Deere & Company: A Bit Expensive, But You've Got Options

Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The sluggish state of the macro-economy has weighed on the bottom line of Deere (NYSE: DE) recently. However, it would be foolish not to expect more vibrant growth some day.  At that time agriculture is expected to outperform due to population growth, which will necessitate spending on agriculture.  Selling cash-secured puts can be an excellent way to reconcile a short-term bearish (or neutral) position with a longer-term bullish position.  Through this strategy you can either own a stock at a reasonable price or collect a premium for the unexecuted contract. 

First some background:  Deere is known by its brand name John Deere.  It is an American corporation based in Moline, Illinois, and is the leading manufacturer of agricultural machinery in the world.  Deere sells tractors, combine harvesters, cotton harvesters, balers, planters/seeders and sprayers.  The company slogan, “Nothing Runs Like a Deere” and its highly recognizable green paint are ubiquitous symbols of modern agriculture.  There is no denying that Deere has established one of the strongest brand names within its peer group.

Valuation

At $85/share Deere is not overpriced, however, there is also not a large margin of safety.  While Deere trades around 11x TTM earnings, the price of cyclical companies have generally been depressed due to economic concerns.  For example, several partners in the machinery industry such as Caterpiller (NYSE: CAT) and Joy (NYSE: JOY) trade for 9.2x and 8.6x forward earnings respectively. While paying a higher price for Deere is warrented based on the strong brand name and the expected outperformance of agriculture relative to mining, caution is still warrented as this premium could quickly fade if higher growth fails to materialize.

However, Deere is a very attractive investment in a number of ways.  The company has generated returns on equity in excess of 40% due in large part due to the comparative advantage of the brand. One method to value the stock is discounted cash flow: assuming 6.4% growth for the next 5 years and 3% terminal growth with a weighted average cost of capital (WACC) of 9.8% predicts a fair value of $93/share.  

While this may seem cheap, a value investor will only purchase a stock if it appears to be undervalued by a minimum of 25%, thus green lighting a buy around $70/share. Revenue growth approximated 6% for the prior ten-year period, which supports our expected fair value.

Adjusted book value

Calculation of an adjusted book value for Deere is another useful exercise to value the company.  When a company can be purchased for near or below its reproduction cost it represents a significant barrier to entry for a competitor company.  Most venture capitalists enjoy being paid, thus why would they build a new company if the market is not granting them a premium for doing so? 

The adjusted book value of Deere is calculated in the table below. I made two changes to the simplest method of tabulating book value through taking assets and subtracting liabilities.  The first stems from Deere’s financial services division.  On Deere's balance sheet liabilities from the financial services division represent a line item liability with no counterbalancing asset.  Because debt from the financial services division is offset by the underlying loan value, I erased this liability from the balance sheet. Second, Deere spends a significant sum on research and development.  A competitor company would need to match this spending to produce a comparable product.  Therefore, I depreciated R&D spending by 10% per annum and added this amount to the adjusted book value.

At $85/share, a purchaser of Deere is paying $1.26 for a company that would cost one dollar to build from the ground up (Table 1).  Thus a deep value investor should again be satisfied to purchase Deere for $70/share.  The maximum discount at which Deere could be purchased relative to adjusted book value occurred in the first quarter of 2009, during the depths of the financial crisis.  Then, Deere’s adjusted book value stood at $21.3B even as the stock traded down to represent a market cap of $14.6B.  So beware, a comparable bear market at some future date could send Deere to $50/share or approximately 30% below the cost-basis I am targeting, but every year you wait the company is worth more.

