Seeking Alpha
Long only, growth at reasonable price, value, research analyst
Profile| Send Message|
( followers)  

It may be true that "Nothing Runs Like a Deere," but it also makes for an unpleasant sound when it smacks into the reality of tougher operating conditions. Deere (NYSE:DE) typically enjoys a premium valuation within the heavy machinery space -- a recognition of the company's market share, strong brand equity, and reliable performance history. Unfortunately, Deere is showing that it's not immune to the larger economy or operating missteps.

Global Sales and Manufacturing Inefficiencies Chew Into Profits

Deere actually didn't do all that bad on the top line when it reported Q3 2012 earnings today. While there were estimates out there over $10.2 billion, Deere's 15% overall growth and 16% overall equipment revenue growth was basically in line with expectations. The company's huge agriculture and turf business saw 14% revenue growth, while the construction and forestry business jumped almost 23%.

Margins were meaningfully less impressive, however. Gross margin slid about 70 basis points, due in large part to higher material costs. The company also saw meaningful inefficiencies in the agriculture and turf business, though, and overall segment profit growth of 16% was disappointing, as was the scant 40 basis points of agriculture and turf margin improvement.

Macro, Not Manufacturing, Seems Like the Bigger Concern

I don't think investors should make too much of the margin misstep this quarter; even a good operator like Deere is going to have an off quarter every so often. That's particularly true when a company is not only operating at a high utilization rate, but also trying to introduce multiple new products.

The macro outlook may be the bigger concern, especially as conditions in Western Europe and Asia appear to be softening. Pretty much every company that sells heavy machinery to Asia, from Caterpillar (NYSE:CAT) to Eaton (NYSE:ETN) and Cummins (NYSE:CMI), is seeing a tougher road ahead, so this is not exactly unusual. At the same time, it's a good reminder that Deere is not quite as unique as some of its most bullish supporters might like to think.

Since the last earnings report, the U.S. drought has become a major talking point. As Deere detailed in its conference call, though, the link between droughts and equipment demand isn't necessarily intuitive.

Farmers make purchasing decisions on the basis of cash receipts, and crop insurance ought to eliminate a lot of the downside in most drought-stricken areas. What's more, low inventory levels going into next year ought to be supportive for prices and equipment demand in North America. That said, my back-of-the-envelope math suggests to me that projected yields can't fall much further without some impact to demand.

The Best Can Still Be Better

Not only is Deere the biggest name in agricultural equipment, with roughly 25% share, the company seems to be growing its lead. AGCO (NYSE:AGCO) saw 15% reported revenue growth this quarter, while CNH (NYSE:CNH) posted 11% constant-currency growth. What's more, Deere continues to maintain a meaningful edge when it comes to the profitability of its agriculture operations, even though it meaningfully out-spends AGCO and CNH in R&D.

The company's FarmSight initiative is an example of where that edge may pay off down the road in the form of even stronger share. FarmSight is basically an integrated platform of software and hardware that allows farmers to increase their productivity. While it can work with almost all equipment, naturally it runs best with Deere equipment. Seeing as how farms are getting larger and larger, more efficient operation and supervision is key to making those enterprises work.

It's worth wondering if FarmSight can eventually cross-pollinate into Deere's construction business. Construction is a much smaller part of Deere's operations than at Caterpillar, CNH, or Komatsu (OTCPK:KMTUY), but it's not insignificant. Certainly there are different challenges here (farming is pretty much a two-dimensional activity, while construction is more three-dimensional), but an edge is an edge and both Caterpillar and Komatsu have highlighted the growing importance of technology and automation for heavy equipment customers.

The Bottom Line

To an interested non-owner like me, the lower revision in investor expectations for Deere is not necessarily a bad thing. Though I'm well aware of the risk that the North America and global farm equipment markets could worsen, that's the price of getting into the game. What's more, let's not pretend that other industrials like Cummins, Caterpillar, and Komatsu don't have their own macro/cyclical risks as well.

The real key to Deere's long-term value is the extent to which recent free cash flow trends have been aberrant. Deere has been spending aggressively on capex, depressing free cash flow. If the company can leverage these investments over the next decade, the returns could be impressive. Barring a real breakdown in the agriculture cycle, Deere could be as much as 30% undervalued today -- making it an interesting, if risky, pick during this period of turbulence in the industrial sector.

Source: Deere Smacks Into The Wall Of Worry