Wednesday, May 4, 2016

An Elephant For Berkshire, or Rather a Deere

Warren Buffett took his Elephant Gun out once last year with the purchase of Precision Castparts and there might be an opportunity to do so again soon with one of the worlds most iconic brands, John Deere. Deere & Company (DE) is absolutely the type of business that Buffett would consider for Berkshire Hathaway. It has few competitors and is easily the best business in its industry. In the United States, farmers by far prefer John Deere green to the other competitors AGCO and CNH Global (1).


Having this wonderful brand allows Deere to not just sell more tractors and equipment, but to sell them at a higher price. This is evident when you compare the average gross margins over the last 5 years. 
  • Deere = 25%
  • AGCO=21%
  • CNH = 18%
If this isn't the kind of moat Buffett is looking for then I don't know what is.
Since Deere sells most of its products to commodity producers it is a cyclical business. But, farmers and construction companies can only wait so long to replace their equipment. This causes Deere to have lumpy earnings but Buffett historically has had no problem with this if he is getting a great business. Deere is no doubt in one of those lumpy periods right now as revenues and earnings are down around 30% since 2013 when grain prices were much higher. 



Deere helps many of its customers finance their equipment. Since 2010 Deere has seen its loan portfolio grow from $17.6 billion to $24 billion. In 2002 its loan portfolio was just $9 billion. Because of its stronger financial position, there is an argument to be made that Deere would benefit from being part of Berkshire Hathaway. 

The farming industry has been going through dramatic changes in recent years seeing larger and more sophisticated equipment. Many of the functions such as planting, driving a grain cart, and harvesting are now automated. It is very possible that 10 years from now a person is not required to physically operate the equipment. Because Deere has much higher margins and profits than it's competitors it will be able to allocate more money to developing these technologies, thereby increasing the massive moat it already has.

John Deere Self-Driving Equipment (CBS Special)



Normally I prefer using owner earnings to figure out the earning power for the business but for Deere that is rather difficult. Deere finances a lot of their customers equipment themselves. This causes much of Deere's cash from operations to flow into these leases. For Deere I actually consider earnings per share (EPS) to be a good proxy for the company's earning power. Below is a graph showing Deere's EPS from 1998-2015.



Berkshire recently purchased Precision Castparts, an aerospace parts supplier, for $32 billion. PCP was making about $1.6 billion at the time of the purchase. This means Buffett paid 20 times earnings or accepted a 5% earnings yield on this investment. PCP is nearly certain to have higher earnings in the future as it is a fantastic business and I think this stretched the limits of how high Buffett is willing to pay up for a great business.

The idea to purchase Precision Castparts for Berkshire came from one of the new investment managers, Todd Combs. Todd first bought PCP for his Berkshire investment portfolio in the 3rd quarter of 2012. Just before the 4th of July in 2015 Mark Donegan, the PCP CEO, stopped by Berkshire to meet with Todd and at the end of the meeting Buffett stopped in to chat. He was very impressed by Donegan and asked Todd Combs to see if the board of PCP would be receptive to an offer from Berkshire. Buffett has committed to never doing a hostile takeover so this is very important. The board was receptive, Berkshire made their $235 per share offer, and they accepted the offer.

In interviews Buffett makes it seem like he didn't really follow the company that closely but I would say that is extremely unlikely. Though he allows Todd and Ted to make their own investment decisions I'm sure he keeps up with the businesses they own as that is his favorite hobby! Once Buffett realized how good Donegan was as a manager I think it was an easy decision for him to make an offer.

Todd and Ted

(2)

Berkshire currently owns a $1.9 billion position in Deere. Todd and Ted manage $9 billion for the company so this would make it a 21% position for one of these managers. I think it very possible that a situation similar to Precision CastParts could happen if Deere's board of directors is open to an offer. If they are not it is a non-starter and Buffett won't pursue a deal any further.

Because of Deere's cyclicality I don't believe Buffett would pay the high premium he did for PCP. But I think it is reasonable that he would accept a 7% earnings yield vs 5% for Precision Castparts. With earnings of $5.77 in 2015 this means Buffett would be willing to pay around $82 ($26 Billion) to purchase the whole business. Right now that is where the stock is trading so it is unlikely that there is a deal to be made as the board would want a premium to the stock price. If the price were to decline to $70 or less I think it is very possible for the wheels to get turning on Berkshire making an offer.

Berkshire Hathaway currently has about $43 billion in cash on it's balance sheet. $23 billion of that can be used for a deal as Buffett has said he will never go below $20 billion. With a market cap of $26 billion, Deere is the right size for Berkshire to be able to handle comfortably with a small debt issuance or waiting a few more months for cash to pour into Omaha.

Right now there is probably not a deal to be made for Berkshire purchasing Deere, but it is getting close! In summary:
  1. Deere is a great business with a strong moat and is almost certain to be making more money in 10 years.
  2. If the Deere board is open to it, Berkshire might make an offer.
  3. I don't believe an offer would be for much more than $82 so the stock probably has to trade down to around $70 for a period of time before one would be made.

John Deere S690

(3)

Disclosure: No position in Deere

1. http://www.machinefinder.com/ww/en-US/articles/john-deere-dominates-brand-loyalty-among-midwest-farming-base-2192

2. http://www.cnbc.com/2014/10/14/warren-buffetts-stock-pickers-are-crushing-it.html
3. https://www.deere.com/en_US/products/equipment/grain_harvesting/combines/s_series/s690/s690.page

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