Deere (DE) is certainly not an ordinary heavy machinery company. Farmers tend to be loyal to brands and Deere has one of the most valuable brands in the world, let alone just in farm machinery. The trouble with Deere as a stock, though, is trying to balance out what is clearly a strong North American market with the past cyclicality of this business and industry.
A Few Hiccups In The Start To The Year
On balance Deere had a solid start to its fiscal year, but there were a couple of details that concern me as they relate to growth expectations. Total revenue rose 11% for the quarter and equipment revenue rose by a like amount - giving the company a better start to the year than expected.
Unfortunately for sentiment, equipment was softer than expected and much of the outperformance came from the financing operations. Ag equipment sales were up a disappointing 8% (split almost evenly between price and volume) while most analysts were looking for double-digit growth, and the 22% growth in construction sales looks nice but was in line with expectations.
Just as the revenue number takes some explaining, so too does the profit performance. Broadly speaking, equipment margins outperformed expectation even as they contracted 30 basis points (equipment operating profits rose 8%). All in all Deere did a good job of offsetting higher material costs and costs related to new emissions standards (Tier 4). That said, incremental margins of just 4.5% in agricultural equipment were disappointing and sap much of the enthusiasm for the stronger construction results.
Peeking At The Peak
Curiously, a lot of sell-side analysts don't seem to want to listen to Deere management's own opinions about the equipment cycle. Specifically, management has said more than once in recent months that they believed North American farm demand was running about 120% of the cycle norm - basically in line with prior peaks. Yet, many analysts think Deere's own guidance is too low and will likely point to management's decision to boost ag equipment sales guidance to the high end of the range as proof.
I'm not so certain. Strong crop prices, low rates, and more competition between seed companies like Monsanto (MON) and DuPont (DD) has helped farmers, but these factors don't last forever. Moreover, while I do believe that Deere can pick up share from competitors like Agco (AGCO) and CNH (CNH) in Latin America and Eastern Europe, is there enough business there to offset declines in North America?
Perhaps North America won't decline. Maybe we have reached a new permanently higher plateau with crop prices and maybe factors like ethanol demand will mean that future cyclical dips don't go so slow. That said, I'm very nervous about "it's different this time" stories in cyclical industries.
Construction Nice, But Not Really Material
That pick-up in construction revenue was good to see, as were the solid mid-teens incremental margins. That said, construction is a pretty small part of what Deere does. While I'll buy the idea that a recovery in construction can offset some risk of slowing momentum in North American agricultural, investors who want to play a recovery in construction will do better with names like Caterpillar (CAT), Manitowoc (MTW), Kubota (KUB), or Komatsu (KMTUY.PK).
The Bottom Line
There's a lot to like about Deere - there's that great and iconic brand, impressive market share, and a very clean balance sheet (debt looks high at first glance, but most of that supports the financing business). My problem with the stock is that machinery is not my preferred play on ag today - I currently hold Monsanto (farmers buy seeds every year and don't have a lot of choice about it) and I'd be willing to consider a few beaten-up fertilizer stocks as well.
I'm also nervous about the expectations that analysts have put into their models. Analysts are forecasting free cash flow conversion rates nearly double the company's long-term average and essentially forecasting that Deere will hit peak free cash flow and then sustain it. What's more, while Deere has definitely shown cyclicality in the past, almost no long-range sell-side models show any of that in the future.
Going along with these numbers means projecting low-teens compound free cash flow over the next decade. That seems ambitious enough for a company like Caterpillar or Cummins (CMI) with multiple addressable markets, to say nothing of a more focused company like Deere. Worse still, even that sort of growth expectation still suggests that the stock is less than 10% undervalued.
Much as I respect Deere management and like the company, I just don't see how the numbers work. I'd be very careful buying this stock today, and would probably be considering chandelier stops if I owned it. With too many good heavy industrial companies trading at meaningful discounts to fair value, chasing this Deere may be inviting trouble.
Disclosure: I am long MON.
