March 22, 2017

At current valuations, DE is priced to improve from cycle-lows to near cycle-highs, but fundamental headwinds and management sentiment signal otherwise


  • Markets expect DE to see Adjusted ROA expand from current cycle-low 9% levels to cycle-high levels of 15% over the next five years and sustain those levels, even though DE has historically been highly cyclical
  • Management appears concerned about margins, macroeconomic pressures, and their used equipment fleet, which will pressure their ability to improve margins or turns to meet expectations
  • DE also trades at a premium valuation relative to its peer group and relative to its historical valuations, relative to both Adjusted Assets (2.4x UAFRS-adjusted P/B) and Adjusted Earnings (22.5x UAFRS-adjusted P/E), further signaling that the best case scenario is already priced in, and that equity downside is likely
  • DE’s returns are materially distorted by how as-reported GAAP accounting treats R&D as an expense as opposed to an investment, not capturing the required investment to justify DE’s current earnings

 

Embedded Expectations Analysis

As investors, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends to give a clearer picture into what the market is projecting for the firm.

DE is currently trading at a 22.5x UAFRS-based P/E, which is historically high. At these levels, the market is pricing in expectations for Adjusted ROA to increase from 9% in 2016 to 15% in 2021, accompanied by no Adjusted Asset growth. These expectations imply that 2016 results were a cycle-trough, and profitability will begin expanding back towards cycle-high levels. However, several indicators, including historical profitability trends, valuation relative to peers, and management sentiment, signal that these expectations may be too positive.

de1

Performance and Valuation Prime™ Chart

Deere & Company (DE) manufactures and distributes equipment used in agriculture, turf care, construction, forestry, and financial services. Agriculture and Turf Care (Ag & Turf) equipment includes a full line of tractors, harvesters, and sprayers, and spans to lawn mowers and golf course equipment. Their Construction & Forestry segment focuses primarily on larger construction equipment, including dozers, loaders, dump trucks, log harvesters, and related attachments. Meanwhile, their financing division focuses solely on financing sales and leases of new and used Deere equipment.

Given their heavy industrial exposure and the firm’s exposure to the health of the overall economy, DE has historically seen cyclical profitability. Initially, the company saw Adjusted ROA improve from 6% levels in 2002 to a high of 19% in 2008, before compressing back to 10% in 2009, in the wake of the Great Recession. Subsequently, Adjusted ROA rebounded to a new high of 21% in 2013, but has since faded again to 9% levels. Meanwhile, Adjusted Asset growth has been volatile, with positive growth in 11 of the past 16 years, while ranging between -6% and 13%.

Given DE’s historical inability to sustain Adjusted ROA at the levels that the market is currently pricing, and considering the highly cyclical nature of the business, current expectations appear too optimistic.

For context, the PVP chart above reflects the real, economic performance and valuation measures of Deere & Company (DE) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.

The four panels above explain the company’s historical corporate performance and valuation levels, plus consensus estimates for forecast years, as well as what the market is currently pricing in terms of expectations for profitability and growth.

Peer Analysis – Valuations Relative to Profitability

A major benefit of adjusting as-reported financial statements is to clear away accounting distortions to allow for more accurate peer-to-peer comparisons. To this end, we have included a scatter chart below that plots DE against its peers based on their Adjusted Price-to-Assets ratio (V/A’) and Adjusted ROA (ROA’).

Looking across industries, markets, and time, there has been a very strong relationship between a company’s ROA’ relative to the corporate average (6%) ROA’, and the multiple the market will pay above the value of the company’s Asset’ base, in terms of a UAFRS-based P/B (V/A’) multiple. A company that generates a 6% ROA’ will tend to trade at a 1.0x Adjusted P/B, and a company that generates an 18% ROA’ will trade at a 3.0x Adjusted P/B, etc.

de2

Relative to its peers, DE appears fairly valued at best, with its 2.4x UAFRS-based P/B and 10% Adjusted ROA. In order to justify current valuations, DE would need to see ROA levels closer to 14%-15%, which would require either a greater than 1.4x expansion from current levels, or prospects of significant growth, which analysts are not currently projecting. As such, DE appears to be fairly valued at best relative to peers, or even overvalued at the moment, indicating that equity upside is likely limited.

