TIVP004: John Deere (DE): Sowing the Seeds of Growth w/ Shawn O’Malley

24:57Basically, it aggregates all of the data that's been collected about their land, how it's being used, their crops, how their machinery is performing, and more stuff like that. And this is super helpful for planning out a planting or harvesting season, monitoring in real time how things are going, and analyzing whether further optimizations can be made in the future. The Operations Center API has over 250 interconnected software apps to support farmers, including Harvest Profit, an app that helps farmers track the economics of their business. Sort of like how a Roomba maps out your home and learns how to vacuum more efficiently, John Deere's equipment does the same thing.

25:35They build a map of the farmer's acreage, learn its nuances, and then share those findings with the farmers. This could be super subtle stuff like pointing out that there's some overlap where the farmer is unnecessarily tilling, seeding, or spraying the same few inches or few feet in a row, or providing suggestions on the exact speed to drive equipment at for maximum efficiency without going too fast and, for example, not spraying crops properly. Deer can also recommend to farmers what varieties of crops to grow, where specifically on the property to grow them, and what crop protections, like certain types of pesticides, should be applied.

26:14Farmers work at such massive scales that seemingly small optimizations can make a big difference. Your typical corn farmer in Iowa might oversee thousands of acres of land, plant hundreds of millions of seeds, and lay down hundreds of thousands of pounds of fertilizer. There are also so many other variables involved, like how much rainfall there's been that year, average temperatures, and how late or how early a frost came. Weather can be a hugely complicating factor that farmers need assistance with. What's really powerful about Deere's machine learning here is that it's not just learning about your farm.

26:47It's been trained on years of data from thousands of other farms. So there's just a massive backlog of data to build on and make recommendations off of. And that recommendation engine is only getting more powerful over time. Deere has more sensors taking in agricultural data than anyone. After signing a deal with SpaceX to use its Starlink services, satellite connected machines are another big part of the story for Deere and providing internet to rural areas to keep machines online. For instance, about 70 % of Brazil's productive agricultural land is not internet connected, and even in the US, about 30 % of arable lands aren't.

27:25Imagine a farmer in Iowa for a moment, let's call him Fred. Realistically, Fred has 40 chances in his lifetime to optimize the economics of his farm and pass on a profitable operation to the next generation. Deere's aim then is to help farmers like Fred accelerate their learning through the power of data and multiply their chances for success. What if Fred could instead learn from 40 ,000 other lifetimes through insights gleaned from the digitalization of farming. In digitizing farms, there are now more than 640 ,000 connected deer machines in the market, double the level from 2022, and expected to triple by 2026.

28:05As Deere's management said, the data flywheel gets more powerful as we connect more equipment, collect more data, and generate insights that are not available to individual farmers alone nor to our competitors. As such, the medium-term goal is to connect 1.5 million machines across 500 million acres of land. Here's another line from the company showing its capabilities in action. Quote, we take the high-resolution planting data from the planter, we send it to the operations center, and we create a digital representation of where each seed was planted in the field. And this knowledge of the planting lines is then sent back down to the sprayer and back down to the combine so that when farmers enter the field, our equipment can navigate the field using the precise location of each plant that was recorded in a prior step.

28:53This all shows why there's a good case to be made for how the agriculture industry is evolving from one-off equipment sales to more software as a service. What's also powerful about this dynamic from Deere's perspective is that if they can genuinely produce a product that's more efficient for farmers, then generally speaking, once one farmer adopts it, most others will have to. Otherwise, they will no longer be cost competitive. And it's not like they can make up for that by just charging higher prices for corn or wheat. Unlike with new editions of an iPhone where you can just shrug off some marginal advancements in technology, even marginal improvements can be a big differentiator for farmers in terms of the returns they can earn.

29:34To show what I mean, here's an outline of what the economics for farmers in the US might look like. A typical US farmer growing soybeans or corn might earn$500 or$800 per acre in revenue, with a 50 % gross margin and a 5-10 % net profit margin in a normal year. Just taking the middle point of those number ranges, a farmer with 700 acres growing a staple crop might earn a profit of around$34 ,000. Depending on whether they own the land, how they account for their own wages, subsidies, and other revenue streams they may have, the income they actually earn can vary pretty widely. So that's just a simplified number showing what things might look like.

