Tickers in this Article: DE, CAT, AGCO, CNH
Deere (NYSE:DE) is a curious stock. It seems all too common for investors to bid these shares up into earnings (up about 12% this time), only to be disappointed when management's guidance sounds more conservative than they wanted. And yet, more often than not, the company does fine (or better) the next time around. While this pattern can be frustrating for investors who get stomach aches over the week to week moves in their portfolio, it's an opportunity for investors to make entries (or exits) at better prices.

Fiscal Second Quarter Earnings Come In Okay

This wasn't a super quarter for Deere, but it wasn't bad. Manufacturing revenue rose 9% for the quarter on a 3% improvement in realized prices, good for a 3% beat versus the average estimate. Ag sales were stronger than expected (up 12%), but construction and forestry was weak (down 6%) despite little optimism about this business going into the quarter.

Margins, too, were mixed. Gross margin weakened slightly, but not by enough to worry about. Overall operating income rose 8%, with ag income up 13% (and with stronger margins than expected), while construction income plunged another third and disappointed on margins. On an operating basis, Deere had an okay quarter relative to expectations, with a sizable bottom-line beat if you adjust for a higher than expected tax rate.

Really, Few Surprises In The Big Picture

As I said, there was absolutely no reason to think that Deere was going to have a great (or even good) quarter in its construction business. Caterpillar (NYSE:CAT) and CNH (NYSE:CNH) both had weak results, and Eaton's (NYSE:ETN) hydraulics business (which gets about one-quarter of its revenue from the construction equipment market) was down about 9% on an organic basis.

Likewise, the results in agriculture and turf aren't surprising. AGCO (NYSE:AGCO) reported a couple of weeks ago, with ag equipment organic revenue growth of 8%. Deere's results relative to AGCO were pretty consistent with what we've seen – AGCO is still doing very well in Latin America (its line up of small tractors sells well there) and Deere is more than holding its own in North America. Along similar lines, it seems like Deere is following a familiar path of setting conservative baseline assumptions and then tweaking them higher – the company's outlook for North America and South America improved incrementally by about 5% each.

Blocking And Tackling May Be Boring, But It Works

Deere can definitely have a bad year, or a bad stretch of years, as we saw in the aftermath of the credit crisis. Over the long term, though, management has built a business that is very good at accumulating shareholder value.

Part and parcel of that performance is understanding what they do well, and looking to find ways to do it just a little better. You're not going to see dramatic restructurings at Deere, nor quick changes in strategy. Deere management has their vision of where their key markets are going (and what they need to do to participate), and they're going to follow that vision.

To that end, I expect management to look to keep costs as low as possible in the construction business, but not at the price of hamstringing the business for the eventual recovery. Likewise, I fully expect management to position the company for growth in markets like Russia and India, but not at the cost of expensive M&A or aggressive launches. As these economies evolve, their ag sectors will mechanise and Deere will be there selling them tractors and other types of equipment. There is a risk that others like Kubota (NYSE:KUB) and Mahindra will gain share as early movers, but Deere has taken share from these companies before and is almost certainly looking to play the long-term game.

The Bottom Line

I'm looking for Deere to grow its revenue at a long-term rate of about 5%, which is likely conservative given not only the historical growth rate of nearly 10% over the past decade, but also the ongoing growth in the global ag sector. On the other hand, my expectation of high single-digit free cash flow margins could be aggressive, given that they haven't managed that in a long while (and never for multiple years in a row) and aren't likely to make sweeping changes to the business model.

In any case, I currently see Deere shares worth about $92, which makes them slightly cheap today. While I much prefer to own significantly undervalued shares, there are worse things in the investing world than sticking with high-quality companies, even if the shares aren't huge bargains at a given point in time.

At the time of writing, Stephen Simpson did not own any shares in any of the companies mentioned.

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