When you think “tech companies,” you probably don’t think John Deere (NYSE: DE) or Caterpillar (NYSE:CAT), but these two businesses have been quietly building meaningful technology businesses. In this episode of Industry Focus: Energy, host Nick Sciple is joined by Motley Fool contributor Luis Sanchez to break down what both of those heavy machinery companies are doing in technology, as well as take a high-level view of what it means to be a tech company in 2021.
To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on April 1, 2021.
Nick Sciple: Welcome to Industry Focus, I’m Nick Sciple. Today on the energy and industrials podcast, we’re talking about technology. Of course, we aren’t talking about the kind of technology that helps you sell ads online or play the latest video game. No, we’re talking about the technology that helps blue-collar folks like construction workers and farmers do their work more efficiently. That’s the kind of technology that companies like Caterpillar and John Deere are delivering to their customers today. Today, our Motley Fool contributor Luis Sanchez joins me to break down these two industrial giants and talk about why the market may not be giving them enough credit for their tech offerings. Luis, thanks for joining me on the podcast once again.
Luis Sanchez: Thanks for having me.
Sciple: Always great to have you on the podcast Luis. We’re throwing a curveball, we’re talking about tech on the energy show, and I think one of the big tech words you’ll hear all the time is meta. There’s a metaverse, there’s a metagame, all those sorts of things. Maybe let’s talk about the metaworld of investing. We’re talking today about Caterpillar and John Deere. These are companies we think of as like country music type of companies, hardhat type companies, blue-collar type companies. Are they what do you think of it as a tech company or what is a tech company today in 2021?
Sanchez: That’s actually one of my pet peeves when people talk about “this company is a tech company, and this company is an old-school legacy company.” The line, over time, has not just blurred, it’s disappeared in a lot of ways. In 2021, basically every company, if they’re not tech-enabled, they’re not doing too well. All these companies are using tech. They may not be pure-play tech businesses in the classical sense, but they’re using a lot of tech, as we’ll talk about.
Sciple: Yeah. If you look at the metagame of business, the dominant strategy today involves using some type of tech. That’s part of the strategy you have to play. One of the examples, I think it’s an interesting framework to think about of a transition from a company that’s maybe traditionally hardware-focused to rolling out more technology offerings: Apple‘s always been a technology company, but this move into services and software, I think it’s an interesting example that maybe we can use that as a framework to talk about what’s going on with these two businesses. With that as a background, Luis, can you tell us about the Apple example, and how that maybe applies to what we’re going to talk about today.
Sanchez: Sure. It’s an interesting comparison to make because historically, Apple has always been primarily a hardware company. They sell laptop computers and they were selling iPhones, which they’re primarily making money at the point at which you buy the device. Over the last five years or so, the services side of Apple’s businesses has really taken off, and it’s become a very large business in and of itself. So they are still selling this hardware, but they’ve been able to attach this really high-margin service revenue on top of that. Just to throw out a stat, last year, Apple generated $54 billion in services revenue. Which shows you this company that’s historically been perceived to be pretty much just a hardware company is a massive service/software company too.
Sciple: Absolutely. That opportunity you unlock with your installed base of devices across the world, across all your users. Well, these industrial companies have an installed base of devices just like Apple does, but there are some differences when you think about the type of customer that Apple has and the type of customer that’s maybe using some of these pieces of industrial equipment. What do you think are the biggest differences, maybe between Apple’s business and then the type of technology that these companies are trying to sell to their customers, and maybe how they go about selling it.
Sanchez: The distinction is Apple iPhones, they’re really a consumer product. Consumer products are marketed in a certain way that appeals to people. That could just mean like selling a flashy feature or selling a look. People want to look cool, and I think a lot of people have talked about how Apple devices are still well designed, they’re almost like a fashion statement. Versus like a tractor — certainly, a lot of people do care about what their tractor looks like, I can assure you that. But they probably care most about what kind of load can they haul on the tractor, and really what the ROI is going to be on using a piece of equipment. I think that’s the distinction between how a business analyses an equipment purchase versus when a consumer thinks about which phone they want to buy.