30:11But obviously, this is not a high margin business, and saving costs thanks to using the latest deer equipment can go a long way to improving those slim margins. Operating expenses tend to be mostly fixed for farmers, with land being the biggest single line item. So changes to gross profit largely fall to the bottom line, making farm incomes very cyclical. And since farmers are Deere's biggest customers, that's in large part why Deere's business is so cyclical too. For context, according to the Wall Street Journal, on average, about 7 % of farmers globally replace their equipment each year with an average useful life of around 17 years.

30:49So equipment purchases are infrequent, and farmers can afford to wait a bit depending on their income at a given year, the needs of their operations, or whether say interest rates are abnormally high, but eventually they do have to make replacements. I won't spend a ton of time on it, but Deere also produces equipment for what it calls small agricultural and turf operations. In some ways, these are like all-purpose vehicles. One of this division's bestsellers is called the Gator. They're used everywhere, but I've seen them a bunch at high school and college sporting events. They're sort of like golf carts on steroids that athletic staff love to whip around.

31:25And these small ag tractors Deere sells are a fraction of the size of the tractors it sells to larger scale farms, obviously. So its small ag and turf segment targets a more retail customer and started doing so through big box retailers like Home Depot and Lowe's more than 20 years ago. This sales approach is one of the big differences between the smaller equipment that Deere sells and its machines for more commercial purposes, where sales of larger end machines primarily happen through Deere's dealer network. Despite the stark difference across both segments, it was not until 2021 that Deere split off reporting for its smaller agricultural and turf equipment.

32:02Many things might have led management to make that distinction. The main one is probably the rise of precision ag, which is currently much more suited to large agricultural operations. Moving on to describe Deere's competitive positioning, I'd say this is no easy feat because they produce so many different products and sell them all around the world, but I'll generalize to sort of give a big picture that is hopefully helpful. Before I tell you about Deere's specific competitors though, let me say that Deere benefits comparatively from its massive scale, giving it economies of scale in manufacturing and more resources to spend on R &D proportionately, in addition to its outstanding brand awareness, which further supports sales efforts.

32:43Thanks to Deere's size, even though it spends less as a percentage of revenue on R &D than its next biggest competitor, its absolute spending is four times higher. So that's a pretty incredible technological competitive advantage, especially for an industry that's increasingly being defined by technology. And Deere's well-earned reputation has created a whole culture around customer loyalty to the brand, as many farmers proudly don their yellow and green hats while spending most of their equipment budgets at Deere every year. Some farmers say support for deer is almost territorial or religious, so there's a real subculture built around owning their products.

33:20Deer is the biggest player in an oligopolistic industry, with the most direct competition coming specifically from CNH Industrial and Agco, though neither match deer's size. And deer seems to be the vastly higher quality operation, given that its operating profit margin is about 8 percentage points higher than them both. When I say the industry is an oligopoly with a few big players, with Deere at the forefront of the pack, I mean it. In 1900, there were 166 tractor companies. Today, there are only three full-line tractor companies, Deere, C &H, and Agco, and they collectively control 72 % of the global market.

34:00For agricultural equipment, Deere in particular has 25 % of market share globally and holds over 40 % of the North American market by itself. Within North America, they have 60 % of the market for combines and about two-thirds of the market for new high-horsepower tractors, so for certain products, Deere is far and away the leader. The competition in construction and forestry machinery is much broader, but Deere is still third in these industries behind Caterpillar and Komatsu. The competitive landscape across other geographies varies, but in short, Deere seems to be an established player worldwide, but does not enjoy a competitive position as strong as that in the US.

34:41An important benefit for Deere of its scale and sprawling dealership network is that all these locations reduce the distance an average customer has to travel for maintenance work, which is extremely important to all of Deere's customers, whether they're harvesting corn or working on construction sites. And Deere's large footprint in the US certainly contributes to it being a more distinguished market leader there. I do think Deere's innovation isn't just corporate buzz either. It really separates them from the competition. Both CNH and Agco are playing catch up after years of being well behind.

