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Shares of Deere (NYSE:DE) failed to benefit from the strong market action on Friday after the farm equipment giant received a downgrade from analysts at Bank of America/Merrill Lynch (NYSE:BAC).

I remain on the sidelines. As the short term developments look less favorable for the company, I am a bit worried about the operational and financial leverage if things were to turn South in the short to medium term.

Bank Of America Becomes Cautious

Analysts at Bank of America/Merrill Lynch downgraded Deere from "Buy" to "Neutral" as they have limited faith in a near term construction equipment recovery.

Analyst Gilardi furthermore lowered the price target to $89 per share, suggesting a limited 9% upside from current levels.

After taking a fresh look at farm equipment stocks, the bank is more cautious on the sector. Despite the favorable long-term view for equipment demand, Gilardi is cautious on Deere in the short run.

Lower corn prices and upside risks to USDA crop forecasts are a key risk. Other headwinds are the reduced confidence in a Section 179 extension and headwinds for the CE business. As such, the bank lowered its 2014 and 2015 earnings per share forecast by 3-6%, matched by a lower price target.

Valuation

Deere ended its third quarter with $4.8 billion in cash, equivalents and marketable securities. Total debt, including the liabilities from the financing unit stood at $33.7 billion, resulting in a net debt position of around $29 billion.

Revenues for the first nine months of the year came in at $28.3 billion, up 7.5% on he year before. Net earnings nearly advanced by 15% to $2.73 billion. Note that Deere will report its full year results for the fiscal year, next week on the 20th of November.

Based on Deere's previous outlook full year sales are seen around $36 billion, as earnings could come in around $3.45 billion, the equivalent of $8.75 per share.

Trading around $81.50 per share, the market values Deere at $31.2 billion. This values the company at 0.9 times annual revenues and 9 times annual earnings.

Deere currently pays a quarterly dividend of $0.51 per share, for an annual dividend yield of 2.5%.

Some Historical Perspective

Long term holders of Deere have seen very good returns amidst the soft commodities boom, as shares tripled from $30 in 2004 to $90 by 2008. During the financial crisis, the retrace in commodity prices and worries about leverage, send shares to lows of $25 in 2009.

Since 2011, shares have mostly traded in a $70-$100 trading range, driven by a recovery in commodity prices and continued growth in demand for food across the world.

Between 2009 and 2012, Deere has increased its revenues by some 60% to $34 billion. Net earnings nearly quadrupled to $3.1 billion over the past year, with both earnings and revenues set to rise further this year.

Investment Thesis

Deere has been an excellent investment in the past. To please shareholders going forwards the company has raised its dividend to a yield of 2.5% per annum, while it has repurchased 7% of its outstanding share base in less than two years time, for combined "returns" of 6% per annum to its shareholders.

Despite all this and the favorable long term trends, shares are trading with losses of around 5% year to date, after the company guided for a 5% drop in equipment sales for the final quarter of the year. This implies quite a slowdown from reported 4% growth in the third quarter. While a large portion of the "slowdown" is attributed to a shift of sales, the slowdown is still real, once adjusting for this.

This combined with lower prices in some key soft commodities, after the corn spike, could result in less appealing prospects for Deere, and imply the party is over. In all fairness, operational excellence and strong pricing for milk, among others, is helping Deere in other places.

As such, Deere has some short term headwinds, but the very long term prospects continue to look good and the 9 times earnings multiple is quite appealing, even if 2013 might be a peak year.

There are some concerns though in my opinion. The degree of operational leverage which also works if sales were to fall, could push up the price-earnings ratio quite a bit. The debt position, incurred by the financing unit is high as well. Given that credit losses only run at three basis points of the portfolio, there is not much upside from the current loan book.

As such I remain on the sidelines despite the appealing current price-earnings ratio, dividends and repurchases. The implicit leverage through its operations and the balance sheet make me a bit fearful. That being said, for the very long term an investment in Deere is probably a very safe choice to make.

Source: Deere - Cautious In The Short Run, Long-Term Appeal Remains