Deere May Be Getting Too Little Credit

By Stephen D. Simpson, CFA | August 15, 2013 AAA

The ways things are in the market today, whenever I see an industrial stock that seems to be undervalued by 15% or more, I start wondering what I missed or did wrong in my modeling. While I do believe the North American ag equipment market may well go negative next year, I think the Street may be too down on Deere (NYSE:DE) shares. A combination of weak ag next year and no real construction recovery in sight is grim, yes, but it seems as though investors have been a little gentler with Caterpillar (NYSE:CAT) and Cummins (NYSE:CMI) through their downturns. I'm hesitant to buy into what looks like a bearish and skeptical tape, but Deere is starting to creep up the ranks of my list of value-priced quality stocks.

Margins Come Through In A Big Way In FQ3
There was a lot of negativity going into Deere's quarter, but the company delivered good results on an operating basis. Revenue was up 4% (and down 8% sequentially), but that was a little better than expected. Ag and Turf revenue rose 8%, while Construction and Forestry remain very weak with a further 12% contraction in revenue.

SEE: The Value Investor's Handbook

Deere delivered equipment gross margin improvement of almost two and a half points, significantly better than expectations for more or less steady performance. Operating income was also much better than expected – up 25% on a consolidated (adjusted) basis and up 28% in the equipment operations. By business line, Ag/Turf profits rose 32% as margins hit 17%, while the Construction/Forestry business saw a 5% decline in profits as operating margin actually improved by a half-point.

But It's All About Next Year
I'm not sure any sort of quarterly performance would have significantly improved sentiment on these shares, as investors are increasingly worried about what's going to happen in North America next year (where Deere generates more than half of its Ag business).

Negatives are certainly building. Corn has broken below the “psychologically important” $5/bu level, the USDA is projecting a double-digit decline in crop receipts next year, and years of rising land values are leading to higher rents. Couple that with increasing inventory levels for combines (more than 20% of the business) and high-power tractors, and I can see why investors are worried. What's more, relative to CNH Global (NYSE:CNH) and AGCO (Nasdaq:AGCO), Deere is more exposed to that North American market.

So far, management has yet to hit the panic button. Deere management doesn't issue guidance beyond the next quarter, but I didn't hear anything on the post-earnings call that suggested they're preparing for the sort of declines we've seen in the mining or construction industries. That doesn't mean that they (and shareholders) couldn't be in for a bad surprise and an ugly year, but it seems like a lot of negativity is already getting worked into numbers and expectations.

SEE: A Primer For Investing In Agriculture

Thinking Global, And Will Construction Ever Come Back?
Whether you listen to Caterpillar, Terex (NYSE:TEX), Volvo (Nasdaq:VOLVY), Komatsu (Nasdaq:KMTUY), Kobelco, or components companies like Cummins and Parker-Hannifin (NYSE:PH), there still isn't a whole lot of optimism about the construction industry. While U.S. residential activity appears to be picking up, construction and civil construction have yet to recover. As a business with non-trivial exposure to construction (and more exposure to North America), that's depressing for Deere. Sooner or later this market has to improve, but it still looks like “later” is the way to bet today.

Although Deere can't just flip a switch and increase its global ag presence next year, this remains a long-term opportunity for the company. Areas like Eastern Europe, Africa, and Asia remain meaningfully under-mechanized and though Deere has been, at least in some cases, slow to adapt to local needs, this remains a long-term opportunity to improve revenue growth rates.

The Bottom Line
I'm still modeling roughly 5% long-term annual revenue growth for Deere, with some modest improvements in free cash flow margin from the mid-single digits to the high single digits over the next decade. That works out to a fair value of over $95 today, which makes Deere a noticeably cheap industrial stock in this market.

I'm hesitant to pound the table, though, as I expect the market will remain much more fixated on the potential revenue declines in fiscal 2014 (and 2015?) than the long-term cash flow prospects for this business. If investors want to fight the tape, that's there prerogative, but these shares definitely deserve closer watching at this sort of valuation.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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