35:16CNH, for example, acquired a business called Raven for $2.1 billion in 2022. Raven makes guidance systems, crop spraying gear, and driverless navigation systems that CNH sells on new machines and also retrofits. But many in the industry saw the acquisition as inherently an admission that CNH was behind Deere in building their own tech, making it necessary to buy Raven. In contrast, Deere's growth has been largely organic, and it operates just one tractor and combine brand, John Deere, recognizable by its ubiquitous green and yellow colors, whereas CNH and Agco operate multiple brands, so they don't have the same singular recognition that the John Deere brand has.

35:57Honestly, when you haven't followed a company or industry for years, it can be hard to know the nuances of these kinds of things. Still, by most accounts, it seems pretty well accepted that Deere is the industry leader, both in size and technology. Deere's management has been quite effective with strategizing and driving industry trends, but also equally capable in financial discipline too. They've overseen a balance sheet healthy enough to earn an A rating from credit rating agencies, and that has ensured that they have access to low-cost, short - and long-term funding as needed. And while it's often so tempting for companies to acquire other businesses as a way to artificially create growth, Deere's management team has used M &A selectively, with the 2017 purchase of Workgreen for$5.2 billion being the most important acquisition in recent years, while coming at a modest 9.5 times operating earnings.

36:47Work Green meaningfully enriched Deere's road building business while complementing its existing business in earthmoving equipment. The deal moved Deere's construction equipment business from being the 10th largest in the world to number three. They also have been diligent about returning cash to shareholders through both dividends and buybacks. Over the last decade or so, Deere has generated nearly$50 billion of operating cash flow, with three-fifths of that going toward capital expenditures that are reinvested into the company,$7 billion toward M &A, around$10 billion toward dividends, and$22 billion on share buybacks.

37:20Those massive buybacks have been enough to effectively gobble up 20 % of Deere's total share count. For the record, large dividend and buyback programs by themselves aren't objectively a good thing. Dividends are probably the least preferable in my opinion, because not only is Deere paying income taxes on that money, but now they're paying it out to shareholders who have to pay income taxes on it again. And then when it comes to share buybacks, these are only really creating value for shareholders if the share repurchase price is below the company's intrinsic value per share, which is sort of abstract.

37:53But the point is, I don't want to see management just buying back stock at any price. You want them to be very intentional about it. But all in all, share buybacks are more beneficial for remaining shareholders because they don't create a taxable event. The stock price might go up and you will own a larger chunk of the company, but no taxes are owed from your perspective. So ideally, I like to see companies either fully reinvesting in growth opportunities if they can do so with any remaining cash, and if there aren't sufficiently attractive investment opportunities, then an intelligent approach to share buybacks is okay too.

38:26That's a bit of a tangent, and I'm definitely being a bit of a perfectionist, but there are good, less good, and bad ways to return capital to shareholders. My impression of Deere is that they do a decent job striking this balance between reinvesting and not letting cash sit idly on the balance sheet, and thus either paying it out as dividends or doing buybacks if the stock is trading at attractive levels. Management actually aims to pay out 25 to 35 % of normalized earnings as dividends each year, meaning not the actual earnings that year, but an adjusted number based on where we are in the agricultural CapEx cycle.

39:01I take it as a good sign as well that besides the great financial crisis and a down cycle in agriculture between 2014 and 2018, the company has continually grown dividends for many years. Altogether, since 2004, Deere has returned an impressive 60 % of its cash flow from operations to shareholders. For Deere, the future remains all about staying on the cutting edge. According to both Deere and third-party estimates, there's a nearly$160 billion addressable market for incremental advances in agricultural, construction, and forestry technology. The company expects to capture about 25 % of that value in the coming years.

39:38That implies a deer has$38 billion of additional revenue growth opportunities before it. One example of what this would look like is deer's focus on building self-driving agricultural vehicles. While some equipment can already be remotely controlled, imagine if almost the entire process was autonomous. You could run tractors and combines 24-7 with no sick days. This isn't a distant dream either. They plan to have a fully autonomous corn and soy production system by 2030, including spring tillage, planting, spraying, harvest, and fall tillage. Deere is also leaning into climate tech too. They recently introduced electric drivetrains for their equipment.

