Deere’s (NYSE: DE) stock has had a fantastic run over the last five years (up 151% versus a 48% rise in the S&P 500). Still, a few investment analysts downgraded the stock recently on fears that its agricultural machinery sales were slowing. I thought I’d look at the stock’s buy and sell case in light of the downgrades.
The most robust bear case is that falling crop prices and rising interest rates are pressuring spending on agricultural machinery and will lead to a cyclical high in Deere’s fortunes. This argument is based on the traditional cyclicality of Deere’s earnings and its sensitivity to farmers’ income from crops.
As the chart below shows, Deere’s earnings tend to move in the direction of U.S. farmers’ income from crops (used as a proxy for global income; the U.S. is Deere’s most significant market).
Data sources: U.S. Department of Agriculture (USDA), Capedge.com, Crop receipt forecast for 2023 from the USDA. Deere net income 2023 estimate is the midpoint of company guidance.
Moreover, farmers’ income from crops tends to move in the direction of the prices for key crops like corn, soybean, wheat, and cotton.
U.S. Corn Farm Price Received data by YCharts.
That’s a concern because all three crop prices are down over the last year. Corn is down 28%, soybean is down 8%, wheat is down 32%, and cotton is down 10%. While it’s tough to predict the future direction of commodity prices, the reality is that the dip in prices puts pressure on farmers’ income for 2024.
In summary, the bears argue that Deere’s revenue and earnings (measured below in terms of earnings before interest, taxation, depreciation, and amortization, or EBITDA) are about to hit a peak, so the lowly-looking enterprise value (market cap plus net debt), or EV, to EBITDA multiple is a value trap.
DE EBITDA (TTM) data by YCharts.
The glass-half-full view argues that even if the fall in crop prices will put some pressure on spending, Deere is a significantly different business to when it was in, say, 2014, when the company hit a cyclical peak. As such, investors should be more willing to pay a higher valuation.
First, its EBITDA margin profile is much higher than previously, and investors should be willing to pay a premium for a company with higher-quality earnings.
DE EBITDA Margin (TTM) data by YCharts.
Second, and closely connected with the first point, Deere has made great strides in expanding its precision agriculture solutions, and they provide the company with a powerful secular growth driver. Let’s put it this way: Even if crop prices and income fall, new smart farming applications can enhance profitability, enabling farmers to buy them.
Third, calling the peak in crop prices is notoriously difficult, and all it will take is a rise in prices over the next six months, and forecasters will be scrambling for the pencils to upgrade farmers’ income estimates.
Fourth, Deere is a different company than it was in 2014. Back then, its agriculture and turf operations generated 5.6 times the profit of its construction & forestry operations. That ratio (adding the production and precision agriculture and small agriculture and turf operations and dividing by construction and forestry operations) was 3.1 times in 2022. The change partly reflects the $5.2 billion acquisition of road construction equipment company Wirtgen in 2017.
Moreover, the construction and forestry segment has a long-term growth opportunity from infrastructure spending in the U.S. and globally.
Image source: Getty Images.
All told, a balanced viewpoint sees the potential for some near-term disappointment but would favor buying the stock on any significant weakness. That’s a rather lengthy way of saying it’s not a “buy” right now, but it’s worth taking a nibble if the company reports some disappointing news and the stock sells off. The long-term outlook for the company is excellent.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends Deere. The Motley Fool has a disclosure policy.
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