy catting the best has its perks
(valuation c
alibration) and its downsides (price inflation from crowd
-herding). Time to exercise
patience.
10
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