Bears Take a Bite Out of Deere

Deere and Company (DE) reported earnings for the fiscal second quarter that showed an 18% increase in revenue and a 22% rise in net income (see conference call transcript). However, the stock was off about 10% yesterday as profit fell below estimates and the company forecast tough times ahead in housing.

The world’s largest farm equipment maker benefited from a boom in the price of agricultural commodities such as wheat, corn, and rice all of which are trading near their all time highs. The rising prices have enabled farmers to buy new, bigger, or additional equipment. Deere management expects an increase in sales of farm equipment of about 35% over last year’s results. Furthermore, the company is experiencing good expansion overseas as the weak dollar makes Deere’s equipment more affordable to foreign farmers.

The sales growth in farm equipment at home and abroad is certainly a bright spot, but Deere did not meet analysts’ expectations for net income and earnings. Analysts had estimated that the growth in farm equipment sales would have more of an impact on the bottom line. Also, Deere maintained guidance for the year ahead, which was a disappointment.

The strides made in farm equipment are being offset by weakness in the U.S. housing market, as earnings in the construction division were down 14%. Deere’s management expects that the weakness in housing will continue to plague that unit, and they expect housing starts to slow this year to a 60 year low. The company expects global sales for the construction and forestry unit to decline by 3% in 2008.

Currently, Ockham Research has a Sell rating on Deere because the current price remains too high for our value investing methodology. Deere has perhaps benefited from the commodity boom more than is justified. On a price-to-cash flow basis, DE is currently selling at 11.54 times cash flow per share, which is 26% above the normal level. Even more out of balance is the price-to-sales valuation—the current measure is 1.36 compared to a normal range of .717-1.11—this is 48% above what the market has traditionally been willing to pay. These valuation metrics were calculated after the stock price took the 10% hit.

Based on these valuation metrics and given current sales and cash flow levels, under normal circumstances we would expect the stock to trade around $74 per share.

Disclosure: none