As ever with cyclical stocks like Deere & Company (DE -0.14%), it's essential to understand their earnings' and valuations' up-and-down nature. Unfortunately, many investors have been caught out by thinking valuations look cheap because earnings are soaring, only to watch in disappointment as earnings collapse and the valuation suddenly looks expensive. So with that warning in mind, is Deere still a good value, or is the company's strong run in recent years (up 134% in three years) about to come to an end?
What you need to know before buying Deere stock
The agricultural, construction, and road building machinery stock is defined as a cyclical stock because sales of its key product (agricultural machinery) are tied to trends in farmers' income, which in turn relies on crop prices. It's a relationship that generally holds up -- in case you are wondering, the jump in revenue in 2018 is partly down to the acquisition of road building equipment company Wirtgen at the end of 2017. Wirtgen had $3.4 billion in revenue in 2017.
Data by YCharts
Armed with this knowledge, it's safe to say that if you think crop prices are heading sharply lower, Deere is a stock to avoid. On the other hand, if you think they will move higher and are positive on infrastructure and road building investment, then Deere is in the early innings of a long cycle of growth in its earnings.
What it means for Deere's valuation
Investors can see how these points play out in the valuations given to the company by the market. As you can see below, the increase in crop prices in 2020 resulted in a significant increase in earnings before interest, taxes, depreciation, and amortization (EBITDA) and free cash flow (FCF). Given the strength in Deere's order book and its success in rolling out its precision agriculture technology (embedded in its hardware), Wall Street analysts believe Deere will report strong results in 2022 and also in 2023.
It's a view backed up by Deere's manager of investor communications, Rachel Bach, on the recent earnings call when talking about its agriculture and turf end markets. "Our order books for the remainder of the current fiscal year are full, and we see signs of robust demand into 2023 with some order books already full through the first half of next year," she said.
For reference, FCF is dipping in 2022 because management is investing more in working capital to ensure strong production growth to meet demand. A combination of supply chain issues easing in 2023 should see strong growth in EBITDA and robust growth in FCF. Due to significant supply chain issues in the first half of its fiscal year, Deere is facing an unusual year in which it's ramping production to unseasonably high levels in its fiscal fourth quarter to catch up and complete its already partially built equipment.
Data source: marketscreener.com, 2022-2024 are Wall Street analyst consensus, millions of U.S. Dollars.
All of which plays out in the valuations of the company. The above-mentioned EBITDA and FCF figures translate into the following enterprise value (market cap plus net debt), or EV, to EBITDA multiples and price to FCF multiples. As the chart demonstrates, buying Deere on a high multiple was a good trade: As crop prices rose, so did Deere's earnings. Thus, buying Deere on a favorable multiple in 2023 could be an even better deal.
Data source: author's analysis based on Wall Street consensus.
Is Deere stock a buy?
On balance, Deere looks like a good value. While it's tough to predict where crop prices and global farmers' income are heading, it would be a mistake to automatically assume they are about to fall off a cliff. Moreover, the company's progress in winning market share amid high take-up rates for its precision agriculture technology means it can continue to outperform its end markets. In addition, Deere's attractiveness as a stock with growth drivers unaligned to the global economy makes it even more desirable in the current environment.