Sciple: One other distinction — we can talk about this as we move into Caterpillar — is just the rate of adoption. I think the regular consumer, may be quicker to it to pick up the new iPhone or the new piece of technology than maybe some of these older industries that have been around for a long time. We’ve been mining and farming for 100-plus years. Some folks in these industries maybe have some ways of doing things that they’re less willing to change, or really need to see dollars-and-cents about why we’re going to make this changeover.
Let’s get into Caterpillar. We’ve been using this Apple analogy, I talked about the installed base of devices. When you think about Caterpillar, what is this installed base, what is this traditional business that the company has been at?
Sanchez: Caterpillar is a global heavy-equipment conglomerate. They serve all sorts of different end markets. They’re building mining equipment. They’re doing a lot of construction equipment — excavators and backhoes. They are also servicing the energy market with pumps, and they are servicing the transportation market. If you need to do a big, heavy project, whether it’s build a building or move a bunch of rocks or move a bunch of fluid, Caterpillar is probably going to be involved at some point in that process.
Sciple: Exactly. If you drive into a construction site or a mine or anything like that, there’s going to be a Caterpillar piece of equipment out there. When you talk about Caterpillar’s business historically, the hardware, where has Caterpillar made its money?
Sanchez: I think the way to think about it is like Caterpillar is an OEM. They sell the equipment and they distribute it through dealers. I think the best analogy is to compare it to the automotive market, where you have Ford and GM that are making the equipment, and then they’re distributing through dealers who they sell to at a wholesale price, and who mark it up. The transformation that’s really happened over the last 10 years or so is that now, this equipment is coming pre-installed with a software and pre-installed with a bunch of sensors. The primary way that Caterpillar is making their money off of this is they’re putting more stuff into the equipment, so they’re charging more money for the equipment. But there also is an opportunity down the road, and in some cases today, where they’re actually charging extra for some of this technology.
Sciple: Right. I think one of the things you talked about with me, Luis, is how servicing is really an important part of Caterpillar’s business. There is a certain amount of recurring revenue with these devices. Now, as you attach some of this technology, you get maybe other forms of recurring revenue as well as it can maybe help the servicing side of their business as well.
Sanchez: For sure. The mind-blowing statistic that someone told me was, over the life of the average Caterpillar machine — and there’s a diversity of different machines — but over the life of a machine, a multiple of somewhere in the order of four or five times as much money is spent on parts and servicing for that equipment than is spent on the original price. That illustrates the aftermarket revenue opportunities as they refer to it. To contextualize that even more, these machines aren’t cheap. Some of these pieces of equipment could go for seven-figure dollar amounts. If you think about a mining company that might be spending $1 million on a large truck that can haul this material, and then think about the millions and millions of dollars they spend over a 10 to 20 year life on servicing that equipment, you could really start to understand like, “OK, this business model is really interesting, and it’s not just about a one-time transaction.”
Sciple: Absolutely. I think that illustrates another one of those points we talked about earlier about maybe the difference between Apple’s attachment of some of these technology services versus Caterpillar. You’re getting a new iPhone every three years, you’re not turning over your Caterpillar piece of equipment except for every five, 10 years, depending maybe if you buy used, maybe shorter than that but when you’re talking about this new technology that the top-of-the-line equipment with the latest technology to Caterpillar is implementing, what are those offerings the company has and why is this something that’s really going to be meaningful for customers and for the business?
Sanchez: For sure. They have various different technologies that they’re using, and they categorize it into three buckets. The first bucket is what they call telematics, the second bucket is the automation, and the last bucket is e-commerce. To start with telematics, it’s a fancy word but essentially, what it means is you’re putting a bunch of sensors into the machine. You’re putting sensors that can give you data about the health of the machine, which parts of the machine need to be serviced, where the machine is (so, GPS). You’re really turning that equipment into something that generates data that can be analyzed. Obviously, you can directly translate that into software, because once you have data, then you can do something with the data. What the goal is here is twofold. The first part of it is all about efficiency, so it’s helping customers figure out how to better utilize their equipment. The customers, they could see the analytics and they could like, “OK, these machines are operating at 90% utilization. I currently have a fleet of 100 trucks, maybe I only need 95 if I want to be fully utilizing.” It helps customers make decisions about how to optimize.
