Chit Chat Stocks - Deere: A Wide Moat Stock Hiding In Plain Sight? With Best Anchor Stocks (Ticker: DE)

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Starting point is 00:01:32 episode. Welcome to Chitchat Stocks. Today, we are joined by a recurring guest. I think we can call it at this point. I've been on a number of times onto this show. And it is Leandro. He is the author of Best Anchor Stocks, a phenomenal stock research blog. And today we are talking about a company that most Americans are definitely familiar with. It is John Deere. And Leandro just had a long form research piece on John Deere with a wonderful title. I'll also say John Deere cultivating technology i thought that was really well done um but why don't we i guess kick things off with first of all welcome to the show and then secondly here how did you come across john dear to begin with well first of all uh brett ryan thanks for having me i think this is i don't know

Starting point is 00:02:33 i've lost count maybe the fourth or fifth time i come to the to the show um so yeah the the title actually was the first title i came up with sometimes uh inspiration comes so uh it's great to know that that you liked it so the how i came across john deere was actually interesting because i saw a tweet of someone who who was reading a book called the john deere way uh the book goes about it's about the company's history but it goes up to 2005 um but well that gave me like that just led me to look at deer in a screener because i typically when i'm when i know what to study i will maybe go over the company in a screener read the proxy statement and all that and then i will make the decision to study in depth so i looked at it through a

Starting point is 00:03:25 screener and i saw the huge debt load and also that the stock had had a massive run since the pandemic. So that made me almost pass on it. But I decided to give it a go to give the book a go because I love reading about corporate history, especially these companies that have been operating for so, so long, right? Because you get to learn what makes a company durable or what makes a company great. I read the book. And then after reading the book, I realized that maybe the screener was not as accurate as, as I thought. And I decided to, to dig deeper after, after finishing the book. Okay. And we'll get to specifically what makes people when looking at the screener, it's almost similar to an automotive company that has

Starting point is 00:04:15 the financing arm, but we'll get into the details of that, uh, throughout this episode, I'm sure. And I think we did have some people ask that on Twitter specifically. So I guess we'll hopefully answer that uh but let's get to the segments here john deer or deer and company people listening especially in the united states will recognize that it has the tractors that they see or if they're in a residential neighborhood maybe the lawn mowing equipment but where do they make their money where are they actually selling to customers how does this all work what's what's driving this business in 2024 yeah so basically before maybe digging into the segments uh just give it's good to give a glance um at the numbers right so deer generated around 61 billion in sales and in its

Starting point is 00:05:07 fiscal year 2023 with a net income margin of almost 17 percent right so it's it's a very big business and also quite profitable at this point. So as you said, the company basically sells agricultural and construction equipment, right? And then all the related service and parts and all the related revenue streams that come out of that. So the company can be divided into two large segments, right? Two main segments. The first one is equipment operations, and they make money selling the equipment and

Starting point is 00:05:43 then servicing this equipment and selling additional parts and also that we probably will go over this later also the the technology part and then they have the financial segment so in equipment operations there are three main sub-segments right one is production and and precision agriculture this is simply put where they sell the large equipments and all the related technology right the deer decided to start um technological agriculture in the large equipment because it's where it makes the most sense right now i mean if you have a huge crop then very small improvements in yield thanks to agriculture can yield like very good returns so they started there and this segment this sub-segment uh makes around 43 percent of

Starting point is 00:06:34 of sales right of the company's total sales and as it's a large uh large equipments and the customers are mainly the the large farmers in the in the u.s in in brazil also it's less usual to see large equipment in places like europe right because the farms are are much smaller um they distribute them exclusively across the dealer base right so these dealers are exclusive dealers for for deer and they basically buy the equipment from deer and then resell it well resell it it's new but they resell it to the to the end customer so so deer doesn't sell the equipment to the farmer deer sells the equipment to the dealers who later sell the the equipment to the farmers then you have the small agriculture and turf which probably a lot of people have seen

Starting point is 00:07:26 this, right? Even if you don't have a farm, it's the smaller equipment and also the equipment that you see in golf courses or in people's houses. This is around 23% of sales. And this one is distributed across the dealers, but also through big box retailers like Home Depot and Lowe's, because obviously the target customer is different. And then finally, you have in equipment operations construction and forestry which similar to small agriculture makes around 23 percent of sales i mean it's called construction and forestry but forestry is like a minimal part of this right it's two percent i think of the company's total revenue and so construction is 21 percent so much more weight to construction and this is also distributed across the company's dealer base

Starting point is 00:08:19 And then what's interesting is that they have a financial segment, but many people get scared when they hear about this because they say, OK, leverage. I mean, let's say that a lot of bankruptcies start with something related to financials and leverage. So Deere uses this as an enabler of its equipment operations. Right. So it's not the main business. And as you said, Bread is similar to what many auto companies do. I'd say it's similar, but at the same time, it's different, right? Because this is a financial segment that is very tailored to a niche, and the customers are the same customers that have been working with Deere for many decades. Whereas in the car industry, each consumer is different, right?