40:18These help to reduce fuel costs and carbon emissions, and their use often comes with government subsidies, which are complemented by the fact that many farmers have onsite renewables like wind and solar to help power their vehicles. Correspondingly, Deere offers its own battery technology and charging infrastructure. Deere is just such a cool company to me. Maybe I was the only one who didn't realize it, but I had no idea they were such a trailblazing company in this way. I've only been more and more blown away as I've learned more about them. It's easy to get excited about all the different things they're working on, especially since they have such a strong track record in bringing their capabilities to life.

40:55Continuing to look ahead, the consensus on Wall Street seems to be that Deere's revenue will be flat in 2025, but will grow again by 4 % in 2026, and Morningstar forecasts, approximately 5 % annual revenue growth from 2026 through 2028. For deer, it helps that farmers are still relatively flush with cash. Their equipment fleets are older than in prior business cycles. But on the flip side, farm income is falling off its peak and the geopolitical environment is fragile, to say the least. And in construction equipment, strength from infrastructure spending, thanks to large government spending plans like the Inflation Reduction Act, is partially offset by slowing growth in residential home, office, and retail construction.

41:36The biggest knock on Deere as a quality compounder is simply the inescapable cyclicality of the farming industry. The normal business cycle has its ebbs and flows, but the ag cycle is like a chicken with its head cut off, bouncing around. Spending can jump unpredictably based on everything from weather, crop disease outbreaks, labor availability, and commodity prices, to interest rates and government policies. But Deere's sales are fundamentally connected to how farmers are doing, as farmers' net cash flows are the biggest cyclical driver of demand for Deere's high-priced equipment. Beyond agriculture, Deere is tied to cyclical trends in housing market conditions, consumer spending patterns, and general economic conditions that affect demand for its lawn and garden tractors, residential and commercial mowers, and golf and turf equipment.

42:23Same story for its forestry, road building, and construction equipment. Deere's global operations definitely helped to nerf some of this cyclicality, since different countries have different weather and economic trends, but it doesn't completely eliminate the fluctuations. 2022 and 2023 were exceptionally strong years for Deere, so 2024 has marked a significant pullback in spending on their machinery, the number of sales metrics declining by 10-20%. 2024 was largely a below average year with revenues and profits coming in at roughly 80 to 90 % of what management thinks they can earn mid-cycle.

42:58Lower commodity prices and higher interest rates, plus some abnormally high weather volatility, have made it a bad year for the global agricultural industry. Without a doubt, Deere has felt the effects of that, which again is not unexpected. So don't let big year-over-year declines in revenues, profits, and even profit margins scare you. I'm not saying to write these off if they're worse than expected. That's just what happens in cyclical businesses like Deere. Let's take a quick break and hear from today's sponsors.

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46:49All right, back to the show. Looking at 2024, Dear CEO says they were at the same point in their business cycle in 2020, meaning 2020 is a better year for comparison than say 2023 or 2022. In 2024 versus 2020, operating profit margins were seven percentage points higher, showing how Deere has structurally lowered costs and improved profitability throughout the organization. When thinking about risks with Deere, there's a lot to consider. Misreading the business cycle around agriculture and machinery spending more broadly could mean investing at a bad time or totally miscalibrating your valuation for the company.

47:25Deere is also exposed to potential union-related issues since 80 % of its U.S. production and maintenance employees are unionized, as are most international employees as well. We saw this in effect when 10 ,000 of Deere's workers went on strike back in 2021 for five weeks. Beyond the production disruptions was the cost of the negotiations themselves, where Deere agreed to immediately raise salaries by 10%, with more raises promised in the future and a$8 ,500 signing bonus. The incremental cost of these salary increases will come out to around$300 million a year, according to Deere's CFO. More speculative risks include the possibility that plant-based diets and lab-grown meats will change food consumption patterns globally, which would ripple back and affect big agriculture.

48:10Changes in inflation and interest rates can also have considerably negative effects on farmers and their ability to continue spending on the latest machinery. And then there's, of course, an element of credit risk in Deere's financial services subsidiary, where an economic downturn could trigger an above-average wave of defaults on machine and equipment purchases. There are also all sorts of operational risks, from falling short of promised technological innovations to building up too much or too little inventory. Being an industry leader in the way that deer is can be a blessing and a curse, too.

