Buy Deere And Watch It Run

Last April, I recommended that investors buy Caterpillar CAT due to the fact that short-term macroeconomic issues had depressed its valuation. CAT has been the top performing Dow stock in 2014 and is up about 25% since my original call, pushing its valuation high enough to the point that it now only earns our Neutral rating.

Luckily, investors have another opportunity to invest in a high quality industrial company with a great brand at a cheap valuation. Deere & Company DE is a market leader in agricultural machinery with a growing business in construction and forestry. Deere grew after-tax profit (NOPAT) by 20% in 2013, but the stock missed out on the bull run entirely and is nearly unchanged from a year ago. After the company cut its sales forecast on May 14 and the stock fell roughly 4%, DE is now a solid buy-on-the-dip opportunity.

DE is a Market Leader

DE’s 18% return on invested capital (ROIC) ranks third out of the 25 construction and farm machinery companies we cover. Its 11% NOPAT margin ranks fifth. For both of these metrics, DE ranks significantly ahead of its most significant competitor, AGCO Corporation AGCO, which has an ROIC of 12% and a NOPAT margin of 7%.

DE’s superior margins and returns, in addition to its larger scale, give it a competitive advantage over AGCO that it’s utilized effectively. Even though Brazil had been dominated by AGCO in the past, over the past decade DE has managed to gain a 20% market share in the country by offering lower prices and leveraging its well-known brand.

In recent years, DE management has done especially well at creating shareholder value. DE’s economic earnings margin (Return on invested capital-Weighted average cost of capital) in 2013 was the highest it has been in the history of our model.

The Construction and Forestry segment gives DE a bit of diversification, even if it is much smaller at only 16% of revenue. In the first half of 2014, as Agriculture and Turf segment revenues declined by 7%, Construction and Forestry helped to offset this decline somewhat with a 3% increase in revenue and a 48% increase in operating profit.

Short Term Issues, Long Term Opportunity

There is no doubt that 2014 will be a tough year for DE’s bottom line. Falling agricultural commodity prices have hurt farm incomes, which in turn decreases the amount of spending on DE’s agricultural products. Management has guided to a 4% decrease in revenue for 2014, even accounting for a recovering housing market spurring growth in the Construction and Forestry segment.

Investors should not confuse these short-term macroeconomic issues as a long-term problem for DE. As global population grows by over 1% a year, and millions are lifted out of poverty every year, the amount of food production the world requires is only going to increase.

Meanwhile, DE is keeping costs low this year to minimize the decline in its profits, and the company should have no problem generating enough free cash flow to maintain its dividend and fund its buyback program. The company authorized $8 billion (24% of market cap) in buyback in December. DE’s most recent Form 10-Q shows that the company repurchased ~$1.1 billion worth of stock in the first six months of FY 2014, which leaves a significant amount of funds remaining.

DE’s large buyback is a great sign for investors, as it signals that the company believes in its long-term future and is committed to buying shares this year while they are undervalued.

Buy on the Dip

DE had been outperforming the market this year until it cut its sales forecast from a 3% decline to a 4% decline on May 14 and the stock dropped by 4%.

At its current valuation of ~$91/share, DE has a price-to-economic book value (PEBV) ratio of just 0.8, which implies a permanent 20% decline from 2013’s NOPAT. It seems unlikely that DE will experience a 20% decline in NOPAT this year, and even less likely that the company will never bounce back and grow profits after that point.

Even with highly conservative forward expectations, DE looks significantly undervalued. If we give the company credit for just 10 years of 4% NOPAT growth compounded annually, which incorporates a 9% decline in 2014, the stock has a present value of ~$130/share or 45% upside from the current valuation.

Sell CAT, Buy DE

We are not bearish on CAT by any means, but at these levels we no longer consider it a great value stock. If CAT grows NOPAT by 7% compounded annually for 15 years (roughly the same growth rate as its last 15 years), the stock is worth ~$115/share today, still above the current valuation of ~$105/share, but not by all that much.

If you bought CAT when we recommended it last April, you’ve earned a 25% return and outperformed the market. DE today presents many of the same opportunities that CAT did last April. It’s an undervalued market leader with short-term issues but strong growth potential in the long-term. DE may be an even better bet than CAT was due to the fact that demand for agricultural products is a bit more stable than construction/mining.

Good Holdings Make Good Funds

Mutual fund investors should also take a look at the Oppenheimer Main Street Select Fund (OMSCX), which allocates 3.2% of its assets to DE and earns our Attractive rating.

Sam McBride contributed to this report.

Disclosure: Sam McBride currently owns CAT but may sell CAT and buy DE in the next 72 hours. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector or theme.