Deere: I Am Slowly Turning Bullish

Summary

• Deere reported its first earnings decline since the economic bottom of 2016/2017 as higher costs more than offset higher sales.
• The company is being pressured by uncertainty among farmers and bad weather.
• Nonetheless, we might be close to the start of an equipment replacement cycle as both the economy and sentiment among farmers are bottoming.

John Deere's (NYSE:DE) just released fourth quarter was not pretty. The company reported declining earnings for the first time since the 2017 bottom, as production costs and overall slower margins hit already weak sales growth. The stock was down significantly after earnings, as investors become cautious due to the ongoing trade war and pressure on farmers. Nonetheless, I think Deere is not a sell. I am even turning bullish, as the one reason why I did not become a bull in August seems to be turning. And that's economic growth expectations.

Source: John Deere

Here's Why Q4 Was Bad

Let's start by looking at the bottom line. I always like to start here to see how well or poorly a company performed before I start looking at details. In this case, we see that adjusted EPS reached $2.14. This is pretty much what analysts expected as consensus expectations were just $0.01 lower at $2.13. In other words, it was already expected that Q4 would be a "bad" quarter. In this case, the company reported an earnings decline of 7%. This is the first decline since the first quarter of fiscal year 2017. Back then, cyclical companies started to see an earnings rebound after the economy bottomed in Q1 of 2016. This lagging effect takes some time and I think we are currently dealing with the same issue as global economic growth has peaked in Q1 of 2018. Since then, the growth rate has plunged from 66% growth to 7% contraction.

Source: Estimize

Let's see how earnings were able to end up lower. First of all, total sales were up 4% to $8.70 billion. This is roughly $250 million above expectations and a relief as the prior quarter saw a 3% sales decline.

Construction and forestry sales were up 8% to $2.95 billion. Both shipment volumes and better pricing contributed to this result. Unfortunately, these factors were more than offset by higher production costs, SG&A costs and a negative mix. This resulted in a 12% decline of operating profit to $261 million.

Unfortunately, sales weakness is expected to continue. For example, construction and forestry sales are expected to be down between 10% and 15% in the fiscal year of 2020. This expected decline is driven by mid-sing-digit underproduction to retail volume versus a building of inventory in 2019. This might sound worse than it is, but it is a measure to lower inventories. Overall orders are expected to remain healthy in FY2020.

The table below shows strong inventory growth in both 2018 and 2019. This is not part of the construction segment, but it supports the overall reduction of inventories in 2020. Worldwide agriculture and turf sales are expected to be down between 5% and 10%. Currency translation is expected to be a 1% headwind while better pricing should provide 2% growth.

Source: Deere Q4/2019 Earnings Presentation

The same data source also confirms the thesis that overall demand is stronger as the company is managing to outperform the market with regard to 2WD tractors in a growing market.

Source: Deere Q4/2019 Earnings Presentation

Moving over to total farm receipts. 2019 cash receipts are expected to be up 2% to $395 billion. Net cash income is expected to be up close to 7% to $113 billion. At this point, it is no surprise, but growth was provided by USDA aid, which delivered $17 billion to the US farm economy in 2019.

Source: Deere Q4/2019 Earnings Presentation

With that said, there is bad news as some analysts are mentioning the comments regarding the cautious behavior of farmers and the pressure on financial services due to lease losses (source).

Lingering trade tensions coupled with a year of difficult growing and harvesting conditions have caused many farmers to become cautious about making major investments in new equipment.

... financial services results have come under pressure due to operating-lease losses.

Nonetheless, going forward, Deere is seeing some improvement as US farmer sentiment is starting to improve as they have learned to adapt to the current (difficult) trade environment. In addition to that, fleet age in the US has reached its highest point in over a decade. This is expected to more or less force farmers over time to invest in new equipment and should enforce a gradual recovery/investment cycle. Personally, I hope this is met by an overall improvement of the trade environment as I am afraid this will otherwise further pressure the quality of farming debt. However, I guess that's something we will find out over the next 2-3 years.

Another point is the move towards precision technology in the farming industry. The move to "high-tech" has been a major driver of the most recent replacement cycle. Unfortunately, in difficult times farmers tend to invest in products that deliver the higher returns on investment. The move to better technology is expected to accelerate once farmers are facing less uncertainties regarding commodity prices, trade and weather.

Why I Am (Becoming) Bullish

This earnings release was not pretty. However, "nobody" expected good numbers as far as I'm concerned. The company saw pressure on margins, currency headwinds and continues to suffer from trade uncertainties. Nonetheless, I have to agree with management. I think it makes sense to say that farmers are adjusting to the circumstances and slowly replacing old equipment. I think we could indeed be on the brink of a replacement cycle. In this case, we even might get some help from the economy. The graph below shows the ISM manufacturing index (orange line). If we are once again at a bottom like we saw in 2016, I expect this company will get a tremendous tailwind again. I even think that farmers are not the only ones who are adjusting to the ongoing trade war difficulties. The S&P 500 is up more than 26% year-to-date as a result of traders betting on a growth recovery and the hope that the trade war is not going to escalate further. I do not think that anyone expects the trade war to get resolved anytime soon.

Source: TradingView

Anyhow, I am not blaming anyone for selling Deere after earnings. It's what happens when traders do not like quotes that indicate uncertainty among farmers and pressure on leases. Nonetheless, I think this stock will find support around the $160 level after attempting a breakout last month.

Source: FINVIZ

The risk/reward is not that bad as I think things look worse than they actually are. Sure, by saying this, I am hoping that the ISM manufacturing index (economy) is going to stabilize around current levels. If this is indeed the case, I think we are looking at a longer-term price target of $200.

Stay tuned!

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.