48:40As it sits at the forefront of agricultural equipment, this just means that every other company is coming after them specifically. Complacency, then, is a real risk for deer. Resting on its laurels is the worst thing it could do. You could probably say as well that a lack of high insider ownership at Deere is a risk in its own way, in the sense that this could be a red flag about the culture, management's incentives, or just whether management has much faith in the business at current valuation levels. This is sort of a mixed bag. On the one hand, I always pay attention to insider ownership because it can definitely signal important things about the company.

49:14On the other hand, high insider ownership can mean that management is being egregiously compensated with stock options that are very dilutive to existing shareholders. Otherwise, for a company as big as Deere, it just takes a very, very long time to accrue a meaningful stake in the company. And given that the company is almost 200 years old, the original founders, who would naturally be the largest shareholders, are long gone. And as time has passed, I'd say it's not surprising either that their descendants have ultimately diversified their wealth. The point is, this isn't some tech startup where the CEO has no skin in the game.

49:47This is an old and massive company. So even for someone who's been on the management team for a decade to accrue what you might call a significant stake would be challenging. The$120 billion market cap, you need to have more than$1 billion worth of stock just to have a 1 % stake in the business. And as I said, if an insider today can build up that large of a stake, they're probably being way overcompensated at shareholders expense. What matters more than the percentage of insider ownership is the incentive structure for management. And Deere made an excellent change to its compensation structure in the early 2000s by prioritizing shareholder value added as the core metric for managers' compensation.

50:26Former CEO Robert Lane led the initiative after concluding that the company had done a good job creating value for employees, farmers, and communities, but it had not been a great company for shareholders. The goal then was to make Deere an outstanding company for shareholders too, and by all measures, the change in compensation structure has worked as hoped. For example, instead of just incentivizing management to reach specific revenue or profit targets, the new incentive structure relates more to capital allocation connected to metrics like operating profit margins, return on assets, return on equity for the financial services division.

51:00So I'm not losing sleep over what you might consider an uninspiring degree of insider ownership, since a focus on large insider ownership is typically more realistic with smaller or at least younger firms. You might find it interesting though that Bill Gates is actually one of the largest investors in Deere, which complements the fact that he's also the largest owner of farmland in the US. So through his firm Cascade Investments, Gates is all in on agriculture with enough conviction in Deere to own more than 7 % of its total outstanding shares. That's a massive position. Bill Gates is obviously a smart guy.

51:34And I'd imagine that Deere stood out to him as he built up his investment in farmland and learned more about the agricultural industry. Before I get into Deere's valuation, I want to share an anecdote on John Deere. Investing legend Phil Fisher called this the scuttlebutt approach to investing. The idea is to try and talk to as many stakeholders as possible in a business to understand it. Anecdotes are only worth so much individually, but you can sort of build a mosaic of insights from conversations with employees, customers, and competitors. For me, I always try to take a scuttlebutt approach to investing and ask people what they think, or at least go on someplace like Reddit and see what's organically being said.

52:12So I spoke with my colleague, Clay Fink, who hosts our We Study Billionaires podcast and whose dad and brother are actually farmers in Lincoln, Nebraska. Clay told me that most farmers where he's from use John Deere, and the big farmers especially seem to always use Deere. From his perspective, though, it wasn't so black and white as to say whether people love the company. He said that with his dad, it's tough to say whether he likes the brand at all or not. While he would probably never switch to another brand, Clay feels that John Deere and other big players in the agriculture industry are squeezing margins for everyday farmers like his dad.

52:44He told me that a big reason his dad used this deer is that they have dealers nearby to help him fix equipment, which again very much aligns with the research I've read on the company. Where Clay's grandpa could fix equipment on his own, the technology is too high tech nowadays, so his dad frequently has to call the dealers who fix things. Net assistance is not cheap. Accordingly, Clay and I both believe that having dealers all over the country is a strong moat for deer. Willingness to pay up for quality machinery and loyalty to a brand like deer is not an irrational perspective to have, even if farmers are sometimes frustrated by the company, given that the cost of large tractors spread over their useful life represents only about 2 % of farm revenue.

53:21This is a much lower percentage than a farmer would spend on seed, fertilizer, and labor, and yet these machines are vital. So even if they're not always happy about being stuck in the middle of Deere's product ecosystem, they're still likely to keep paying up. Farmers have a short, weather-restricted window to complete a task, such as seeding or reaping, and it is critical that the large farm machinery is working when needed, so like I said, having a robust dealer network for repairs is a major advantage. A good scuttlebutt approach is more thorough than this and talks to many more people, but is always reassuring to hear real testimonies to things you read about in some Wall Street analysis or earnings report.

