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Summary

  • Deere & Co. has serious structural issues in its business model.
  • Poor operating results and a dour outlook mean shares are expensive.
  • Market participants are too optimistic regarding Deere's earnings outlook and shares are worth a look for a short candidate.

Shares in equipment manufacturer Deere & Co. (NYSE:DE) have languished for years now. Shareholders who have held the stock have underperformed the market due to questionable fundamentals at Deere and even recently, shares are well off of their highs from this spring. Is there light at the end of the tunnel for Deere shareholders or will shares continue to underperform? In this article we'll take a look at Deere and see if the company can regain its footing and if shares are a buy on a value basis.

(click to enlarge)

To do this I'll use a DCF-type model you can read more about here. The model uses earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at 8% growth annually, and a discount rate, which I've set at the 10 year Treasury plus a risk premium of 6.5%.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$9.09

$8.37

$6.90

$7.21

$7.53

$7.87

x(1+Forecasted earnings growth)

-7.90%

-17.60%

4.50%

4.50%

4.50%

4.50%

=Forecasted earnings per share

$8.37

$6.90

$7.21

$7.53

$7.87

$8.23

Equity Book Value Forecasts

Equity book value at beginning of year

$29.92

$35.89

$40.20

$44.66

$49.28

$54.07

Earnings per share

$8.37

$6.90

$7.21

$7.53

$7.87

$8.23

-Dividends per share

$2.40

$2.59

$2.75

$2.91

$3.09

$3.27

=Equity book value at EOY

$29.92

$35.89

$40.20

$44.66

$49.28

$54.07

$59.02

Abnormal earnings

Equity book value at begin of year

$29.92

$35.89

$40.20

$44.66

$49.28

$54.07

x Equity cost of capital

8.90%

8.90%

8.90%

8.90%

8.90%

8.90%

8.90%

=Normal earnings

$2.66

$3.19

$3.58

$3.97

$4.39

$4.81

Forecasted EPS

$8.37

$6.90

$7.21

$7.53

$7.87

$8.23

-Normal earnings

$2.66

$3.19

$3.58

$3.97

$4.39

$4.81

=Abnormal earnings

$5.71

$3.70

$3.63

$3.56

$3.49

$3.41

Valuation

Future abnormal earnings

$5.71

$3.70

$3.63

$3.56

$3.49

$3.41

x discount factor(0.089)

0.918

0.843

0.774

0.711

0.653

0.600

=Abnormal earnings disc to present

$5.24

$3.12

$2.81

$2.53

$2.28

$2.05

Abnormal earnings in year +6

$3.41

Assumed long-term growth rate

3.00%

Value of terminal year

$57.88

Estimated share price

Sum of discounted AE over horizon

$15.98

+PV of terminal year AE

$34.70

=PV of all AE

$50.68

+Current equity book value

$29.92

=Estimated current share price

$80.60

As you can see the model has produced a fair value for Deere shares of under $81, or around $5 less than where they trade today. While this isn't an enormous discrepancy, it is worth noting as the model is implying DE is expensive right now. I tend to agree with this conclusion and we'll see why right now.

The fundamental problem with Deere is not that management is clueless or that the business has operational issues; the problem is that Deere's customers are subject to the whims of not only commodity markets but the weather as well. Deere has no control over these issues but they are no less destructive to Deere's customer base. We've seen it already this year, as we have in previous years, where the company is forced to cut sales forecasts because of weak demand from farms. This isn't a new issue and it also isn't going away; Deere will always be at the mercy of things it cannot control and that is not a good place to be. In particular, demand for its larger tractors has suffered because of the precarious position farm income is in and that isn't looking good for the future either.

In fact, Deere once again cut sales estimates following its most recent report, further depressing the ability of Deere to actually grow earnings again. And speaking of that, growing earnings has been a real problem at Deere for a couple of years now and if we look at the table above, we see that analysts are forecasting a decline for this year and a massive decline next year of nearly 18%! That is ugly and it speaks to the terrible position that Deere is in with demand for its products. With the company at the mercy of booms and busts in commodities, it may as well be trading these commodities itself; perhaps its operating results would be better.

That's not a real suggestion of course but the fact remains that Deere earnings are largely out of the control of the company. That means that when things are good, Deere can smoke earnings estimates but when things turn south, it has real issues. I don't know about you but that seems like a company I don't want anything to do with and Deere's earnings outlook is dour indeed.

Given the fact that Deere cannot even maintain its current revenue level, or even get close for that matter, and the fact that it is having to lay off people due to ever-decreasing demand, I think there is actually downside risk to the very muted earnings growth forecasts we already discussed. Deere has some very damaging structural issues built into its business model and the fact that shares are still trading for more than 12 times next year's earnings says to me that market participants think there is upside to the company's earnings forecasts. That is a bet I'm unwilling to make given Deere's recent history and the issues we've discussed. If anything, I think Deere will continue to disappoint despite the ridiculously low expectations. This company has serious problems and it is too expensive right now with no margin of safety built in to address those problems.

So what do we do with Deere? I think this is a case of a company that is a great short candidate. With shares around $86 they are still far too expensive. Deere doesn't deserve to trade at 12 times forward earnings as it cannot even maintain its revenue or earnings levels from prior years. A company in this state should be trading for 9 or 10 times forward earnings, implying downside to the high $60s or so for shares. I like the set up here for shorting Deere as shares have already decidedly moved off of the uptrend and are trading well below the 200 DMA, as seen on the chart above. Couple the technical breakdown with the fact that shares are far too expensive and you've got a great candidate to short. Poor operating results and a business model that is subject to the whims of the weather and farmers' preferences make a weak business and that is what we have with Deere.

Source: Deere & Co.: Plowing Its Way To Lower Prices