It's been a great year for investors in Deere (DE -1.18%). At the time of writing, the stock is up 55% year to date, and there's reason to believe that there could be more to come in 2021. Let's take a look at the investment case for the stock in order to see whether it's a good value or not.
Two key reasons why Deere stock will do well
There are two key factors to focus on:
- Deere's early embrace of smart farming technologies has made it a leader in precision agriculture, and this will drive sales growth in the future.
- Deere is a highly cyclical stock that is coming into the mid-cycle of an upswing, and sales can grow significantly from here.
It may seem strange to highlight farming as a highly technological activity, but the reality is that digital technologies are set to revolutionize how farmers go about their business, and Deere is at the forefront.
To understand why, you have to go back to the basics of arable farming and some of the key questions involved: What seeds to plant this year? When to plant? How much water and fertilizer to use? How to care for the crop? When to harvest?
Unfortunately, the consequences of all these decisions are not known until after the final harvest, and then the farmer starts preparing for the following growing season. In the past, farmers relied on experience built up over the years. While that experiential knowledge is extremely valuable, it can be enhanced by the addition of real-time data points that help farmers make the correct decisions. In other words, smart farming.
On an earnings call earlier in the year, Cory Reed, a Deere executive in the agricultural and turf division, said:
We contemplate every single job and decision required to prepare the soil, to plant the seed, to protect and nurture the crop and to harvest it" and "preparing the soil has implications for how to plant seeds and promote uniform emergence, which impacts how we care for that crop throughout the growing season.
Deere's unique position
From using satellites to guide tractors to investing in machine learning and Blue River's computer-vision software, plus the recent acquisition of farm profitability software company Harvest Profit, Deere has consistently led the field in adapting smart technology to farming.
An integrated set of smart technologies combined with Deere's leading agricultural equipment will drive sales for years to come, the company's management predicts. Speaking on the recent earnings call, Chief Technology Officer Jahmy Hindman promised management would discuss some of the new product releases in due course.
Mid-cycle or peak?
Deere's sales tend to be highly cyclical. In common with most other cyclical businesses, Deere's valuation tends to be high at the trough as investors anticipate big earnings increases, and low at the peak when investors anticipate an earnings decrease.
The debate over whether Deere will be in the mid-cycle phase of an upswing in 2021 versus hitting a peak is not an academic one. Consider that the Wall Street analyst consensus for earnings before interest, tax, depreciation, and amortization (EBITDA) is $6.4 billion. This means the stock trades on a 2021 enterprise value (market cap plus net debt) to EBITDA multiple of 19.1 times. That's a very high multiple for Deere at its sales peak. See the valuations at the start of 2009, 2014, and 2019 in the chart below when Deere's sales peaked previously.
Deere's management is arguing that the company will be at 90% of the mid-cycle in 2021, while some analysts think it could actually be at the peak. The argument against Deere is that U.S. net cash farm income of $134 billion is actually the highest figure since $136.1 billion in 2013.
However, nearly all the increase in net cash farm income in 2020 over 2019 comes down to a $24 billion increase in Federal Government payments. Instead, let's focus on what the farmers are actually seeing from crop income. The chart below shows U.S. gross cash farm income, you can see that crop income (what really matters to Deere) hasn't increased dramatically in recent years.
The data in the chart (specifically gross cash income from crops) shows that crop income hasn't increased significantly in recent years. Consequently, it suggests that a multi-year recovery in spending on farming equipment is possible from here. In other words, the fear that Deere will hit a sales peak in 2021 is unlikely to come true.
Deere in 2021?
All told, a combination of Deere's precision agriculture solutions and its position in the cycle mean the company is well placed to do well in 2021. As ever, much will depend on the price directions of key crops like corn, wheat, cotton, and soybean. However, assuming they stay stable, Deere has plenty of opportunity to grow sales and earnings, and next year should be another bumper year for the company as it continues in recovery mode.