With this year's drought potentially rivaling the ones of 1988 and 1980, could tough times be ahead for agriculture and forestry company Deere (DE)? Deere has been successfully transforming itself into an international company, and as a result has tempered its exposure to droughts in the U.S., but Deere still derives slightly over 50% of its revenues from sales in the U.S. So a drought in the U.S. may not have as large a negative impact on Deere's earnings as in prior years, as long as sales hold up in the rest of the world.
In Deere's F2Q 2012 earnings call held on May 16, 2012, the company noted the sovereign debt crisis in Europe has affected Southern Europe more than other areas of Europe, and Deere has less exposure to Southern Europe, which is a plus for the company. The company indicated credit has not dried up and is still available in Europe.
In the previous quarter, Deere reported record quarterly income and sales with revenue over $10 billion which represents year-over-year quarterly growth of 12%. The company indicated the strong results were a result of the strong global farm economy.
In the last quarter, the company raised its 2012 forecast to $3.35 billion, even though the company expects growth in Asia to moderate and expects growth in India to be slightly down. The negative situation in India is partly a result of high interest rates in the region. The company also reduced forecasts in Brazil and Argentina due to droughts in those regions and also due to some negative government policies in Argentina.
Deere's stock price has been in a trading range between $60 and $88 as shown below:
The stock price is currently trading about midway between its trading range bounds and has spiked up in recent days.
With Deere's Q3 earnings release forthcoming on August 15, 2012, an investor in the company might seek to protect an investment in the company, just in case the company reports bad news. It would not be a huge surprise for the company to mute its earnings forecast as a result of the drought. One way to protect an investment is with a protected covered call or collar. A protected covered call positions for a potential return, even if the price of the stock is stagnant, and provides protection. A protected covered call may be entered by selling a call option against the stock and using some of the proceeds to purchase a protective put option for protection or "insurance" against a large drop in price.
A variety of protected covered call positions are available for Deere as shown below:
The top two positions look attractive, and it looks like the 2012 December position has a higher potential return of 2.9% than the 2013 January's potential return of 2.6%, however, these results reflect the expected returns before consideration for dividend payments.
When considering expected dividend payments, the 2012 December position has a potential return of 3.4% (8.6% annualized) and the 2013 January position has a potential return 3.8% (8% annualized). The 2012 December position does have a slightly higher annualized return than the 2013 January position. Either position is attractive, and the 2013 January position is selected as it has a 6.2% maximum loss versus the 2012 December's maximum loss of 6.6%. So, the maximum loss the 2013 January protected covered call can sustain is 6.2%, even if the price of the stock drops to zero.
The specific call option to sell is the 2013 Jan 77.5 at $5.75 and the put option to purchase is the 2013 Jan 70 at $3.30.
- DE stock (existing or purchased)
- Sell DE 2013 Jan 77.5 Call at $5.75
- Buy DE 2013 Jan 70 Put at $3.30
A profit/loss graph for one contract of the Deere protected covered call is shown below:
For a stock price below the $70 strike price of the put option, the value of the protected covered call remains unchanged. If the price of the stock increases to around $85, the position can most likely be rolled in order to realize additional potential return.
Can't wait to hear your comments!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.