Then the other side of it is, this is where the data could actually be predictive and it could actually help the customer maybe know in advance, “This equipment, it might need a new tire in another couple of months, maybe we should get on that.” Or, “There’s a service warning here, so maybe we should get one of our dealers to come over and inspect this.” At the end of the day, why this is really important is because when you’re talking about these large-scale projects like in the oil sands, projects in Canada where there’s hundreds of millions of dollars invested to a project, the ability to optimize that project by 5% or 10% is worth a lot.
Sciple: Right. When you’re trying to avoid downtime in your production, the analogy I think about is you hear this a lot in tech, there will be these SaaS applications. They’re like, “If they save engineers 15 minutes a day, then it makes up for it because of how much you’re paying engineers.” I think it’s the same type of analogy here in this business. If you’re avoiding your fundamentally critical excavator from having downtime and you can predict that or stay one step ahead of that, then those costs that you’re avoiding by making that investment are worth paying X dollars to Caterpillar for that piece of technology. The savings that they can justify to the customer by avoiding those issues makes it easy for Caterpillar to say, “Hey, you guys, give us X amount of dollars for our piece of technology.” It makes that ROI calculation really easy to sell for the company, or easier to sell.
Sanchez: Yeah, totally. That definitely gets back into that calculation of, well, if this equipment is going to help me operate more efficiently, then I can more easily justify paying this six-figure or seven-figure price tag for this equipment. This other bucket of automation that they refer to is also really, really fascinating because we’ve talked about self-driving cars in the automotive space. It sounds like Caterpillar is living in the future because they already have autonomous equipment that’s running at construction sites. Really, primarily mining sites is where you’re seeing a lot of fully autonomous vehicles. They also have vehicles that are controlled remotely from another location, and there’s a ton of interesting applications of this. The first is really safety. We’ve all heard about these mining accidents, whether they be in a copper mine or whether they be in Thailand with the cave incident. So the ability to limit the number of people that actually have to go into a mine, or that have to be at this site where maybe the foundation or the particles in the air aren’t as safe as they would be in other places, that’s great, that’s just awesome.
It’s really cool to see. If you go on Caterpillar’s website or if you just Google, or go on YouTube and look at the automation tools that Caterpillar has, you can see all these really cool vehicles that are operated without a human sitting in the cab or really any human involvement. They have people basically in these control centers who may be monitoring five or six different pieces of autonomous vehicles at the same time. That brings you to the other point, which is this is super-efficient, and this is another way to save money, not only because you can afford to operate with fewer people, but you could run these machines 24/7. Unlike a miner who is going to get tired after spending a day in the mine, as long as you take care of the machine, the machine isn’t going to get tired.
Sciple: Right. I think this is one of those cases where somebody has to take care of that machine. So the job moves from somebody being down in the mine working this really taxing job that not a lot of folks would sign up for if they had other alternatives. So now, folks are maybe taking care of this equipment and all those sorts of things. Also, from the perspective of the company, any time you have accidents or those sorts of things, it is very costly for the business. […]
Let’s talk about this. Maybe the last thing I think is interesting on automation, you mentioned how we do have automation in these mining applications, really being the first place we’re seeing it in the market. One of the things that I think folks need to think about with automation is, part of the complexity of the problem is just all the different variables involved in the task of driving or just the different things that you can encounter, particularly when you’re doing it at high speed. The higher speed you’re at, the more quickly these computers have to make calculations.
When you think about mining — or we’re going to talk about later in agriculture — you’re in a much more controlled environment with fewer variables. A mine is a very controlled space with very controlled routes. Also, secondly, you’re going much, much slower. The calculations you need to make and your margin of error is much broader in these environments. You can just stop the vehicle in the middle of your construction site and it doesn’t bother anything. You can’t just stop your vehicle in the middle of the road when your car gets confused. Both because of the safety aspect, but also just the controlled aspect of the environment makes this a place where automation can come to market sooner than maybe these more complex environments with crazy people all over the road.
Sanchez: Yeah. If you think about it, there’s a few other ways that it’s easier to make these things automated. The first is that you could just stick ugly sensors wherever you want because nobody cares if there’s a really ugly sensor on the hood of the mining vehicle. The other thing is you could put sensors in the field that help the vehicle traverse. You could set it up, like you said, it’s such a controlled environment. It just makes it much easier, much more realistic. It’s a totally different problem, automation and mining. In automation, these industrial fields are a totally different problem than what we see on highways and city streets.