53:58Turning toward Deere's valuation, one of the tricky parts of this is that it's not just Deere's revenues that swing during cyclical turns, their profit margins can fluctuate wildly too. Deere's operating profit margins swung from 15 % in 2013 to 9 % in 2015 and has leapt higher to over 25 % today. So if you were really trying to build out a discounted cash flow model to value the company and project its growth, you'd have to not only get its revenue growth right, but you also have to have a good feel for where its profit margins would go correspondingly as well. Margin swings to this extent are not that common, and it really does complicate the valuation by adding in more layers of assumptions.

54:37However, I do think Deere's higher profit margins are here to stay, since they've mostly come from price increases that customers have absorbed thus far, as well as from subscriptions and part services that are higher margin. It is also good to see that even in downturns, Deere has remained profitable, and during these downturns, they tend to cut down on overhead expenses rather than R &D, which is good because R &D spending is critical for developing new technologies that will drive the company's next wave of growth. In the book, The John Deere Way, David McGee writes that quote, John Lawson was with the company for 44 years and never remembers a time anyone suggested cutting back on research and development spending, even in the toughest times.

55:16This is one of those instances where culture really matters. Clearly, Deere has a culture of thinking long-term. You could easily take shortcuts and reduce R &D spending in a given quarter to boost profits, but that would ultimately come at the cost of the company's reputation and new products. And I mentioned this earlier, but Deere seemingly carries a massive debt load. But in reality, these are mostly just loans that Deere Financial has made in underwriting customers' equipment purchases. Net debt of$60 billion on a company with$110 billion of market value for its equity would be pretty extreme.

55:48At the end of 2023, only about$8.4 billion of its outstanding debt was tied to its equipment operations, with the rest being connected to Deere Financial. This segment also has$6 billion of cash, so the net debt is just a bit over$2 billion, which is a much more conservative picture. Leandro adds in his analysis that, quote, there's no denying that financial services runs with high leverage. It's a financial business, and leverage is a requirement to obtain acceptable returns. We also know financial businesses tend to get into significant trouble due to this leverage when things turn south occasionally.

56:24Am I not worried about Deere following a similar path? The answer is no, and for several reasons. He adds, first, the company has been operating in this niche for almost two centuries. We could argue it knows its customers, both farmers and dealers, well. Looking back, we can see that the company's lost provisions have never spiraled out of control, and even during harsh downturns. This makes sense considering Deere understands the cycles, farmer economics, etc. And again, it's worth mentioning that if Deere Financial did have to collect on an outstanding debt, the collateral would be Deere's own equipment with a high residual value even when used.

56:59So that adds further peace of mind here. Whenever valuing a cyclical business, it's important to keep in mind that valuation metrics like the price to earnings ratio will typically look the cheapest the company is earning the most, since investors are expecting those above average profits to normalize going forward, and will look the most expensive at the bottom of the cycle when earnings are the most depressed. It's sort of the opposite of what you might normally expect. A higher P.E. can mean that stock is cheap if earnings are depressed, and a lower P.E. can mean expensive if earnings are elevated.

57:30So thinking about a fair valuation multiple adds another layer of complexity to any valuation of Deere. For starters, I want to begin with an approach outlined by Aswak to motor in when assessing cyclical businesses. He suggests averaging out the operating margins for a cyclical business over the last decade, and then multiplying that margin by the company's last 12 months of revenue. With Deere, you might, for example, have a higher than normal revenue figure, but that's offset by averaging out the profit margins since the average margins over the last decade will be lower than at the peak of the cycle.

58:00Deere, this gives you a rough proxy of what Deere's normalized operating profits look like, and then so long as you have an estimated growth rate for the company's earnings, return on capital, and cost of capital, you can estimate the value of Deere's operations. It's hard to go through that process in a podcast format, but in this week's Intrinsic Value Newsletter, I'll show how this is done. From there, to get the per share stock value, you'd make some adjustments to this operating asset value by adding the value of the company's assets, like any cash, then subtracting out debt and dividing by the number of shares outstanding.