Table 1: Adjusted Book Value of Deere and Company

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>2012</strong></p> </td> <td> <p><strong>2011</strong></p> </td> <td> <p><strong>2010</strong></p> </td> <td> <p><strong>2009</strong></p> </td> <td> <p><strong>2008</strong></p> </td> <td> <p><strong>2007</strong></p> </td> <td> <p><strong>2006</strong></p> </td> <td> <p><strong>2005</strong></p> </td> <td> <p><strong>2004</strong></p> </td> <td> <p><strong>2003</strong></p> </td> </tr> <tr> <td> <p><strong>Total Shareholder</strong></p> <p><strong>Equity ($M)</strong></p> </td> <td> <p>6800</p> </td> <td> <p>6290</p> </td> <td> <p>4819</p> </td> <td> <p>6533</p> </td> <td> <p>7156</p> </td> <td> <p>7491</p> </td> <td> <p>6852</p> </td> <td> <p>6393</p> </td> <td> <p>4002</p> </td> <td> <p>3163</p> </td> </tr> <tr> <td> <p><strong> </strong></p> <p><strong>Financial</strong></p> <p><strong>Services  ($M)</strong></p> </td> <td> <p>13793</p> </td> <td> <p>13486</p> </td> <td> <p>14319</p> </td> <td> <p>11907</p> </td> <td> <p>9825</p> </td> <td> <p>9615</p> </td> <td> <p>9316</p> </td> <td> <p>8362</p> </td> <td> <p>7677</p> </td> <td> <p>5961</p> </td> </tr> <tr> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> </tr> <tr> <td> <p><strong>R&D Spending  ($M)</strong></p> </td> <td> <p>1226</p> </td> <td> <p>1052</p> </td> <td> <p>977</p> </td> <td> <p>943</p> </td> <td> <p>817</p> </td> <td> <p>726</p> </td> <td> <p>677</p> </td> <td> <p>612</p> </td> <td> <p>577</p> </td> <td> <p>528</p> </td> </tr> <tr> <td> <p><strong> </strong></p> <p><strong>Depreciation</strong></p> <p><strong>Adjustment  ($M)</strong></p> </td> <td> <p>1226</p> </td> <td> <p>956</p> </td> <td> <p>807</p> </td> <td> <p>708</p> </td> <td> <p>558</p> </td> <td> <p>451</p> </td> <td> <p>382</p> </td> <td> <p>314</p> </td> <td> <p>269</p> </td> <td> <p>224</p> </td> </tr> <tr> <td> <p><strong> </strong></p> <p><strong>R&D Value  ($M)</strong></p> </td> <td> <p>5896</p> </td> <td> <p>4670</p> </td> <td> <p>3714</p> </td> <td> <p>2907</p> </td> <td> <p>2198</p> </td> <td> <p>1640</p> </td> <td> <p>1189</p> </td> <td> <p>807</p> </td> <td> <p>493</p> </td> <td> <p>224</p> </td> </tr> <tr> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> </tr> <tr> <td> <p><strong>Adjusted Book</strong></p> <p><strong>Value  ($M)</strong></p> </td> <td> <p>26489</p> </td> <td> <p>24446</p> </td> <td> <p>22852</p> </td> <td> <p>21347</p> </td> <td> <p>19179</p> </td> <td> <p>18746</p> </td> <td> <p>17357</p> </td> <td> <p>15562</p> </td> <td> <p>12172</p> </td> <td> <p>9348</p> </td> </tr> <tr> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> </tr> <tr> <td> <p><strong>Current Market</strong></p> <p><strong>Capitalization  ($M)</strong></p> </td> <td> <p>33588</p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> </tr> <tr> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> </tr> <tr> <td> <p><strong>Ratio</strong></p> </td> <td> <p><strong>0.78</strong></p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> <td> <p> </p> </td> </tr> </tbody> </table>

The case for Deere – why continued growth is very likely

Over the next twenty to thirty years, Deere should experience a number of macro-economic tailwinds. By 2050 the world population is expected to expand from 7B today to approximately 9B.  Much of this growth will occur in emerging markets where Deere has a large exposure (currently 39% revenues outside the United States). 

Another important trend is the large influx of population density out of rural areas and into more densely packed urban centers.  In 2010, for the first time, more than half of the world’s population lived in cities. By 2050 this figure is expected to reach 70%. This change in population density would not be possible without the productivity of modern agriculture and the equipment Deere sells. In the future, fewer workers will labor for the production of food through an increase of efficiency made possible by modern agriculture and equipment. 

Deere is the best of both worlds, you get emerging market growth by investing in a quality American company that has been successfully creating shareholder value for 175 years.

Over the past 10 years $5,000 invested in Deere would have grown to approximately $20,000 with dividends reinvested, a CAGR of 15%.  By purchasing Deere at a depressed valuation there is no reason to believe the performance above will not replicated over the next ten years and beyond.  

An option strategy

With the current turmoil over the fiscal cliff, the volatility in the market has been trending higher, causing the volatility premium of put options to expand. This may create an opportunity whereby you can sell a cash-secured put, guaranteeing that in twelve months you will either own Deere for $70/share or you will receive a fee of in excess of 10% for the capital you have risked.  

A Deere Jan-2014 $77.5 put closed on 12/26/2012 around $5, but traded up to $7 by the close of trading on Friday.  If the option trades at $7.5 you will have the the opportunity outlined above.  In fact, contemplating owning Deere for $70/share may even cause you a twinge of remorse if the stock trades up after you sell the put.  Fret not, dear reader, you can find solace in the fact that if the market value of Deere increases over the next twelve months you will be paid a 10% return for your trouble.  

Conceptually, this strategy is logical if you believe that the sluggishness of the global economy may prevent Deere and Company's stock from "Running Like a Deere."  There are two principle risks: Either Deere trades much below our $70 target (tail risk) or it pulls away beyond $100 where simply buying the stock would have netted a better return.  Due to sluggish global growth and political uncertainty, I expect that Deere may be range bound or even trade lower for a while yet, thus the option strategy seems more attractive at the present time.


The article above should not be construed as a solicitation to enter into any trade on the mentioned security or options derived from it.  Always perform your own due diligence and carefully consider the risks and benefits of this or any investing strategy.  The option strategy of selling puts creates the potential for a temporary loss during a spike in market volatility.  Once you have sold a put you are short a derivative that increases in value with the VIX and decreases in value as DE rises.  Thus, as a trading strategy it can be useful to visualize the value of your put option by visiting StockCharts.com and creating a $VIX:DE SharpChart, which will give a sense of how the option price will behave as volatility increases.

brenoboyle has no positions in the stocks mentioned above. The Motley Fool owns shares of Joy Global. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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