Given what we've heard recently from companies like Deere (DE), Caterpillar (CAT), Monsanto (MON), Eaton (ETN), and Joy Global (JOY), it looks like it's better to serve the overall-wearing community (farmers) as opposed to the hardhat-wearing community (construction and mining). Deere delivered pretty strong performance from its ag business once again, and though management is often conservative it looks like 2013 will be a solid year. That said, Deere is one of those well-loved industrial stocks, so investors shouldn't turn a blind eye toward valuation.
A Good Start To The Fiscal Year
Deere has a well-earned reputation for setting achievable expectations, and this quarter was no exception. Revenue rose 10% on a reported basis, with equipment revenue up 11%. Agriculture and turf continue to be quite strong, with revenue up 16%, while construction was weak (down 7%).
Deere is also doing well with operating/profit leverage. There are a few different ways that analysts and investors look at the company's margins, and the differences largely revolve around the extent to which you factor out finance and interest income. However you do the math, multiple calculations point to a roughly one-point improvement in gross margin, while equipment operating income rose 20%. Within the equipment business, ag/turf income grew by one-third (with an operating margin of roughly 14%), while construction contracted by 43% (with sub-6% margins).
Investors rarely seem to pay much attention to Deere's financial services results, but reported revenue rose 4%, operating income improved 13%, and provisioning for credit losses remains very low.
Like The Mayan Apocalypse, The Equipment Downturn Didn't Show Up
Investors got rattled at a few points during the last year by the thought that 2012 could be the peak year for agricultural equipment demand. So far, it looks like they needn't have worried. Industry-wide tractor and combine volumes picked towards the end of the year, and the continuation of the accelerated depreciation perk certainly won't do any harm.
It's also worth noting that even with Deere's strong sales growth, the North American fleet isn't necessarily a new one. About three-quarters of the U.S. combine fleet is over 10 years old, and while individual farmers may be motivated to keep old machinery running with spit, bailing wire, and hard work, corporate farmers are less inclined to allocate the time and labor to maintaining older equipment.
The situation overseas is likewise largely pro-growth. Admittedly, Europe is a mess right now, but that's an even bigger threat to CNH Global (CNH), AGCO (AGCO), and Claas than it is to Deere. In South America, though, the ongoing growth of the ag sector (and acreage under cultivation) continues to stimulate strong double-digit equipment demand growth.
Does Deere Need To Adapt To New Needs?
The biggest long-term opportunity for Deere is in penetrating the BRIC countries and other major emerging markets like Indonesia. Relative to North America and Western Europe, these countries are barely mechanized at all in the ag sector. The ratio of tractors to farm workers in Brazil, for instance, is about 5% of what it is in the United States, and countries like Pakistan, India, and China depend even more on manual labor.
I don't want to suggest that all Deere has to do is stick a tractor on a boat and send it to Indonesia. There are reasons that these countries haven't mechanized, including significantly lower incomes for farmers, significantly lower wages for workers, and laws/customs that discourage consolidation of farms. All told, it's going to be a long process to see these countries industrialize/mechanize their farming sectors.
It's also worth noting that Deere hasn't necessarily targeted these markets yet with the full force of its product design and manufacturing capability. AGCO has done really well in Brazil in part due to a focus on smaller tractors, but Deere is not as strong yet in smaller equipment nor in the more specialized kinds of equipment that are needed for different types of agriculture (rice cultivation, for instance). I believe that Deere has the capability to adapt, but if they don't, companies like AGCO and Mahindra & Mahindra will be more than happy to do so and grab share in these markets.
Construction Not Looking So Strong
Between the reports from Caterpillar, Deere, Eaton, and Manitowoc (MTW) this quarter, it's hard to feel really good about the construction equipment market. Excess dealer inventories are getting absorbed in China, but that's more of an issue/driver for Caterpillar, Volvo (VOLVY.PK), and Komatsu (KMTUY.PK) than the more domestically-oriented Deere. Even so, Deere's update is a negative read for the sector and the ongoing wrangling in Congress doesn't suggest any near-term improvement in funding for civil engineering and construction projects.
The Bottom Line
Deere and Monsanto tend to track each other and both are relatively good proxies for investor expectations on the farming sector. To that end, the ongoing enthusiasm at Monsanto from both management and Wall Street is an encouraging sign for Deere in 2013. Deere being Deere, though, management was relatively careful with its revisions for expected 2013 demand and company performance.
Deere has been a share-gainer in recent years at the expense of CNH, AGCO, and Kubota (KUB), and I think overall healthy conditions in North and South America support a positive outlook. I'm comfortable with a long-term revenue growth outlook of 4% to 5% on Deere, along with steady improvement in free cash flow generation. All told, I think Deere can grow its free cash flow at a 7-9% rate for the long term. Discounting that back, it suggests a fair value of about $93.
Admittedly, that's not a compelling target relative to today's price, but Deere enjoys pretty solid support and the Street is still bullish on agriculture plays, particularly those with leading share in North and South America. While I'm indifferent about buying Deere at these levels, I'd be happy to hold the shares and would certainly consider a purchase if a broader market sell-off or periodic ag-spending panic sends the shares down into the low $80s.
Disclosure: I am long MON.