2023-11-10 10:32:48 ET
Summary
- John Deere's stock has more than doubled since the pandemic but has recently started trading down from its peak.
- Investors are concerned about Deere's cyclicality and its history of downturns, but the stock has always recovered and seems to always trend upward.
- The upcoming earnings report may show declining order books and softening demand, but North America's demand for equipment remains strong.
Introduction
"Nothing runs like a Deere" has not only been the slogan of one of the most iconic American companies, but it has also been true to its stock, which, after the pandemic, has more than doubled. This year, things have started getting a bit more choppy: on one side, Deere has clearly beaten earnings expectations, but its stock has started trading down from its $450 peak. We are talking about Deere & Company ( DE ) and, as its earnings report approaches, it is time to see what we could expect for such a company.
Summary of previous coverage
Those who have read my articles on agricultural and farming machinery manufacturers should know I am overall bullish on the industry , which is supported by three major trends that are unfolding: world population is increasing and so is the need for food, arable land is scarce leading to new technologies to increase crop yield, skilled labor force is hard to find and this pushed farmers towards autonomous solutions.
Last year, I thought Deere would not benefit as much as CNH Industrial from the rapid surge in inflation and huge pent-up demand. In fact, it was at full production capacity and thus had a couple of quarters where its margins were hit by rising costs not yet offset by pricing and by unfinished vehicles hurting inventories and working capital metrics.
This year, I turned bullish on Deere, too, anticipating pent-up demand was going to make Deere post 2-3 exceptional quarters, which Deere actually did. At the same time, the stock traded up near $450, but has being falling since August and is now down around $360. It appears it could still be headed south for a bit.
What is the major concern for investors with Deere? I think one word can explain it: cyclicality. As we can see from the graph below, in this century alone, Deere has seen three major downturns, with revenues declining 20%-40%, together with the operating margin. Each of these downturns brought the stock down. At the same time, the stock more than recovered from each downturn, trending overall upward.
My buy rating was also supported by one consideration about the upcoming downward part of the cycle. Usually, market leaders hold up better thanks to premium products and customer loyalty. True, Deere may see its sales cut in half for one year or a bit more, but in the meantime fleets age and this gives time for demand to accumulate again. As Deere's management said during the Q1 earnings call :
"Production levels in 2023 are still 20%, 25% below prior replacement cycles." As a result, the average tractor age during 2023 should remain elevated, creating further pent-up demand for new equipment. As a consequence, the replacement cycle will take longer than usual.
In addition, Deere is more exposed than its peers to North America, whose demand for equipment is holding up strong, as we will see in a moment. Last, John Deere is also following the path traced by Caterpillar ( CAT ) in creating a service business taking advantage of digital-enabled solutions that lead to better asset utilization by farmers and to increased monetization by manufacturers. Taking advantage of new hardware and software needs for the tractors and combines its manufactures, Deere is developing a strategy to connect at least 1.5 million machines by 2026 to bring to scale its "Solutions as a service" business model.
As Deere's management stated during the earnings call of Q1:
"We're getting started. I think we're off to a good start. But it's really - you need to consider both our goal to get to sort of through-cycle margins of 20%, but then also minimize the volatility around that 20% as part of the goal suite as well"
Q4 Earnings Preview
Recent concerns about the end of the cycle
Now, there are many signs hinting we are at the peak of the current cycle, or at least close to it.
On one side, it is easy to understand how companies such as Deere are catching up with pent-up demand as supply chain bottlenecks have eased and finished vehicles can be delivered to final customers.
At the same time, it is also easy to understand how, with interest rates rising, costly products such as tractors or combines see cooling demand, because financing becomes more onerous, even though farmer income is holding up quite well.
In addition, we have to consider what we have just recently learned from peers such as Caterpillar, AGCO ( AGCO ), CNH Industrial ( CNHI ) and, since Deere also has a construction and forestry segment, we can also use some recent data from Volvo Group ( VLVLY ) and Terex ( TEX ). The latter has recently disclosed it expects FY 2023 EPS to be $7.05, lower than the estimate of $7.16. The former, in its Q3 earnings report , delivered strong top-line performance, but had to admit that order intake in construction equipment was down by 27% with deliveries decreasing by 21%. According to Volvo, this downturn was "largely driven by lower demand in China following the economic slowdown as well as by cautiousness among customers and dealers in Europe." However, Volvo also reported that North America is the only region where construction is still growing thanks "to continued large infrastructure projects and a strong commercial construction sector that more than offset weaker residential construction amid rising interest rates."
Caterpillar, on its earnings call , mentioned orders down in the quarter with customers displaying capital discipline and showing some "delay in actually pushing the button on committing to firm orders".
Agco, a closer peer to Deere than the ones previously mentioned, also talked about orders "returning to a more normal" environment, with farmer sentiment weakened in Western Europe, leading to a slowing order flow. At the same time, the company disclosed how its penetration of North America is doing well, thanks to the strength of its premium brand Fendt (challenging Deere with the so called " Green Tractors Battle ").
More openly, CNH Industrial cut its FY guidance to annual top-line growth from 3% to 6% compared to the previous range between 8% and 11%, revealing softening demand in South America and announcing an immediate restructuring program to cut SG&A by 5%.