Starting point is 00:09:11 So it's very difficult to see how they will react in case of a recession. And the financial segment is around 8% of sales. So that's basically how Deere is structured. And then can you talk about how they used the, and I think if I'm remembering correctly from your report, they use the finance arm, not necessarily as a profit generator, but kind of to grease the wheels of the agricultural industry and why that's necessary for farmers that may have, I guess it might just be a liquidity issue. Yeah, I mean, when you're buying equipment as a farmer, it's a significant capital outlay, right?

Starting point is 00:09:53 So to facilitate the sale, what Deere does is finance that purchase. Actually, many people think that the equipment makes, even when you finance it, the equipment doesn't make up a large portion of a farmer's cost, right? A lot of people think it's like huge, but in reality, it's like 15 percent. I mean, herbicides and pesticides have a much higher weight on a farmer's cost structure than the equipment per se. So Deere came up with this so that they could basically allow the farmers to renew rather recurringly the equipment. And what you said is really important, right?

Starting point is 00:10:37 Because trouble always comes when a financial segment is trying to maximize profit, because then it's when you start to take more risk. But in this case, Deere is fine with an okay return. Obviously, they want to make money, but they don't want to maximize the money they make. But it's more facilitating the purchase decision of the farmers, right, and enabling the equipment operations to sell systems. So I think that's important because it takes away quite a bit of the risk embedded in any financial segment. Can we go through some of the history? You mentioned that you read the book on John Deere's corporate history. So what do you think, I guess, just go through how this business was started and maybe any important points surrounding its corporate history?

Starting point is 00:11:30 so the the the company has a very long history but i'll try to summarize it so we are not here two hours uh it was founded in 1837 uh so it's more than 180 years old and it was founded by john deere in in illinois right many people know that see the tractors now but deer actually started in agriculture but back then there was no mechanization so they basically what john deer invented was a steel plow and this this sounds like stupid innovation right because plows already existed um but the problem was that in Illinois the the soil was sticky so farmers had to stop uh lowing and they had to clean the plow every time until uh John Deere came came up with a steel plow so the horses this is actually funny and I think I I mentioned it in the in the report

Starting point is 00:12:28 There are some similarities between John Deere and Hermès because they were founded in the same year and also both had to adapt to the arrival of mechanization, right? Hermès started doing accessories for horses and Deere started making equipment for horses in the agriculture industry. And in the 1920s, mechanization arrived and Deere tried to come up with a tractor, but they were not good at it. So they decided to buy their way in, right? So they bought the Waterloo Gasoline Engine Company and they started manufacturing tractors. They had very successful tractors, but the next significant event came in the 1960s when they presented a new generation of power event. So Deere saw that to keep up with the needs of the agriculture industry, they needed to basically have more power in the equipment because the farms were getting very large and it required a lot of iterations to go through all the farms. So then that's the next era of the company to manufacture more powerful equipment.

Starting point is 00:13:41 And then just three years after this event, Deere became the largest company in the industry. for the first time in 1963 and they have never left that spot so they've been since 1963 they have been leading the the industry then the next era of the company got kick-started in 1999 when the company bought navcom so navcom allowed them to include gps signaling in the equipment and that was obviously the starting bit of what is now of what is not going to become uh autonomy right so since 1999 i know that many people think that deer has basically started now to invest in technology but deer made the first tech acquisition so to say in 1999 so so 25 years ago and then the last relevant um event probably came in 2017 when the company made its largest acquisition in history

Starting point is 00:14:41 they acquired wordgen that is a company that was the leading company in road building equipment and actually that that was a bit lucky right because they they bought the company at a fair price in 2017 but of course um they probably didn't expect the huge wave of infrastructure investment that was coming our way right after with a with a 2021 infrastructure act i mean they're going to be a very a beneficiary of this trend so yeah i mean it's a it's a large history but it's one of of leadership especially since 1963 when when they became the the largest company so you mentioned 1963 that's i think doing math in my head here over 60 years ago now what has enabled them to maintain this leadership in what some may call a commodity market where

Starting point is 00:15:37 it's like you have okay this one tractor versus another it's almost like a honda versus a toyota versus a volkswagen why are they so you know quote unquote sticky with their customers as you talked about in your research report yes i think that if you ask any dear customer he'll tell you that probably the most important reason is the dealer. And the dealer has a very important role for several reasons, right? The first one is that most farms in the US are family owned and they have been passed from generation to generation.

Starting point is 00:16:15 So they have a very good relationship with the dealer and they are used to Deere's equipment, right? I recall reading in the book actually that during the Great Depression, a lot of families could keep their farms because deer was nice to them or the dealers were nice to them in enabling them to pay later, right?

