I admit my chosen field of expertise - limited, I completely admit - is not energy, oil, commodities, or stocks in general. I stress that I've no formal training in financial analysis and that I am strictly an amateur. That being said, I've heard somewhere that it's better to be generally right than precisely wrong, and that - generally speaking - common sense and growing earnings prevail in the long run. With that in mind, I've decided to take a critical look at a couple of different cyclical stocks in my portfolio, Schlumberger (NYSE:SLB) and Deere (NYSE:DE). Both stocks are rightly believed to be sensitive to changes in commodities prices, and as a result, both have been under pressure recently - Schlumberger perhaps more so - with concerns about falling prices in crude oil and crops.
As a long-term investor, I'm hoping to find companies that are able to reliably compound their intrinsic value over time. Like most of us here on Seeking Alpha, as much as I value capital appreciation, I value capital preservation, and capital preservation above the scourge of inflation is perhaps the most critical. Beating the market is nice, but beating inflation over a long-term horizon is a critical minimum.
I wished to test the hypothesis that the revenues and earnings of both Deere and Schlumberger were all highly levered to commodities prices. It seems intuitive, but I've yet to see statistical data backing this up. I also wanted to get a sense of if these companies had outperformed their respective related commodities over time on an inflation-adjusted basis.
So for Deere, I gathered up the historical annual average per-bushel prices for grain to correspond with the financial data on Deere I was able gather (from company 10-Ks) and Morningstar. I also gathered the historical annual average prices for Brent Crude and West Texas Intermediate to correspond with available financial data for Schlumberger (again, company 10-Ks). I then applied historical annual inflation rates to the data. What I found was both obvious in some respects, but also interesting.
Deere and Agricultural Products:
With grain prices falling all around the world, it's widely thought that the global economy is about to fall into a prolonged bear cycle for grain prices after a long boom. But as it turns out, on an inflation-adjusted basis, this is hardly the case:
Grain prices actually hit a nadir in the early 2000's, and have been climbing slowly ever since (though the growth has been lumpy and appears to have hit some resistance over the past couple years). Overall, though, for the two decades prior to the turn of the millennium, it appears that the overall story for grains was one of falling prices, presumably aided by rapid advances and distribution of technology, farm consolidation, and rapidly improving global infrastructure. And though since 2000 this trend appears to have reversed a bit (maybe bouncing off some intrinsic level of support), the cost of basic agricultural products has yet to come close to the spike of the early 1970's, or even the average prices of the 1960's or early 1980's.
What about Deere, then? How have this company's revenues and profits changed over this time? Here's how the company has done since 1992 (the first year I'm able to pull data for), with regards to revenue:
Deere's revenue base has gone up steadily over time - hardly surprising - and its revenue growth has been sensitive to changes in commodity prices (also hardly surprising, with a Pearson correlation coefficient of 0.64, significant at p = 0.01). In recent years, though, inflation-adjusted revenue growth has widely outpaced the growth in commodity pricing, which suggests to me that the firm may have other sources of revenue perhaps less sensitive to the vicissitudes of the commodities markets. Overall, while the trend in commodity pricing has been a positive one over the past decade, Deere's revenue growth has been far more robust.
The story for margins is perhaps a bit more subtle. Operating margins (Pearson coefficient 0.62) seem to accentuate swings in commodity pricing while net margins tend to hew a little more closely to the overall trend (correlation 0.68). Both margins have tended to grow over time in a manner that either materially outpaces (operating margin) or mildly outpaces (net margin) the overall trend in commodity pricing.
Looking at the bottom line, Deere's growth is a bit less apparent, but so is the correlation to overall commodity pricing (Pearson correlation coefficient of 0.52, significant at p = 0.02). In recent years, though Deere's inflation-adjusted EPS trend has been unmistakably positive (since a nadir in 2001), it has swung wildly to the upside (see the peak in 2003) and the downside (the post-recession drop in 2008). The numbers bear out the eyeball test, however, and suggest that Deere's earnings, on a per-share basis, are still sensitive to commodity pricing - but are not strictly tied to either commodity pricing or growth of the revenue base. Certainly, the firm's commitment to a share buyback program has helped. But it's clear one can't simply draw a straight line between commodity pricing and earnings power for Deere.