Sciple: Yeah. It’s interesting, we kind of have these two things happening at the same time. Really, some of the innovations that we have in these industrial settings are going to be useful in other places. It’s interesting — I keep using “interesting,” — but if you have an interest in autonomy, then this is an area to watch as far as the places where we’re going to see it on the market first. Now, the last bucket you mentioned, Luis, is e-commerce. How does that plug into Caterpillar’s strategy when it comes to technology?
Sanchez: As it implies, e-commerce is about selling. This is giving the dealers more tools to market products, more ways to connect customers with dealers, whether that’s an app or a website. There’s a really good Cat app where not only can you browse the catalog, but you can also do things, you could also request certain servicing features, and this is where it all comes together, because you’re connecting the machines with all these sensors and the app has all the information about your machine, it can make it easier to know like, “OK, well, which part do I need exactly?” or “Which parts are compatible with my machine?”
The other side of this is cool too, which is the fact that they’re collecting this data on the health of these machines — it helps the dealers know what inventory they need to carry. If you talk to a Cat dealer, then they’ll tell you like, “Well, with all these telematics and GPS, we know what equipment is in the field. We know what’s actually being operated, and we know the health of that equipment.” If all of a sudden, all these machines break at the same time, they hopefully are going to have a little bit of a warning ahead of that, and as you can imagine, like the supply chain for this really complicated equipment is not straightforward. This actually helps the companies better, more-quickly service customers, but also to run with lower inventory, which helps Caterpillar become a more profitable company.
The last thing too, is that because the customers are more engaged with the dealers. This whole aftermarket parts market of the heavy equipment industry — there are private-label parts makers. Part of this whole push is that Caterpillar wants to maintain or to have more market share in this aftermarket business. By having more connection between the dealer and the customer, they have a better chance of securing that aftermarket parts of business.
Sciple: Which goes back into that study you mentioned earlier about how the servicing part of the business is even larger than the equipment sales, which ties into maybe my last question on Caterpillar before we move on to John Deere. When you think about the size of this tech opportunity and where it fits into Caterpillar’s strategy, how would you describe that to folks?
Sanchez: Yes, I think it’s twofold, maybe even threefold. The first is that offering more value to the customer allows the company to justify higher prices for their equipment. They can increase the prices on the equipment on average like 5% per year or have a nice healthy inflation rate because they’re delivering more value to the customer. That’s one way that it helps Caterpillar benefit. The other benefit is what we were just saying about the parts market share. A couple of years ago, Caterpillar had this Investor Day where they gave us a target, and they said, we currently do about $14 billion a year in parts revenue, but in 10 years, we want to double that to $28 billion. A lot of that is really just from getting more of that pie. That’s a huge revenue opportunity, and it’s also higher-margin revenue, right? Selling parts and selling services is higher-margin than selling the OEM equipment. And I guess the last thing I would say about this is by adding more technology into the equipment, it just gives Caterpillar another opportunity to differentiate versus the other manufacturers that maybe haven’t made as much of an investment. I think it’s brand-building and brand-enhancing.
Sciple: Again, it sounds like the Apple story — brand and average selling prices is a big part of that story as well. We will come back to Caterpillar and maybe [talk] some on valuation after we talk about John Deere. Let’s move on to John Deere now. How would you compare and contrast John Deere’s tech strategy to Caterpillar’s approach that we just outlined?
Sanchez: Well, the biggest difference is like John Deere does make some construction equipment like little excavators and things like that, but what John Deere is known for is selling to farmers, and selling to the agricultural market. There is a really big difference in that end customer — the farmer versus selling to a construction company or a mining company — and that has a lot to do with the sophistication of the buyer and the scale of the buyer. A construction company or a mining company, is usually like this huge multibillion-dollar operation. Very sophisticated. They have people doing all the math to figure out how much more efficient, and how much money this equipment is going to cost them. Your average farmer is a 57 year old entrepreneur, who owns like a couple of 100 acres of land and has been probably doing it in their whole life in a multi-generational setup. They’re not the demographic that’s the technology early adopters. Introducing technology to a farmer is a little bit different than introducing technology to your construction company.