58:31In the basic model I built for Deere, I followed this approach from Aswath to Motoren and found that the stock was, at least through this lens, pretty overvalued. That said, averaging the last decade's margins to normalize Deere's profitability doesn't account for the fact that the company is increasingly relying on software subscriptions and other services that have higher profit margins. If you take management at their word and think the company can hit 20 % normalized margins versus their 14 % average operating margins over the last decade, then that improves Deere's value per share considerably, but I still found it to be modestly overvalued.

59:04In a third, even more optimistic scenario, since management said 2024 represents about 80 to 90 % of their mid-cycle earnings, we could correspondingly add a multiplier to Deere's 2024 revenues to try and get a normalized revenue number and then slap on management's targeted 20 % operating profit margin too. That basically embeds two layers of optimistic assumptions for both revenue and margins. And correspondingly, if those are accurate, then I do get a valuation for the company where the stock looks more attractively priced. But obviously, there's a reason I said this was the optimistic scenario.

59:36You're putting a ton of trust in management's projections just to justify a modest premium to the stock's current valuation, which isn't something I generally feel great about. And I'll add that when you value different companies, you don't always have the same conviction in your numbers. I'm not equally confident in the accuracy of every valuation. Similar to how I felt about trying to value coupang, there are a lot of moving parts here at Deere, so I'm not particularly confident in my valuations. Not only are Deere's cyclical sales a complicating factor, but so is Deere's financial services division.

1:00:08All that leverage and borrowing expenses makes it tricky to value the rest of the company's operations in a vacuum. And then when you consider that Deere has a large and growing software business, there are all sorts of adjustments that need to be made to capitalize R &D. Without going on too much of a tangent, current accounting rules don't reflect economic reality for many tech companies because most spending they do on developing applications and software mostly has to get expensed immediately, which can artificially reduce net income pretty substantially. Yet if a company builds a factory, it can depreciate the cost of that over 30 years.

1:00:41So the point is that technology costs often get written off immediately, and you'd want to adjust at least some portion of R &D expenses to reflect that the software John Deere has built will have value for years. And again, that's a complicated process too. I probably sound like I'm copping out of putting in the extra effort to build an extremely thorough model for Deere, but there's a good reason that Warren Buffett has a too hard basket for stocks. You don't necessarily get any extra reward for figuring out how to value Deere's manufacturing business, accounting for the effects of its financial services division, and then adjusting its accounting to reflect that its software technologies are lasting assets.

1:01:18Given this, it's probably best to just rely on a very simple mental framework for thinking about the company's potential returns to shareholders. Free cash flow is what drives returns for shareholders. And today, management says they're generating about 80 % of mid-cycle earnings. So we're in the midst of a down cycle. With a 3.6 % free cash flow yield at the time of recording, I just divide that number by 0.8 to get an estimate of normalized mid-cycle free cash flows. Doing so suggests a 4.5 % free cash flow yield. And so long as the company can continue growing revenue between 3 % to 5 % on average, with more of that revenue coming from higher margin subscriptions and tech services, then earnings per share could rise even faster than revenues at 5 % or more per year.

1:02:01A 4 % plus free cash flow yield plus 5 % earnings growth plus Deere continuing to be aggressive about buybacks makes a pretty strong case for Deere growing earnings per share by 10 % or more over the next few years, and you'd expect the stock's performance to closely follow that. I think the story here for Deere is how much you believe in their technology and, thus, their ability to transform a chunk of their revenues from being just machinery sales to being more subscription-based with higher profit margins. There are all kinds of tech-enabled add-on services that Deere can offer, and if that works out as hoped, that will be a huge boon for the business in a few different ways.

1:02:37Firstly, less cyclical revenues are always a good thing for stability and business planning. Correspondingly, subscription-based revenues have a negative cash conversion cycle, meaning Deere gets paid upfront before services are rendered and therefore can treat that float as a form of interest-free financing, which is really advantageous compared to paying to produce a tractor first, then getting paid for it later once it's sold. From the stock's perspective, an improved cash conversion cycle and less cyclical revenues would almost certainly boost the company's valuation across different multiples because markets generally pay up for earnings quality.

