2 Reasons Deere's Stock Is Undervalued

| About: Deere & (DE)

Historically the stock prices of Deere (NYSE:DE) and other agricultural equipment firms and retailers like Case-New Holland (NYSE:CNH), Titan Machinery (NASDAQ:TITN), AGCO (NYSE:AGCO), Tractor Supply (NASDAQ:TSCO), Valmont (NYSE:VAL), and Lindsay (NYSE:LNN) have tended to closely track the price of corn. When corn prices go up, farmers tend to make more money, and they spend that money on new equipment from Deere and other firms. This relationship is especially strong for Deere and Corn, but it holds true for all of the stocks above to some extent. (Correlation coefficients between all of the stock prices above and corn are statistically significant to at least the 5% level, see my blog here for more details.)

This close correlation between corn prices and these stocks led UBS and several other analysts to lower their views on the stocks. However, these downgrades are questionable for two reasons. First, the correlation holds much more strongly when the changes in corn's price are driven by demand dynamics rather than supply issues, and second, many analysts may be underestimating the severity of the ongoing drought in the Midwest as a result of the deceptively large amount of moisture the area has received in the last few months.

First, when dealing the correlation between Deere's stock price and the price of corn, it is important to distinguish between supply and demand shocks. The price of corn will increase due to (1) a reduction in supply, (2) an increase in demand, or both as shown below. An increase in demand for corn is most common when the economy gets stronger, or when gas prices go much higher. The first scenario leads people to eat more meat which results in more demand for livestock and hence more demand for corn as a livestock feed. The second scenario leads to increased ethanol production for which corn is a common input. Absent a war in Korea, gas prices look unlikely to change enough to dramatically impact the use of ethanol, but if the economy continues to pick up steam, and China and India continue to grow rapidly, it is entirely possible corn demand could increase. This would be good for Deere. Short of the EU imploding, it is unlikely that global corn demand will fall dramatically. Historically, these kinds of changes in demand for corn have been the driving factor in corn's correlation to the stock price of Deere and the other firms mentioned above.

On the supply side, corn is most often affected by drought or advancements in seeds, fertilizers, planting techniques, etc. In the longer term, corn supply has been increasing as a result of these kinds of technology advances. Increases in supply lower the price of corn, while decreases raise the price of corn. UBS and other analysts are essentially relying on the recently increased USDA estimates of corn supplies and forecasting that corn prices will fall. However, since this is a supply side effect, it will likely have less impact on the price of corn, even if the price does fall.

This should make sense intuitively, when demand rises and farmers have a lot of corn to sell, they get higher prices for that corn and make lots of money leading them to buy additional farming equipment. However, when prices rise due to a supply short fall, farmers by definition have less corn to sell, so the price increase does not raise overall income, and the farmers are no more likely to buy additional equipment. As such, demand for corn is the factor that will tend to drive Deere's fortunes.

This brings me to my second point as it relates to Deere and the other agricultural firms - there is still a good deal of uncertainty as to whether corn prices actually will fall. The USDA says farmers have a lot of corn supply on hand, but whether that a lot of additional supply will be produced this growing season remains to be seen.

This year and last year, corn supply was dramatically constrained by drought which pushed up the price of corn. To put the severity of this drought into perspective, the following charts come from the national drought monitoring center and can be found here.

The first image shows the level of drought conditions at the start of last April. Darker/deeper colors indicate more severe drought. What the chart essentially shows is that last April corn growing conditions across the Midwest were pretty good.

April 2012 Drought Conditions

However, by June of last year (second image), a serious drought had developed across the region. The drought intensified over the summer and by August, much of the great plains were in a severe drought (third image).

June 2012

August 2012

The drought persisted into October (fourth image), and while it has eased up somewhat over the last few months, in general conditions across important agricultural states like Nebraska and Kansas remain extremely severe as shown by the final image which illustrates the current drought conditions.

October 2012

April 2013

While the recent snow fall across much of the country has certainly helped ease the severity of the drought, the plains states are a long way from being back to normal. The drought last year was so severe that according the national drought center, much of the soil in the Midwest has lost a significant amount of moisture that will be very difficult to replace without significant and persistent rainfall. That is, these states don't need big rainstorms all at once - they need lots of rain coming down slowly and consistently. If the Midwest doesn't get that kind of rain over the next couple of months, then the corn harvest may be less robust than is widely assumed.

Disclosure: I am long TSCO, TITN, ADM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.