Starting point is 00:16:39 So they extended their payment terms. So obviously they are very grateful for that and they keep choosing deer because maybe it's their grandchildren that are running the farm now. And then the other important part is that the density of deer's dealer network is superior to other competitors.

Starting point is 00:16:57 And in the agriculture industry, it's very important to have a dense network because the downtime is basically like, well, farmers can't afford downtime, right? Because you harvest over very short periods. And if your equipment is not up and running, then you potentially could lose all the harvest. So I'd say that the dealer is probably the most important part of the mode. and and obviously there there's more but i think we'll we'll talk about it later also the install base is is important especially now that technology is coming into play but i mean there's more i agree that it's a commodity like market right it's one tractor versus uh the other and they have very uh similar uh technical specs but at the same time there's much more playing a role in the

Starting point is 00:17:50 farmer's decision than just the um the technical characteristic characteristics of the equipment and as i said before also the equipment makes a lowish portion of the farmer's cost right so there's not a very high incentive to switch once you are used to one type of equipment can we go through the relationship with the dealers a little more here So is it almost like an auto dealer in a way where they're independent? It's kind of feels like a franchisee type relationship where they are using John Deere's name, but they are running their own separate business. Is that basically the arrangement? Yeah, that's how it's organized.

Starting point is 00:18:37 And actually, Deere started incentivizing dealer concentration, right? So some dealers started buying others because that makes them more efficient. But yeah, I mean, dealers are independent and they basically, but obviously they are in close contact to Deere, especially to manage inventory, right? This industry is cyclical. So Deere also doesn't want the dealer channel to be bloated with inventory because then when the downturn comes, it's when you start to suffer. And obviously, now with technology coming into play, I think it's going to be more important to keep the inventory tight because obviously, equipment can get obsolete quite fast. Okay. And you mentioned this is in the United States. What about international? I know the United States is their biggest market, but Europe, Brazil, other places, is this relationship still there? Or is it something they're trying to build out? Or is it different in these markets? I mean, it depends on the geography, right? In the emerging geographies, deer has an established position, but sometimes doesn't lead. For example, in India, Mahindra is the number one player for tractors. But for example, Europe, deer still leads, but not by such a wide margin as in the US.

Starting point is 00:19:58 The reason is what I mentioned earlier, that the characteristics of U.S. farms are much more tailored to deer's large equipment, which is the best, and where deer has the highest market share. And maybe in Europe is, for example, more tailored to smaller agricultural equipment, right? Farms here are not as large. A country where dealer is will probably be quite strong because it shares similar characteristics with the U.S. is Brazil. And in the latest earnings call, also management mentioned that in Brazil they don't have a constraint in the U.S. to harvest. So they they have several turns to the soil so they can harvest several times during the same season. So that means that technology is going to be more important. Right. Because you are like iterations. There are more iterations.

Starting point is 00:20:51 So small improvements in one equipment can have like tremendous, a tremendous impact on the income statement. But I mean, Deere is the leading player in the U.S. and in large agricultural equipment. It also leads, I would say, we cannot make generalizations, but I would say it leads in other countries. But the leadership is not as strong as in the U.S. The only thing I would say here, apart from that, is that the fact that technology is now going to be more important and probably the area is going to end up with more technology probably makes it somewhat easier to penetrate the emerging markets. Okay, and that leads into this next question. We are going to talk about the technology stuff. It is important to their growth going forward.

Starting point is 00:21:36 And as you talked about in your report, potentially already helped widen the moat and will widen it further. and I will, I do have a follow-up on maybe, I think you talked about basically the farmers in Europe. I think the governments are incentivizing them to get bigger so the crop yields can go up, but maybe we'll save that for a follow-up for later. But let's hit the technology one. They say their main focus, I mean, it's right there in their first slides in their investor presentations. They say they want to modernize agriculture with technology solutions. Now, I think people would go, well, how exactly are you going to do that? And I think there's been a lot of startups in this space. I remember one that was kind of famous, which I would call App

Starting point is 00:22:21 Harvest, which is probably a little bit different than Deere Technologies. But I think there's probably some skepticism, I guess, among value type investors, people that are not willing to bet on, hey, what is the future going to bring here? Are we seeing it actually today? So I guess the questions I have are, are you confident that Deere is in a leading position here and can win with this strategy? Is it going to be competitive? And is it already showing up in the financials today just as an overview from an investment perspective and how this technology segment can drive growth for Deere over the next few decades? Yeah. So as I discussed earlier, this actually has been the focus for almost 25 years, right?