1:03:12The more predictable that earnings are, the higher the price to earnings ratio typically, and as Deere migrates from a more cyclical business to a less cyclical one, relative improvements in the average P-E ratio throughout the business cycle would be a real tailwind for investors' returns. I said this earlier, but just to have it at the top of mind, again, by 2030, Deere hopes to have 40 % of its revenues coming from recurring sources, with 10 % coming from subscriptions specifically. So we're still in the early stages of that transition, but it's very much on the horizon. However, I will say Deere will always be a company oriented around equipment sales.

1:03:48As Leandra frames it, quote, I don't anticipate Deere will look like a software business in the coming years, but the transition to a more software-like model should undoubtedly improve the company's margin and cash conversion profile. All in all, I remain impressed by Deere's long history, customer loyalty, ability to remain an industry leader for so long, commitment to innovating on behalf of farmers, and management's focus on creating value for shareholders. Just looking at the company's returns on invested capital in the past few years, Deere has had some impressive results, even in light of the post-pandemic era being an upcycle for the agricultural industry.

1:04:25Looking at Deere's core equipment sales business, so not counting the financial services division, its ROIC has surged higher in part because the company has been able to raise prices so meaningfully in the last few years. Pricing power is the best way to boost returns because it comes at no marginal expense. There's no cost to raising prices besides potential fall-offs and sales volumes. But for Deere, higher prices more than made up for any corresponding declines in sales volumes, contributing considerably to its return on capital calculations. This is a good demonstration of how Deere's business quality has already improved.

1:04:59And for many of the reasons we have discussed today, I expect it will continue to improve. I really try not to rely excessively on models if there's a more common sense way to understand things, and which on Deere, I feel that it's a high quality company that's becoming increasingly greater quality. With that said, Deere is going into my too hard pile. I've learned a lot studying the business, and it is one I'm going to keep tabs on and maybe revisit in a future episode, but I probably won't have FOMO either if it does well, simply because I just don't feel as though I understand it well enough.

1:05:29With well north of$100 billion market capitalization, Deere is just so big. Think about the company you work at and the nuances of trying to understand everything that's going on there. It just gets so much harder as the business scales up, so I don't necessarily expect to find many large cap companies bordering on mega cap that are easy to understand in full or aren't already trading at fair value. For now, I want to focus on opportunities where I can walk away and feel like I understand how the business is structured, who it's competing with, what's going on in the geographies it operates in, and all that sort of stuff.

1:06:00Deer's global operations with so many different product lines means that it's competing directly and indirectly with dozens and dozens of different companies and is vulnerable to many different factors. With time, I might get more comfortable with that, but with only a week to research the company, you can see why I put it in my too hard pile. It probably doesn't help that I grew up in the suburbs, so the agricultural industry is completely new to me, and it's no simple thing to wrap one's head around. When I compare Deere with Ulta, I can clearly envision who Ulta competes with because I've been to Sephora and use Amazon almost every day.

1:06:32They also only operate in the US and have one core business model. And they don't have a huge technology focus either. For better or worse, Ulta is much more understandable to me, and I'm probably biased by that, but I'd rather be biased in that way than invest in businesses that I don't understand well enough. So I don't plan to add Deere to our intrinsic value portfolio, but I do want to hear what you think. On Spotify and YouTube, you can leave your comments below and tell me whether you agree with the decision. With that, I'll wrap things up today with a timely quote from John Deere himself.

1:07:05The man behind the brand tells us, quote, I will never put my name on a product that does not have in it the best that is in me. It's safe to say that mentality has continued well on after his death. Before I go, I want to give one last shout out to Leandro of the Best Anchor Stocks newsletter for his excellent coverage of John Deere. And I also want to mention that if you're planning to be in Omaha this year for the Berkshire Hathaway shareholder meeting, please don't be a stranger. Investors Podcast Network is hosting two nights of events with free food and drinks, and I'd love to meet you in person there.

1:07:38For more information, just email sean at theinvestorspodcast.com. That's S-H-A-W-N at theinvestorspodcast.com. Thanks for listening. I'll see you again next week as I break down another fascinating business and look for high quality investments to add to our intrinsic value portfolio.

1:08:18consult a professional. This show is copyrighted by the Investors Podcast Network. Written permissions must be granted before syndication or rebroadcasting.