Corn Is Green, Not Yellow

| About: Deere & (DE)

Summary

The agricultural commodity slump shows little sign of ending.

Analyst ratings are confusing: some are upgrading, some downgrading.

My thesis is unchanged: DE's quality will carry it through the agriculture downturn.

DE's dealer footprint is a special advantage they have over its competition.

Catalyst: Corn prices are still low; when they turn higher, look for increased sales for DE.

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Since my last article recommending an investment in John Deere (NYSE:DE), its stock price is up 8%. That's not very impressive compared to the S&P 500 (+15%) but it's in line with its competitors:

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Source: Google Finance

Like its competitors, DE has also dropped in the past week as the corn and soybean harvests appear to be high. It was predicted before that maybe bad weather would reduce the harvest and push prices up. Farmers make more money when corn prices are high, and can afford newer equipment. This in turn raises EPS for agricultural equipment companies like John Deere.

This cycle in agricultural products is partly natural (supply) and partly human-caused (demand). Right now supply of many crops is high, while demand is lower. You don't have to have an economics degree to know that combination will equal lower prices for the time being.

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Analysts' consensus opinion: ¯\_(ツ)_/¯

Analysts are all over the map on John Deere. Here are the latest ratings since the Q2 results on May 20, 2016:

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Source: MarketBeat

Some analysts are upgrading while others are downgrading. Half of them are sitting on their hands with a "reiterated rating". And this is all on the same news. The fact that different analysts have differing opinions isn't strange, but the breadth of their estimates is. The price targets range from $50 to $105. One of those is going to be way off.

If you listen to the Q2 conference call, or read the transcript, you can hear the analysts' questions at the end. This call was pretty standard. Questions were about minute details of the income statement or balance sheet, or when earnings would be recognized. No fundamental problems were brought up, which can be seen in the three upgrades that were given after the call. Of course, the "upgrade" given by Cowen and Company seems odd, given that their target price is $50 (DE was at $80 on that day). That looks like a mistake.

The one downgrade by Piper Jaffray a few days ago is even weirder. They weren't on the earnings call so we don't know of any issues specific to DE they are worried about. Apparently, one analyst thinks that crop prices will stay low. That seems like a pretty weak reason to cut 12% off of your price. Now, if he had predicted the downturn in 2014, that would have been something!

DE's business model is unchanged

The overall message of the earnings call was that DE is doing the best it can in a low sales environment. Management's Net Income guidance for 2016 is something between $1.2 billion and $1.25 billion. It was $1.2 billion in the first part of the call, then under analyst questioning it was admitted to be a bit higher.

Tony Huegel (Director of Investor Relations): "1.2 billion in income is also a rounded number and, in this case it is actually rounding down a little bit."

Let's call it $1.225 billion (look, I'm an analyst!). Divided by current shares outstanding (316.5 million diluted) gives us $3.87 per share EPS for 2016. That's less than the $4.17 guidance given earlier this year but not crazy low. So, really any change in rating or price target will depend on whether an analyst thinks that these low earnings will persist for years. What evidence do we have to support that?

DE's dealer footprint will allow it to take advantage when the time comes

Compared to its competitors AGCO (NYSE:AGCO), Kubota (OTCPK:KUBTY), and CNH Industrial (NYSE:CNHI), John Deere has an expansive network of dealers. This allows it to sustain "top-of-mind" brand awareness among its customers. Its recognizable green branding helps as well. But when a piece of equipment breaks down in the middle of harvest or planting, a local dealership that can quickly source the needed parts is more important than any brand. Of course, any service or parts sold makes DE more money, but those dealerships can be expensive to maintain while sales are low.

John Deere consolidated some of its smaller dealerships in the 2000s because of this. It helped inventory management because larger dealerships were better at predicting demand and improved customer service. A larger dealership is more likely to have needed parts on hand, and can better afford overnight shipping. Because of this, these more professional locations are better brand ambassadors for DE's new "Precision Ag Management Solutions". These are basically high-tech field monitoring and management products, hardware and software, that complement Deere's traditional offerings. This focus on new technology in an old industry is another advantage for John Deere over its competitors. Here is a graph of research spending over the past 5 years.

DE Research and Development Expense (Annual) Chart

Research and Development Expense (Annual) data by YCharts

I couldn't get the data for Kubota, but as you can see CNHI and AGCO both spend less (combined) than DE. Also, note that DE's research spending is flat over the past two years of decreasing sales. John Deere appears committed to staying ahead of the technology curve. It could have spent less this year to boost net income and look good for the analysts, but at the expense of future margins. Instead, that R&D will ensure higher margin growth when crop prices come out of their current slump.

Valuation

Assuming a $3.87 EPS for 2016 does little to reassure owners of DE, but that's what the numbers tell us. That is the third lowest EPS in the past 10 years. It's not a good sign and lends credence to the analyst downgrades. 10 years ago the EPS was $3.59, so that is only a 0.83% growth rate to today.

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
EPS 3.59 4 4.7 2.06 4.35 6.63 7.63 9.09 8.63 5.77 3.87
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A better method to estimate the growth rate of earnings is to compare similar periods. 2001-2008 were one cycle and 2009-2016 appears to be another:

DE EPS Diluted (Annual) Chart

DE EPS Diluted (Annual) data by YCharts

Taking the average EPS from the first cycle ($2.48) and comparing it to the second ($6.00), annualized over an 8-year cycle, gives us a growth rate of 11.7%. That's much bigger than 0.83%!

EPS $3.87
Growth Rate 11.67%
Years 8
Terminal Growth Rate 4.00%
Terminal Years 16
Discount Rate 8.00%
Valuation $88.27
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That's a 12% discount from today's price ($77.69). This is also a relatively conservative valuation. The growth rate was calculated based on 8-year averages. If we had also done that for the EPS, it would have been $6.00 and increased the valuation by 55% ($137!). Regardless, John Deere is relatively underpriced, unless of course something has changed to render Deere's significant advantages meaningless. Any ideas? Post them below.

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Disclosure: I am/we are long DE.

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.

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