Starting point is 00:23:02 But I think that there are two things that probably have, let's say, increased the penetration of technology in the agriculture industry. One is obviously technological innovation, right? Chips are much better now. So obviously tech is much cheaper. And the second one is probably regulation. Because, I mean, Deere knew that in the past they could make farmers more profitable with more power. But I mean, the availability of land to farm is decreasing, but the needs are increasing, right? So now power is not enough.

Starting point is 00:23:39 They need technology to be more productive. So I think that's precipitating the transition to technology, but it's not something new. I think they are, I am confident that they can achieve this. First, because they have been doing it for a long time. and also because Deere is the largest player and spends quite a bit on R&D and has a great tech stack, right? The tech stack has been built

Starting point is 00:24:04 both organically and inorganically. So they have some things that they've done in-house, but they also have made some tuck-ins, especially for robotics and automation. I think that when one thinks about technology, right, the first natural thing to think is that switching costs are going to decrease, right? Because obviously technology brings disruption risks.

Starting point is 00:24:30 While I agree with that in most industry, I think that's not a very relevant concern for deer. And the reason is that the tech improvements in the equipment have to come through data, right? And to collect that data, you need the install base. So you cannot come from scratch and manufacture, for example, sea and spray that deer has, right? Because CN spray basically is that before farmers, when they wanted to fertilize, they basically had to go or to spray pesticide.

Starting point is 00:25:03 They basically had to put it to all of the crop. That's changing now because now one of Deere's equipment can go through all the plants and they will detect real time what plants need pesticide and what plants don't need pesticide. pesticides. So that obviously is very relevant for farmers because the cost of fertilizers and pesticides have skyrocketed. I mean, you cannot develop that technology unless you have seen a lot of equipment go through a lot of crops, right? So I think it's somewhat different in that the install base is what fuels the software. I think it's also worth thinking about network effects that the technology um the technology can bring i mean this is probably a word that is used too much also uh especially and many times where it's not used the correct way but i mean farmers

Starting point is 00:26:04 are sell a commodity right so they are price takers i mean a farmer in in illinois cannot decide the price at which he is selling his his crop um this means that they have to focus in their cost structure and if a farmer is more productive uh than uh than me that because he is using for example dear equipment thanks to technology then that means that he can basically underprice me right so i'll still be profitable so that means that a farmer that's not on the best technology will probably end up going to the best technology just to remain competitive because they are price takers. And I think that's something

Starting point is 00:26:41 that we can potentially see with Deere, even capturing more market share. I mean, their market share is huge, but if technology is going to gain penetration, which is probably inevitable because most of Deere's competitors are following the same steps, then probably the best technology

Starting point is 00:27:01 will get the larger install base and that larger install base will power the best technology. That's how I see it. And I think that the results are already showing in the financials, more in the margin than in the recurrence. I mean, the margins, just to give some numbers here, in the last down cycle that went from 2013, I think, to 2017 or so, Deere had mid-cycle operating margins of 16%. And at the end of this year, management expects that they'll be at mid-cycle earnings, and they are now expecting 21% operating margins. So that's 500 basis points improvement, and that's basically technology.

Starting point is 00:27:51 In the recurring part, probably it's going to take more to play out, right? The subscriptions and all that. But we are already starting to see that technology in the income statement through the margins. So you mentioned the example of the pesticides, not just being a blanket throw out there, targeted pesticides. They've made quite a few acquisitions. Do you have any other examples of how they're deploying this technology? Because I know most of the listeners here aren't going to be experts on farming techniques, but I think it'd be interesting to get some meat on the bone of what they're actually doing for their customers. So another very relevant one probably is autonomy, right? Because right now, one of the constraints of the agriculture industry is labor. And obviously, you need to be in the equipment right now to harvest.

Starting point is 00:28:48 But maybe in the future, not so distant future, I think management is expecting a fully autonomous structure as soon as 2025. You'll be able to leave the equipment maybe working at night, right? So then you don't have that labor constraint because you can go to sleep and keep harvesting. That's one of the other examples. But obviously, there are more. I think that the other part is that they are going to help farmers learn how to be more productive, right, through the John Deere Operations Center. Basically, that's where you control all your harvest. They'll probably tell you that when is the best moment to put the seeds, when is the best moment to harvest.

Starting point is 00:29:33 So I think there's there's a lot going on. And I think it's it's a segment that's bound for for for technological disruption. Right. Especially because if you think about it, we cannot I don't think that governments are going to afford inflation in in the food space. We already saw what happened with that. And if they keep putting more regulation to how you can crop, then obviously, or how you can harvest, then obviously it's going to have an important impact on inflation. And lastly, one thing that I actually talked about Deere with Sri from SVN Capital, and he told me that in the US, and this is true, when farmers are not doing well, then the government will quickly grant money or maybe give them tax breaks so that they can purchase new equipment and all. So that's obviously beneficial for deer, right? Regulation can be, it's a headwind. Well, for me, it's a double tailwind. One because of this and the other one because the other regulation is making technology inevitable.