Sciple: We’ve talked about how farmers are maybe a little bit different from the type of customer you are getting in construction and mining the Caterpillar deals with. When we look at the technology that John Deere is rolling out and trying to market to their customers, what type of technology offerings does John Deere have today?
Sanchez: John Deere, they market their technology effort — they use this phrase called precision agriculture. This is like an all-encompassing phrase, which basically means a smart farm. It’s a little bit different, but may kind of break down these ideas, precision agriculture also into a couple of different categories. One category is guidance. Another category is telematics. And then lastly, I would just refer to the last thing is like software. There’s some similarities here between the way that they categorize it with Caterpillar. Guidance is a little bit different though, from Caterpillar in the sense that Caterpillar is already automating a lot of vehicles, but farm equipment is not yet fully automated. Guidance is more like the Tesla Autopilot version of automation, where they’re helping farmers with auto-steering and routing. John Deere, one of their most popular software offerings is called AutoTrak, which essentially lines up your machine, whether it’s a combine or a tractor, to the most optimal way to pass through the field. Whether you’re tilling the soil or harvesting grain or whatever you’re doing. Essentially, it makes the process of sitting in the cab a little bit more passive, so you don’t have to like manually steer the cab. It helps for a few reasons like first, it couldn’t. What John Deere says, it’s like using a future like AutoTrak can keep the person operating the machine like operating it for longer. They’ll not tire out as quickly. The second thing is efficiency. The software will figure out the most efficient routes. Again, we could save the farmer maybe like 20% of their time, which obviously is meaningful when you’re doing this for like 12 hours a day.
Sciple: Yeah. I’m thinking about mowing your grass. It makes sure that we make the most efficient passes. Also you can get the lawnmower that has the self propulsion. You could still push the lawnmower on your own, but if you have the one with the self propulsion, of course you’re going to get the one, that helps you push it. Same type of thing here in the tractor business, I think one of the things we talked about before, Luis, is this a product that over time folks become more accustomed to and more dependent on, and more willing to pay up for.
Sanchez: Yeah. This is a really interesting case study, when you think about adoption of tech. AutoTrak is almost 20 years old, I believe. I think it was introduced in the mid 2000s and at the time, no one really wanted this. They didn’t know why they needed it. Like the adoption rate when they launched, it was like 5% or 10%. I think John Deere is literally giving it away, so that people would become more accustomed to it. Fast-forward 10, 15 years and almost everyone who is operating one of these machines is using AutoTrak. In fact, people will not buy a used piece of John Deere equipment unless it has AutoTrak working. It’s a huge deal when you start looking at the market for these machines. Why is that? I guess, given enough time even these like older demographics will learn how technology can benefit them. Maybe it just takes 10 or 20 years. And I’m sure John Deere has made the AutoTrak feature easier to use and much more useful as well.
Sciple: Yeah, I think it’s kind of human nature, or like automatic cars. I’m sure for a while there were people like, “I’m going to stick with the standard transmission.” Now, you have to try really hard to find one, because convenience sells. At the end of the day, people are lazy, for better or worse. If you can find a way to let people be lazy and still get the job done, sooner or later they will pay up for it.
You talked about the telematics side of John Deere’s offering as well. That is similar to what Caterpillar’s offering. Does it fit differently into John Deere’s strategy though, relative to what Caterpillar’s trying to do?
Sanchez: Telematics is all about putting sensors into the machine. So it’s like making them smarter. Same thing as Caterpillar, they’re collecting data on the health of machines, figuring out what parts they need to be replaced. But John Deere is actually going even further than Caterpillar in some of the applications of this. A couple of really cool things that I was learning about was, some of the sensors on these tractors and harvesters are collecting soil samples while the machine is passing through the field. The machine is determining what treatment needs to be made to the soil, or maybe some parts of the field may need to be treated a little bit differently. Maybe you want to spray one pesticide in a certain part of the field, and you want to put a fertilizer in another part of the field. It actually enables you to do things that you just aren’t able to do without this kind of more advanced technology.
The other thing, too, is the level of precision that you could get with some of these more advanced machines in terms of getting the seedbed placed to the right position, to like the millimeter, it’s crazy. It’s crazy how much better they’re able to optimize the process of farming when you start adding really sophisticated software. Why do you need to get the seedbed even more precise? Well, there’s a lot of factors that, like an old machine that built was like 50 years ago, can’t figure out. For example, if there’s a hill, right, or if there’s rocks, maybe you don’t want to place some of the seedbed on a rock. Or maybe you want to put it on a certain part of the hill where it’s going to get better conditions. It can calculate things on the fly that can actually be really meaningful to someone who is trying to get the most out of their land.
