There's been plenty of optimism in the farm & construction machinery industry as Deere (NYSE:DE) management has offered the notion that the bottom is quickly approaching. Some believe this case holds merit as sales only declined 3% year-over-year during the fourth quarter. Analysts also broadly favor staying with the stock as the industry recovery in tandem with incremental cost cuts (estimated to be 500 million dollars over the next two years) will serve as identifiable catalysts. While there is no denying Deere is an incredible company with a wide moat, we think the market is pricing a best case scenario.
Don't Expect Much
Most equipment purchases took place between 2011 and 2014 as the business generated record sales. Unfortunately, the truth of the matter is that equipment fleets in Deere's end markets are still remarkably young, and are actually the youngest in history. This market data has been confirmed through various news reports that follow the industry closely. The end result is that equipment purchases be extended further out in time, making annual sales lower than what was recently shown, especially relative to the last few years. That also means return metrics, like return on invested capital, will probably be lower too.
There's also active debate that Deere's activity of purchase its own equipment could ultimately hurt results longer term. The buying is coming through the Financial Services segment in order to mitigate the negative effects of the current down-cycle. Of course this is activity is accounted for through financial statement consolidations, but the net impact to the business overall will serve as a headwind to future performance. Put simply, the proposed net effect is that future sales will be lower given that demand will be absorbed by this pre-existing inventory. Lastly, we don't expect sales to pick up through market share as the competition is aggressive, and Deere already controls most of US and Canada (representing more than two-thirds of historical sales on average).
We decided to look at Deere's efficiency. As one might expect, it's probably not as good as it once given the law of large numbers. And we do actually credit the company for doing well with its equipment pricing power, however after conducting a Du Pont Analysis, the results are pretty worrying. The main takeaway that we found was that ROE in the last twelve months fell to soft measure of just 23%, that is the lowest since 2009. While it partially makes sense given we sitting at the "industry trough", there's another outlier. Not only is asset turnover offering a poor read, the company's equity multiplier, or more simply financial leverage relative to total assets, has increased to a record high (average total assets over average total equity). So in effect, we are seeing lower ROEs and higher leverage levels (which is clearly a terrible fundamental divergence). In other words, we can expect that the business will be less profitable in the future.
Balance Sheet Risk
Leverage impacts a company in both directions, good and bad. Deere has a highly levered balance sheet with 31 billion in net debt, representing more than 50% of total assets, and ~18 billion of this debt will mature roughly over the next 4 years. With interest rates on the rise, management will be required to refinance its debt at a higher cost if it plans on sustaining its current capital structure (funding operations and covering dividends). That in turn means higher interest expenses. If we assume a modest increase of 1% for this partial balance, and assume it comes through by combination of higher LIBOR rates and/or the small possibility of a credit downgrade, the business could face a gross increase of 150-200mm in interest expenses on an annual basis. Including the net tax shield, the net expense would be around ~120mm, and shave approximately $0.35-40 cents off EPS using today's count of 315 million in shares outstanding.
While the industry dynamics are constantly changing, we think sales will remain markedly lower than the prior peak for the foreseeable future. We think that means margins will not revert back much due to the lack of operating leverage, despite the positive effect of upcoming cost cuts.
If we take the average net income over the last 10 years, the most recent cycle, the result comes out to approximately 2.2 billion. Using today's share count, that puts EPS at approximately $7. However if we account for the increased financing costs, albeit using a conservative estimation, it works back closer to $6.50. If we assume that can play out, the business is currently trading at ~17x earnings, or showing an earnings yield of just 6%. The only way the stock turns cheap is if you forecast aggressively, but that doesn't serve as a very good investment thesis.
Regarding capital return, management practically halted share repurchases and the current dividend yield of 2.2% just doesn't seem all that enticing, particularly relative to market alternatives. An industry peer, Caterpillar (NYSE:CAT), for example offers 3%, which we still would not consider all that great.
Just circling around to the buyback again, when management stops these programs in generally means they have better use for deployable capital. In other words, repurchase shares would not be accretive return on invested capital which could be a red flag for the current share price. Interestingly, insider selling has also been fairly severe according to Finviz.com:
Finally, the news also briefed everyone that Berkshire exited its entire stake in Deere through its most recent 13F. Given those three sentiment related factors, we believe that now is certainly not the time to purchase shares of Deere.
Even though we fully expect Deere to beat earnings, as it has in the last 11 quarters, we don't believe there is a fundamental shift in the industry. At the price of $109, this is not a cheap stock. If we consider a reversion to the previous top back in mid-2015, the stock has approximately 10-15% downside. While it does ultimately depend on your broker, shorting the equity is fairly inexpensive as short interest has declined to its lowest level since 2014. If you enjoyed this article, please click the "Follow" button at the top of the page. Thank you for reading and please comment below.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in DE over the next 72 hours.
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.