Starting point is 00:30:48 But at the same time, you could see it as technology being a risk, right? Because farmers are going to be less and less profitable. Okay, let's talk about the management team and maybe the proxy statement a little bit. obviously this is not a founder-led company as most people might imagine seeing as it was founded in 1837 so who's in charge of the company today what do you think of them and maybe talk about their capital returns strategy yes i think the management team is very good right now it's john may i think he has been leading the company since 2017 if i'm not mistaken and they have a clearly defined strategy right they want to make deer a technology company and um i think that's something

Starting point is 00:31:35 very important in the management team or something that i value a lot maybe it's not as important for other people is management continuity i mean in in its 186 year history deer has had 10 ceos obviously this is skewed to the family ceos which were in place for 40 years right but But of the last eight CEOs or no, of the last four or five CEOs, all of them have been at least at the helm for eight to nine years. I mean, that just demonstrates that they want, like the board wants the CEO to be able to implement their strategy. um i think the best thing probably about john may is that he the strategy might or might not work but he's committed to it and he has put all the resources of the company and all the employees behind it so i think that's very important right because uh a lot of times you'll see companies

Starting point is 00:32:33 that claim to be following a strategy but then you see all kinds of different things in all the teams in the company. So I think that's positive. And I think that probably one of the best things about the management team and the proxy statement is the incentive system. I mean, it surprises me a lot when I read proxy statements to see how bad a lot of compensation structures are in the management teams, right? I mean, it's like they have been, it's like as if they were done by consultants oh wait because that that's who does that yeah yeah we got to pay the compensation consultants so we can uh excuse ourselves to get paid an adjusted EBITDA or unadjusted EBITDA yeah i mean what's crazy is that you pay a consultant that doesn't know your company

Starting point is 00:33:23 uh to to set uh and doesn't know your company or the strategy to say the to set the compensation structure which obviously has plays a huge role in both in both of those uh things so before Or going over the incentive system, I think it's important to know where it comes from. Deere had from the year 2000 to the year 2009, had a CEO called Robert Lane. And he said that Deere was a great company for farmers, for every type of customers, for the employees, for the community. But it was lacking being a very good company for shareholders, right? The company was quite cyclical. and they didn't like that and maybe focused on growth at all costs, right?

Starting point is 00:34:12 And maybe protecting against down cycles. So he decided to add shareholder value added to the compensation structure in an effort to make the management teams focus on shareholder value creation. And surprise, it worked, right? When you change a compensation structure, it normally, and to focus on the right things, it normally works. when you see it's crazy because when you look at the best compounders you can find a high percentage of great compensation structures right and when you look at the worst uh performers you

Starting point is 00:34:46 tend to find very very bad compensation structures um this doesn't mean that obviously if you come against a very good compensation structure the company will be a home run but obviously it's something that needs to be there so that the short-term incentive is based on operating return on assets and sales and obviously they have different objectives for the financial segment which the the kpi is uh roe so we turn on equity and the long-term incentive is based on shareholder value added which basically it's probably one of the best ways to compensate management because you compensate them to grow but only to grow when it makes sense for shareholders so where you when you are adding value and obviously that makes management think a lot about the investments

Starting point is 00:35:32 because it's not like it's the for me it's a very good metric because it focuses both focuses both on growth and on returns whereas other metrics might focus just on returns for example i mean if you compensate based on roic then you can basically focus more on the return than on growing because maybe you grow very, you don't grow a lot, but you are not putting a lot of capital on the line. But here you have to grow and grow in a profitable way. So I think obviously that has worked very well, judging by how Deere has performed and how the margins have progressed and also the returns. So for me, this is one of the strong suits of the company. I mean, it's not a perfect compensation structure,

Starting point is 00:36:19 but it's probably better than 95% of those that you see out there. Yeah. I would agree as well on that. I think it's interesting when you said around the year 2000 is when they tried to make this switch. 2007 when he, when he was going to leave, he just,

Starting point is 00:36:39 well, before leaving actually three, three years before leaving, he, he put that. Okay. So at the end of his tenure, but yeah,

Starting point is 00:36:47 Well, I think the comparison still applies. That's when their shares outstanding started consistently going down and they started, it seems like returning capital through buybacks in a, at least, you know, for a cyclical as best they can in a consistent manner. One thing on the ownership, you mentioned this in your article, the largest owner is Cascade Investments. And I know this probably is not going to be a game changer for anyone on the thesis, but can you tell the listeners what that is and how that actually might connect to Deere and why it can show that it's possibly just a wide mode business? Finchat.io is the complete stock research platform for fundamental investors. They have all the standard financial data on more than 100,000 stocks globally. And beyond that, they have company-specific segment and KPI data on more than 1,500 stocks. So to give some examples here, you want to see Netflix's average