Sciple: Always adding efficiency I think is more important than ever because the world population keeps growing and yet we’re not making new farmland. The story of the past 200 years has been able to increase efficiency, and then hopefully, some of this technology can allow us to continue doing that. But when you talk about an industry that’s been around for hundreds of years and talked about how farmers can skew less tech-savvy, there is a question of, some customers asking, do I really need this or do customers really want this? Is that an issue that John Deere is dealing with among its customers?
Sanchez: For sure. Because it comes down to like cost, to a degree rate, because people see, “Do I really want to pay 15% more for the latest tractor that has some new optimized software for how to plan to better seed better? I’ve been farming for 50 years, I think I know what I’m doing.” There’s a resistance to change, and you’re not only telling people to change, but you’re telling people to pay up to change. There’s definitely some friction there.
There’s a little bit of controversy too, with some of the things that John Deere specifically is doing. Last year, there was a scandal called the “right to repair” issue, where John Deere was essentially locking out anyone who wasn’t an official John Deere dealer or certified maintenance person from repairing their vehicle. You’re talking about preventing people who own their own equipment from making their own repairs because they don’t have access to the console of their machine. There’s a couple of things there. You’re asking people who have done something a certain way for many years to change, you’re asking them to pay more for this stuff, and they’re not even sure how to use it. And then you’re also throwing in some limitations to what people can do with their machines. There’s certainly been some push and pull with the way John Deere has rolled out some of this technology.
Sciple: Yeah. I think the interesting thing, we’ve talked about this iPhone analogy a little bit throughout the story. The right to repair story, I think has a great analogy with the iPhone, because you have folks literally trying to jailbreak their John Deere tractors so they could do repairs to this equipment. These same types of conflicts or jailbreak situations that we see in consumer products, you’re seeing the same type of stuff happen in these industrial products.
Any final thoughts there on the customer issue and the extent to which that may affect the rollout of John Deere’s attack going forward?
Sanchez: Yeah. You could do some research online and see all these stories of people complaining that they can’t repair their own tractor but there is another side of that story, and the other side of the story, is that there is regulatory reasons why you don’t necessarily want people to tamper with some of the software or some of the hardware in these machines. I think there’s two sides to that story. Just to summarize it really quickly: There are things that you could do if you had access to this equipment such that you can add more horsepower to the machines and make them less compliant to emission standards and other kind of regulations that would actually make the machines more profitable to the farmer, but make them not so street legal. I think you got to be careful with some of the narratives that you read out there, and really try to understand both sides of it.
I do think that if we are bringing this all the way back to the Apple example, the John Deere technology effort reminds me a lot more of the iPhone than what Caterpillar is doing. It feels like it’s a lot more the way they’re marketing it, and some of the features and the way they’re selling things. It feels a lot more like selling to a consumer.
Sciple: Another thing that I wanted to point out on the Apple analogy on John Deere as we kind of move into the financial aspect of their technology offering, is very recently, just in the past week or so, John Deere has come out and announced that they’re going to report their software revenue as a separate line item in their financial reporting, which echoes back to Apple’s move to report their services line item separately in their financials. What does it say about how John Deere wants this software business to be part of the narrative we look at as investors going forward?
Sanchez: It’s really smart, because everyone knows that a software or a tech business is going to get a higher multiple than some stodgy old equipment business. To the extent that they can set a different narrative, you’d be hard pressed if you asked your average person, “Is John Deere and Caterpillar a tech company?”, you’d be hard pressed to convince them that they are tech companies. But if John Deere can convince investors that a significant portion of our earnings are coming from tech, pay a higher multiple for our stock, I think that’s a really savvy move.
Sciple: Well Luis, I guess the question that I have to ask is, can they convince you when you look at how big their software opportunity might be, and their potential to grow — is that something that makes the stock interesting to you today or what are your thoughts? This is a stock that’s run an incredible amount in the past year, John Deere specifically.
