Shares of Deere & Company (NYSE: DE) are trading higher in the pre-market session of Friday morning; the stock is set to open higher by as much as 6.6% as investors pile into the store. The renewed bullish sentiment comes amid the company's latest press release, relaying the second quarter 2023 results to investors. Within this report, management showcased strong performance and execution across different segments, with a focus on farming equipment. 

There is a hidden tailwind in the ensuing farming equipment demand to be had, one that analysts may already be reflecting in their price targets, as companies like CF Industries (NYSE: CF) express their views on the near-term future for the farming industry. CF Industries operates as a chemicals manufacturer to make farming volumes possible. However, once crops are ready, farmers must turn to Deere for the proper tools and equipment. As CF points to high farming volumes for the remainder of 2023, Deere investors may experience more than just a double-digit upside potential set by analysts.

Catching a Wave

Deere reports a 34% bump in net sales for the second quarter of 2023 compared to the same period a year prior. Operational efficiencies enabled net income to grow at a faster clip of 36%. These increased cash flows and a margin boost opened a path for management to consider returning some cash to shareholders after a fantastic year. Close to $2.5 billion from the free cash flow pool was allocated to repurchase as many as 11.6 million shares off the open market; as management buys shares, this could be one of the first signs of undervaluation seen in the stock today. 

Most of the sales growth came from the company's 'Production and Precision Agriculture,' representing all their farming-based product lines. With a net sales increase of 53% over the past twelve months, this segment brought in $7.8 billion in revenue, with a further operating profit bump of 105% amid favorable pricing conditions.

The segment's operating margin stood at 20.6% in the second quarter of 2022; today, it stood at 27.7% due to pricing power in the face of pent-up demand. Management provided some guidance for this segment within their earnings presentation, pointing to an approximate 20% sales boost for the end of the year and a 25% to 26% operating margin to represent a slight decline from today's levels. 

Within CF Industries' earnings presentation, management points to a widely followed indicator that can predict farming activity in the future. Deere investors will find interest in the current state of the stocks-to-use ratios presented by CF, where a ten-year low ratio implies that supply levels today are inadequate relative to global demand.

During rising stocks-to-use ratios, such as 2014-2017, the Deere chart would portray the stock rallying by as much as 128%. The connection becomes clear once investors understand that CF industries are first in the farming value chain, where demand for their products will - and has - act as an indicator for farming equipment demand, where Deere stock shines after that. 

Expectations Set

Even after today's rally, Deere analyst ratings are set on a consensus 20% upside. These targets may be driven by the following activity to be had in the agricultural segment of the company as the farming indicators pick up steam in the coming years. In addition, however, Wall Street may be focused on more conventional metrics. Excluding the COVID-19 effects on stock valuation, DE stock is sitting at an eight-year low price-to-earnings ratio of 14.2x.

Historically speaking, these multiples have hovered between the 20.0x to 24.0x range, significantly discounting Deere's potential as of today. What matters more for investors is the outlooks set for 2023 by management, where further optimization and growth can drive pleasant surprises. 

Deere management is now expecting net income to fall between $9.25 billion and $9.50 billion, representing a 29.7% to 33.2% advance from net income reported for the end of the year 2022. With operating cash flows targeted at $10 billion to $10.5 billion and a capital expenditure guidance falling at $1.5 billion, investors are expected to be left with 2023 total free cash flow levels of $8.5 billion to $9.0 billion.

As management lays out its capital allocation strategy, it becomes evident that the free cash flow generated will drive the stock even higher. With a priority on keeping an "A" rating on credit, Deere management will dedicate a sum of these free cash flow levels to maintaining balance sheet integrity and liquidity. The company must remember about growth to reinvest into itself or other outside growth projects. The next tier of free cash flow allocation goes entirely to shareholders. 

Targeting a 25% to 35% payout ratio for 2023, Deere's dividend today yields nearly 1.2% annually. It will be expected to rise as these conditions improve. Lastly, the remaining free cash flow will be deployed via share repurchases; considering that management chose to repurchase a significant volume (nearly 2.2% of the company's market cap) during the past quarter, investors can lean on the assumption that insiders believe the stock to be cheap.