Starting point is 00:37:36 revenue per member over the last 10 years, they've got it. You like to track YouTube's advertising revenue, they've got that too. If you want to see Celsius's revenue that comes from Costco, how much of their revenue comes from Costco, they also have that. So the breadth of FinChat segment and KPI data truly is one of a kind. I use FinChat every day to track and manage all my investments. I also use it to discover new investments. And if you want to get 15% off any paid plan, go to FinChat.io slash chitchat. That's FinChat.io slash chitchat to get 15% off any paid plan. The link will also be in our show notes. Earlier in the show, you heard us talk about the investing platform public.com that's where you can trade options with no

Starting point is 00:38:22 commissions or per contract fees and you get a rebate of up to 18 cents per contract nerd wallet recently gave public five out of five stars for options trading if you want to see why go to public.com and start getting a rebate of up to 18 cents per contract traded this is paid for by public investing options are not suitable for all investors and carry significant risk full disclosures are in the podcast description us members only yeah so cascade investment i think owns around uh speaking from memory here maybe eight percent of of the company and cascade investment is bill gates um investment vehicle so basically bill gates owns uh i i think a lot of people know that bill gates owns deer maybe not so much that he owns such a considerable chunk of

Starting point is 00:39:10 the company and this is interesting because bill gates is also the individual who owns the most farmland in the u.s right so i think he probably knows a thing or two about farming in the u.s and i mean it's it's positive to see him as a shareholder i don't think it's as you said game changing or anything but it's just like it's it's anecdotal but also interesting yeah i think it's funny how i i obviously am not there when he's he's buying this farmland or managing the farmland but i think it might be funny that he's like wow we have to kind of go with deer there's no way we switch this is our most important value add here so maybe we should consider putting it in the in the investment portfolio um let's move on to the valuation deer is cyclical um i think a lot of

Starting point is 00:40:01 people get turned off on that right away. You look at it today, I think it trades at close to about 10 times earnings. But again, obviously, cyclicals, it can be dangerous to invest when it has a low PE. So how are you valuing the stock as someone who wants to buy and hold for the long term? And I guess, is the company de-cycling itself? Sorry, I can't say that. And how could maybe change things uh you know how could i think you mentioned in the article it's dangerous to say it's different this time but how could it actually be a little bit different over the next couple of decades versus the last few yeah so some some thoughts on on cyclicality there um i was very reluctant to own cyclical companies uh maybe a year ago or so until i read the book capital

Starting point is 00:40:48 returns because if you have um if you're in a cyclical company that's secular and where management knows very well the cycle and how to invest counter cyclically to counter cyclically then you're going to have um potentially management amplifying your returns right um i mean there is cyclical but it's not like uh if it loses money in down cycles the margins go down but it still remains quite profitable in the down cycle. And another thing I think a lot of people are probably worried with the current cycle, right? Because management has said

Starting point is 00:41:28 that we are probably at the end of this year, we are going to be around mid-cycle earnings. And that's going to be, I think it's a mid-teens decline. And a lot of people are a bit skeptical, right? Because we've seen a huge run since the pandemic. But what management has stressed constantly and what I think they are, I mean, they are right. The current cycle, the cycles in the industry come from volume, right?

Starting point is 00:41:58 So if people are renovating the equipment or the equipment is newer than the average, then farmers will defer their purchases. But management has argued that a huge part of the current cycle has come from price. And that's that's actually makes it different because you can see a huge run with without without it being a super cycle. Right. They've taken a lot of pricing due to supply constraint and also because technology they are including technology in their in their equipment. When when Deere starts with a technological application that they are going to apply to a machine, They're first applied to some of them. And then when it gains adoption, they will include it in every new equipment and they will hike the price. So there's a lot of that going on too.

Starting point is 00:42:54 So the variable to look at here is volume and not revenues, right? But a lot of people are looking at the cycle through the revenues. In fact, I think the average age of combines and tractors is around the average, the historical average. So it's not like we're going to have a super down cycle. So they basically argue that by the end of next year will be around 90% of mid-cycle earnings. And that's what I use to value the company, right? I mean, I could do a period and try to predict the agricultural cycle, but I don't think I'm going to do a better job than management doing that. Yeah, unless you can predict the weather. I don't think, you know, yeah, yeah.

Starting point is 00:43:45 It's very tough, right? Because a lot of things go into the cycle. But what I think or what I'm confident in is that the cycle is not going to have an impact on the long term of the company. So I think that getting the multiples, maybe not the multiples, but the free cash flow yield, next year's free cash flow yield is a good way to understand where the company is on a normalized basis, right? I mean, a lot of people will say that the down cycle is going to be much tougher. And that's fair. I mean, they don't go from an up cycle to mid cycle.