Sanchez: Yeah. I think that to the extent that you can look at things like AutoTrak that they are making people pay extra for, you couldn’t really argue that AutoTrak and some of these software tools are not a really valuable source of recurring revenue that didn’t exist 20, 30 years ago. When you look at some of these things that they are attaching that have different financial characteristics than just selling a tractor, yes, you certainly should give them credit for that. However, I wouldn’t suddenly think of John Deere as the next Tesla because at the end of the day, you have to think about [this] — the success of their customer is going to determine the success of being able to sell things to the customer. If farmers are doing really well because of the parts of the economy that help farmers, so like rising prices for certain crops, the value of land. If those things are doing well, then the farmers doing well, then the farmer is going to be able to have more money to invest in new equipment and pay for new technology. You can’t completely divorce John Deere from the fact that it is selling to a resource industry that does have ties to macroeconomic factors.
Sciple: Absolutely. When you look at these companies that are all-time highs, we do have toward all-time high multiples. In this new universe though, do you think times have changed and these companies deserve higher multiples than they would have historically? We’re in a universe where 15 times earnings for even some of these industrial companies — we’re not in that universe anymore. Because even these companies have tech offerings, and recurring revenue, and all of the things that we look at for these higher multiple businesses.
Sanchez: Yeah. I think that where we are in the cycle, too, makes these really interesting because we’re potentially in a situation where spending on infrastructure could go up, and where inflation could raise the price of certain goods that could help some of these commodity prices. For farmers that would be like crops, for Caterpillar that could be something like oil and gas, which a lot of their customers are involved in. I think you do have to think about the cycle. If you think about the actual business composition where Caterpillar is at, is last year, 40% of their revenue came from parts and services. And parts and services as we mentioned, it’s a higher-margin revenue, so maybe that is more valuable. If they do hit their goals in terms of doubling their parts and services revenue over this period of time, well, you should probably give them some credit for that because that’s probably going to result in margin expansion. We’ve already seen some margin expansion from both of these companies. The ability to operate more in that parts and servicing side of the business also actually takes out some of the cyclicality, so it makes their revenue models less volatile from year to year.
Sciple: So you’re less subject to these cycles that you’re talking about earlier. You’re always subject to — if nobody wants to drill for oil and gas, they are not going to go buy the Caterpillar equipment or what have you, but they do have something that smooths out some of that revenue going forward.
To wrap everything up here, we’ve talked about how some of these big industrial giants are starting to integrate technology more and more into their business models. This isn’t a trend that’s going to go into reverse anytime soon. As you look out to the next, say, five years of the continuation of this trend, what are some things you’re looking for and are going to be paying attention to?
Sanchez: Sure. There’s a lot of interesting things that these companies are still working on that they still have visibility to roll out. I think for John Deere, the 300-pound gorilla is probably getting from autopilot to fully autonomous. If you talk to the company and if you talk to people who know this space, they’ll tell you that they have all the technology to make tractors and to make farming equipment fully autonomous, but they haven’t yet put it all together to make that happen. Actually, regulators aren’t there yet in terms of letting them do it, so that’s actually something where I think that to the extent that we could get full self-driving approved on the regulatory side in the automotive market, that can make it easier to smooth the process for some of this farm equipment and some of these other industries to get regulatory blessing to become fully autonomous.
If you think about it, it solves a lot of problems because agriculture is an industry where we have to deal with seasonal labor issues, labor shortage issues, and so to the extent that you can allow these companies, allow farmers to operate more autonomously and less human-capital intensive, I think it could really change the shape of that industry. Then for both of these companies, Caterpillar and Deere, electrification of the machines is going to be another really big one. It’s not as easy to electrify a really big piece of heavy equipment as it is to electrify a relatively small car. I think the technology for doing that is going to take a little bit longer just to be able to have as much torque and as much hauling power as they need, but when it happens, that’s just another thing that they could roll out and make these machines that much better.
Sciple: That’s something we’ll be watching for, Luis, and as we have things to discuss in that space, we’ll be looking forward to having you back on to break it all down. Looking forward to having you on next time.
Sanchez: Thanks. Me too.
Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don’t buy or sell anything based solely on what you hear. Thanks to Andy Franks for her work behind the virtual glass, for Luis Sanchez. I’m Nick Sciple. Thanks for listening, and Fool on!
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.