Analyst and Management Expectations

Analysts have similar expectations to the market in terms of the Adjusted ROA trend, expecting Adjusted ROA to expand from trough 9% levels in 2016 to 12% through 2018. But analysts only believe the company can do this by aggressively shrinking the company’s asset base, by 10% in the next year, a far more aggressive contraction than the market is pricing in to get to similar ROA’. Analysts appear to be pricing in a shrink-to-improve mentality where the company gets rid of poorer performing businesses, while the market is overly optimistic that the company can reach and sustain near-peak ROA’ with much more limited shrinkage.

Valens’ qualitative analysis of the firm’s Q1 2017 earnings call highlights that management is excited about their Ag & Turf industry outlook. However, they appear concerned about inflation and unfavorable FX offsetting any cost reduction initiatives, and about continued margin pressures. Moreover, they appear concerned about the sustainability of recent EPS improvements, and may be concerned about the condition of their used equipment fleet. Finally, they may lack confidence in their assertion that all of their businesses will remain solidly profitable, and may be concerned about ongoing expenses related to their voluntary separation program.

Given management concerns surrounding margins, macroeconomic pressures, and their used equipment fleet, DE may not be able to hit the margin expansion and asset utilization improvement targets that the market is expecting, further justifying equity downside.

Performance Drivers – Sales, Margins and Turns

It can be helpful to break down Adjusted ROA into its DuPont formula parts, UAFRS Earnings Margin and UAFRS Asset Turnover, which are cleaned up margins and turns metrics used to calculate Adjusted ROA. The chart below details both Adjusted Earnings Margin and Adjusted Asset Turns historically, to help us better understand the drivers of the firm’s profitability and performance.

de3

As mentioned above, DE has historically been a highly cyclical business. Cyclicality in Adjusted ROA has been driven by cyclicality in both UAFRS-based Earnings Margins and Asset Turns. While Adjusted Earnings Margins improved from 4% in 2002 to 9% in 2007, they fell back to 6% in 2009. Subsequently, Margins improved to 11% in 2013, but have since fallen back to 6%. Meanwhile, Adjusted Asset Turns, which improved from 1.4x in 2001 to 2.3x in 2008, have since fallen to a new low of 1.3x.

For the company to get back to near-peak ROA’, they will need to see both Adjusted Asset Turns and Adjusted Earnings Margin improve materially. However, as mentioned above, management has concerns about inflationary pressures limiting the margin benefit of any cost reductions they achieve, meaning they’ll struggle to meet those margin expectations. Also, with management concerned about the utilization rates of their used equipment fleet, they also appear to have pressures limiting their ability to improve Adjusted Asset Turns.

Impact of Adjustments

This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historical economic profitability of a firm and allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.

de4

The chart above highlights via common-size financial statements the impact that UAFRS adjustments have on DE’s asset base and earnings. The largest adjustment to the firm’s Adjusted Net Asset base and Adjusted Earnings comes from UAFRS’ capitalization of research & development. DE has regular, material investments in R&D each year that as-reported financial statements treat as expenses. This violates one of the core principles of accounting, which is that expenses should be recognized in the period when the related revenue is incurred. R&D investment is an investment in the long-term cash flow generation of the company. Because as-reported metrics treat R&D investment as an expense, as opposed to an investment, net income is artificially decreased. Net income is then materially understated relative to UAFRS-based Earnings.

Another significant adjustment made to the firm’s assets and earnings is UAFRS capitalization of operating leases. DE’s operating lease expense is material. The decision management makes between investing in capex and investing in a lease is not a decision between an expense and an investment, but rather a decision in how management wants to finance their investments. If they would rather spend cash up front for the asset, they will spend capex. However, if they want to spread the cost of the asset over several years, they will instead choose to lease the asset. That said, as-reported accounting statements treat one as an investment, and the other as an expense that does not impact the balance sheet.

Valuation Matrix – ROA’ and Asset’ Growth as Drivers of Valuation

When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential prices for DE at various levels of profitability (in terms of Adjusted ROA) and growth (Adjusted Asset growth). Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.

de5

To justify current prices, DE would need to see Adjusted ROA expand to near cycle-high Adjusted ROA levels last seen in 2014, accompanied by no Adjusted Asset growth. Given the unlikelihood of the firm surpassing these expectations considering its historical performance, markets appear to be pricing in the best-case scenario, limiting near-term equity upside.

Moreover, when considering fundamental headwinds, management communication signals, and valuations on the higher end of historical levels, the firm may disappoint on expectations, potentially driving equity downside going forward.

 

To find out more about Deere & Company (DE) and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is regarded around the world for his expertise in forensic accounting and “forensic fundamental” analysis, particularly in corporate performance and valuation.