Starting point is 00:44:25 They typically go through an up cycle, go through mid cycle and then to the down cycle. But what an investor should care about, in my opinion, is about the normalized earnings, not about the earnings in the up cycle or the down cycle. And on the last question on de-cycling, I would say that it's possible and it will happen, but it will probably take, as I said before, quite a bit of time. I mean, we'll probably see that Deere is more profitable through the cycles before seeing that Deere doesn't have cycles. I think that's how one should look at it, because they are expecting 10% subscription revenue, I think, by 2030. And that, together with the parts and all the service, will take around, let's say, the portion of sales that are recurring to 40%, which is considerable, right? But not something that will decycle a company. And also that's sales.

Starting point is 00:45:31 Probably on profits, it's going to be a larger amount because service, parts, and subscriptions are much higher margin than the equipment. So let's say that deer ends 2013, 60% of recurring net income or operating income. That's, I mean, that's substantial, but I don't think it's enough to not suffer the agricultural cycle, right? For anyone who is listening, they're not watching. I just shared my screen and showed some of the numbers, but to kind of quantify what Leandro is talking about here. And I know you mentioned that revenue is not the figure to track, but if you

Starting point is 00:46:10 to demonstrate kind of the margin expansion and the share buyback and the impact it can have when a management team knows what they're doing. Revenue has grown at about 4.3% a year over the last decade and earnings per share has grown at 14% a year. Kind of just goes to show the margin expansion and how management has been able to take advantage of some of the ups and downs. Yeah. And I think that's a good way of thinking about the next, even if you don't want to. So I'll do my little evaluation exercise here. So if you take the free cash flow that Deere is going to generate

Starting point is 00:46:45 probably by the end of next year or the management guidance, that puts the company around a 5% free cash flow yield, right? A decade ago is when the, you can argue that we are now in a peak cycle and a decade ago, you could

Starting point is 00:47:02 also argue, well, you know for sure that we were in a peak cycle, which was 2013. So if you get the 4% CAGR in revenue, and then you add a bit of margin expansion, that already is going to take you probably, and also the better cash conversion, right? Because when you are working with subscription technology and all the recurring parts, your cash conversion is going to improve when the equipment operations naturally makes a lower portion of the company.

Starting point is 00:47:26 I think it's pretty fair to think that the free cash flow here can grow at mid to high single digits, right? And with the current free cash flow yield, I know this is an approximation and very napkin numbers, but it will take you to a higher than double digit return, which for a company such as Deere, I think it's quite interesting, especially since you are taking for granted all the optionality, right? Because you're assuming that the company can grow at the same pace as when technology was actually not as important as it will be in the future. But obviously, it's impossible to know if technology is going to have a huge impact on growth or just on margins. Okay. One question before we close things up, unless Brett has a couple more follow-ups. What do you see as the biggest risks to Deere as an investment?

Starting point is 00:48:25 and then also regarding their competitive advantage? Do you think there's any risk that this goes away over time? Well, I think right off the top of my head, I can think probably the most important risk right now is going to be Unions. Deere suffered a strike, I think it was 2020 or 2021. And obviously, they had to stop their manufacturing for, I think, five weeks. And the new labor agreement is much more expensive than the last one.

Starting point is 00:49:03 So that obviously has an impact on margins. You cannot probably see it in the financials because at that same time, there was a supply crunch. So basically, there are high prices and then sort of the impact of the strike was sort of hidden. And they have significant labor agreements, I think, renewing relatively soon, probably one next year and one in 2027. So I think that's an important risk. But at the same time, I think it's a risk that should diminish for the same reason that I said, right? If 60% of your business is recurring and it's made up less of equipment operations, then you are not as reliant on the manufacturing where the strike happened, where a strike normally happens, right?

Starting point is 00:49:50 Because it's where you have the low value added labor, so to say, but it's also very, very important. So I think that's one risk. I say another risk that I have read about is the one on autonomy, maybe benefiting smaller equipment. Because if you have basically a system, an equipment that can be harvesting throughout the night for the whole night, maybe you don't need such a large harvester, right? Because you can leave the equipment working. That's a fair concern. But at the same time, you can think that deer will probably have the best technology and they also have small agriculture, right? So they could adapt to that.