To sum up, Deere story has been one of steady growth, even in the face of changes in commodity pricing. Though margins may be pressured with a drop in commodity pricing, the firm has been careful to shore up the bottom line with share buybacks, and has largely been successful in expanding its margins beyond what might be predicted based upon a 1-to-1 relationship to commodities pricing alone. I'd have liked to compare Deere's revenues and earnings to overall farm income, but with the web site broken, those data weren't available to me. Nevertheless, commodities pricing provides a useful surrogate. The biggest question seems to be what the long-term (read: greater than 5-10 years) story is for commodities pricing. Arable land per person has been decreasing steadily since 1961:
Whereas overall world crop productivity has steadily improved to keep prices in check:
In order for commodity prices to remain stable, crop productivity will have to continue to improve commensurately. Without continued farm productivity improvements, food output relative to a burgeoning world population will decline, and food prices will climb. And it is unlikely that continued farm productivity improvements will come without continued investments into technology and improvements in efficiency. Either way, in the long term, agricultural companies like Deere stand to benefit.
Schlumberger and Crude Prices:
In stark contrast to the falling price of basic grains, the inflation-adjusted price of crude oil has risen inexorably over the past few decades. Schlumberger's inflation-adjusted revenue has also risen commensurately over this time, almost in lockstep (Pearson coefficient 0.90).
With falling crude oil prices (now down in the high $60's as of this writing), one might reasonably expect Schlumberger's earnings to fall as well. However, despite the company's apparent revenue sensitivity, Schlumberger's earnings sensitivity to crude prices has grown more muted over time, and the correlation between earnings and changes in crude price are not nearly as eye-popping (a correlation coefficient of only 0.58), suggesting to me that a key component of my previous investment thesis - that Schlumberger's service offerings remain valuable to oil companies even in a time of falling crude prices, as enhancements to efficiency become all the more critical - is a valid one. From this, it might be suggested that though Schlumberger may not get as much upside in earnings growth when crude prices recover, it shouldn't have as much downside in earnings decline either.
Part of this has to do with a stabilization in the company's operating and net margins, which show a similar resilience against changes in crude pricing:
Moreover, though oil prices may be temporarily down, history has demonstrated that this typically doesn't last for long. Of the 18 years examined, yearly price decreases were observed in 7, and yearly price increases in 11. Moreover, the magnitude of crude oil price increases has historically been far greater than the decline, with an average year-to-year increase of +27.1% vs. an average year-to-year decline of -14.2%. With this year looking like a down year for oil, a recovery in the near term - say, 1-2 years - is a reasonable expectation, which would certainly fit into the time horizon for a long-term investor like me.
Simply put, Schlumberger's fundamentals remain strong and aren't nearly as levered to crude prices as one might expect. The recent drop in price seems to severely discount Schlumberger's operating history, and ignores the company's resilience. Moreover, investors appear to be betting on a sustained (> 3-5 year) decline in crude prices. History suggests that this has almost never been the case, barring a structural change to the oil industry, and that significant drops in crude prices are generally followed by significant increases in follow-up years - sometimes for sustained periods of time, even when prices are adjusted for inflation.
In short, though Deere and Schlumberger are both levered to varying degrees to their respective commodities markets, a statistical look suggests that the current pessimism regarding their prospects is not necessarily supported by history. In the case of Deere, the company's earnings are indeed highly levered to grain prices, but the fundamental trends for a long-term increase in prices remain intact. In Schlumberger's case, though it's difficult to tell what oil will do in the intermediate-to-long term, the company remains less levered to oil prices than one might expect (suggesting a more resilient business model), and though there may be an oil glut at the moment, history suggests that these hardly last for very long. For both of these companies, the long-term story remains solidly intact, despite the near-term pessimism - which may be providing long-term investors an attractive entry point.
Disclosure: The author is long DE, SLB.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. The author is not a professional financial adviser. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.