Both Agco and CNH Industrial reported stronger sales in large ag, while small ag is already slowing consistently.
Deere itself, in its last earnings call talked about its last fiscal quarter (the one we are about to see reported) with the following warning:
If you think about the fourth quarter, we'll see revenues flattish to maybe down a little bit in ag. [...] The big driver there is we are seeing a return to, again, this normal seasonality, which does mean that we will institute normal factory shutdowns particularly at Harvester Works, which historically we've done factory shutdowns in the month of September and/or October. [...] We haven't done that the last couple of years as we've been running behind on delivering machines to customers in late in '21 and then all the way really through 2022. So that's really the big impact that we're going to see happen in the fourth quarter.
[...] we'll see a heavier R&D spend in the fourth quarter, that's a timing thing. Our fourth quarter does tend to be a little heavy most years from an R&D perspective. That is certainly going to be true this year as well.
[...] you'll see a little less Brazil mix as well in the fourth quarter.
So, kind of all three of those things will conspire together to bring down margins just a shade in the fourth quarter when you compare them to third quarter results.
If we add a fourth factor, that is tough pricing comps because price increases took place in the last half of 2022, the picture we are outlining points to flattish revenue. Margins will likely remain high or will actually increase, thanks to commodity prices decreasing. But the outlook for 2024 won't be as bold as the ones we have been used to.
To sum things up we have declining order books with customers being more cost conscious. However, North America seems to be holding up well and, as far as major product lines go, large ag is doing better than small ag.
Let's now look at Deere's latest available annual data. First of all, in 2022 North America made up 55.3% of total sales. This sets Deere's geographic mix as more protected from severe downturns as its competitors are, since they rely more on Europe.
Secondly, Deere sees around 41% of its revenues coming from large ag (or production ag) with another 24% coming from construction and forestry. This, too, as we can see from the revenue breakdown by product lines shown below, partly insulates Deere from current weakness.
However, the reason why large ag is holding up better than small ag is not related to organic strength in this product line, but, rather to internal challenges within manufacturers. In other words, in large ag, it takes more time to receive all the right components and then assemble them in a highly technological product compared to the time small ag products need to be manufactured. Therefore, pent-up demand takes more time to be fulfilled, creating a longer streak of strong quarters.
Earnings estimate
Having said all that, we can try to make an educated guess on what to expect from Deere's earnings report.
For sure, everyone's eyes will be on Deere's FY 2024 guidance. This will be even more important as Deere has already started its new fiscal year since this earnings report will be for its fourth fiscal quarter and its fiscal year 2023.
Sure enough, Deere's management will try to inspire confidence regarding its outlook. However, it would be highly surprising to hear bold expectations about next year. We will probably hear about softening demand coupled with still elevated farmer income. We might hear about weaker Brazil and South America, but we should also hear about North America's strength. So, we will need to be good at reading between the lines to truly decipher if Deere is thinking about a gloomy horizon or not.
Last year, Deere reported quarterly sales of $14.35 billion. This year, given what Deere itself said in its last earnings call, we should not see particular top-line growth. Therefore, any result crossing $14.5 billion would be a big surprise. At the same time, I do expect operating margins to go up because of moderating inflation which has caused commodity prices to decrease while prices for finished products have either held up better or have even increased.
Last quarter, operating margin was 23.7%. This quarter, though gross margins will probably go up, we also know that R&D will be higher, impacting operating income.
Let's thus assume another quarter were $14.5 billion in revenues give way to an operating income of $3.34 billion (23% gross margin). From here we need to move down to the bottom line. Deere has a net income margin of 16.4%, which makes us expect at least $2.38 billion in net income. Considering Deere had 288 million shares outstanding at the end of July and assuming Deere has kept on executing its share buyback program, we can make some EPS estimates.
Assuming the share count has remained the same we have estimated Q4 2023 EPS at $8.26.
However, assuming Deere repurchased another five million shares during the past quarter, our estimated EPS could go up to $8.41. This is rather high compared to what analysts are expecting . The average EPS estimate for Q4 2023 is $7.47, which marks the beginning of a downturn cycle, according to investors.
Deere is now trading at a fwd EV/EBITDA below 12, which represents a 12% premium compared to the sector average.
However, a premium is deserved here, not only because we are talking about the clear industry leader, but also because Deere has a long track record of weathering any recession, coming out of each one of them stronger than ever.
For example, if we look at the generated operating cash flow, we see some cyclicality, but also a long-term trajectory pointing upward.
Deere is also trading at a fwd PE of 10.9 and a P/FCF of 11.5. which doesn't make the stock seem that expensive in today's market. For a company like Deere, it seems to be a fair valuation.
So, we will probably see Deere enter into a tougher part of its economic cycle. And yet, the macrotrends I talked above at the beginning of the article won't go away anytime soon. And once demand picks up just a little, Deere becomes a stock able to have sudden and rapid price surges. Setting possible price volatility aside, as Deere drops, the more it appears to me as a stock finally offering a decent opportunity for long-term oriented investors, making me rate it as a buy.
For further details see:
Deere: Should Investors Be Afraid Of Upcoming Earnings?