Starting point is 00:50:35 But they are not as leading in small agriculture than in large agriculture. So any transition that takes the company from large to small is probably not great for the mode. I think those two risks are probably the two most important. And there's also been an FTC complaint related to right to repair. So right to repair is a regulation that basically states that you need to, if someone buys equipment from you, they need to have a reasonable way of servicing that equipment, either themselves or being able to go to any third party provider. and they argue and some some farmers argue that deer is not allowing for that and i i well deer says that 98 of the servicing or of the equipment can still be made by farmers but that the two that cannot be made um it's that way because they could potentially um damage the there are

Starting point is 00:51:42 environmental regulations in the agriculture industry and the equipment is prepared so that the limits are are complied with so they argue that if farmers can access that the software for example they they could potentially change uh those settings and then they would not be regulation compliant i would say those three are are the most important risk but the one i would be most worried about and the one that i am most worried about is probably their unions because it's it's something that's coming right it's not like something that's very far away into the future right and it has happened before and probably will happen again yeah makes sense so as we close things out here uh in your article which i should note is one you made it free

Starting point is 00:52:29 for i think yeah yeah for for this one so anyone can go check it out for for we'll have a link in the show notes there but you write at the end of your article about how you have your best anchor stocks qualities i don't know how many there are but you have these tenants that you look for to basically show that it's a high quality company and qualifies as a best anchor stock. So how does John Deere fit or not fit within that criteria? And how does that make you think about owning versus not owning the stock? Yeah, I mean, I think Deere fits with all of them. So if I go, I think the ones that we have not touched upon, I'll maybe double click on those.

Starting point is 00:53:09 And the other ones, I think they are obvious. The first one is experienced and aligned management. I think we already went over that. Deere actually likes to hire from within. And the current CEO has been in the management team actually since 2012. I think he was the COO before. Then the second one is proven track record of outperformance.

Starting point is 00:53:30 This is pretty easy to judge. You just go back in history and look at it. Then you have the strong mode. I think we also went over this. Enjoying a long-term secular tailwind. Obviously, they are enjoying a long-term secular tailwind in that technology is going to increase in penetration in agriculture. And obviously, the world demands more food, right? And the farmland is reducing, right?

Starting point is 00:53:58 And then you have construction and the long-term secular tailwind is obviously everything related to infrastructure. Then you have optionality. I think that any tech company has optionality because today we are hearing about autonomy, about sea and spray, but we don't know what applications might come in the future, right? Deer can potentially do something around water management, for example, in the farm, which is also important. The sixth one is double digit growth, which I think we already touched upon. Maybe Deere doesn't comply with, I mean, not 100% with this characteristic, but at the same time, you don't need double-digit growth to enjoy double-digit returns, right? I mean, if you are not expecting, if you are starting from a, let's say, reasonable valuation or maybe a high valuation, you do need double-digit growth to enjoy double-digit returns. But I think the valuation here in Deere is not as demanding.

Starting point is 00:54:55 Then the eighth one is lower than usual volatility. I think this one might strike some people that it complies with this. But actually, Deere, despite being a cyclical company, the stock tends to have a rather strange performance, right? Because instead of going down a lot after the down cycle starts, it sort of consolidates for a long time over a tight range. And I think that's an indication like that's the management saying that they believe the company is secular. Obviously, they have cycles. But to be honest, if the company does not comply with this, considering the huge buyback program and that they have a lot of cash generation capacity, for me, it's fine. Because if the stock goes down a lot, I think they will retire a lot of shares.

Starting point is 00:55:49 then resilient during recessions i think there are two ways to to measure this the first one is to go back to the to the past agricultural cycles and see how the company performed and the other one is basically common sense deer has been operating for 180 years so i think that they are resilient against recessions and world wars and pandemics um and the the last one is reasonable valuation which we already went over. I think that it can be summarized in the fact that I believe that Deere is a great company trading at a very reasonable price, right?

Starting point is 00:56:25 I mean, there can be bumps along the way. Now probably a down cycle is starting. Nobody knows how long it might be, how short, but if you are thinking over the long term, I don't think that should really worry you. If you are thinking about your returns in two or three years, maybe you should be worried. and by the way obviously this is not uh investment advice but you can read the deep life if you want

Starting point is 00:56:48 yeah exactly exactly so thank you for joining us uh where can people find your stuff i know there's a substack and also seeking office of both places yeah so in alpha is best anchor stocks and then Substack is bestanchorstocks.com so those two places are also on my Twitter I don't know how to say it now that it's called X on my X that doesn't sound right yeah yeah I tweeted it I tweeted something what do you say with X I X'd something I don't know on my Twitter which is at invest quotes beautiful beautiful yep and we have had uh leandra on the show before talking asml talking luxury stocks talking constellation software yeah exactly yeah and constellation software so all those type of companies covered at best anchor stocks uh so go check that out

Starting point is 00:57:49 we'll have the link in the show notes or go check out his twitter slash x to get all those links as well thank you everyone for joining us let me hit the disclosure we are not financial advisors Anything we say on the show is not formal advice or recommendation. Ryan, I, or any podcast guest may hold securities discussed in this podcast, may have held them in the past, and may buy, sell, or hold them in the future. Thank you, everyone, for tuning in again, and we'll see you next time. You

Chit Chat Stocks - Deere: A Wide Moat Stock Hiding In Plain Sight? With Best Anchor Stocks (Ticker: DE)

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