DE – Holding Pattern – Insulated From China, Risk-Reward Compelling

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Graham Copley / Nick Lipinski



August 27th, 2015

DE – Holding Pattern – Insulated From China, Risk-Reward Compelling

  • After trending higher for much of the summer, DE has been hard hit in the broad market sell-off, leaving its positioning on our Skepticism Index (Exhibit 1) nearly identical to when we published a company specific analysis in late May
    • It continues to look like Deere has a cyclical move higher on this work, as valuation and returns appear to have troughed and the stock tends to trade ahead of earnings
  • DE appears well insulated from Chinese competitive pressure
    • Trade data shows an improving US tractor surplus over time, suggesting China has not yet developed a competitive offering
    • Deere has maintained pricing even as the demand environment has weakened significantly
  • The stock remains attractively valued on several metrics
    • Near an all-time low on a P/E basis relative to the S&P
    • Near an all-time low on normalized earnings – our model shows a mid-cycle value well in excess of $100 per share (close to $150)
    • We think the $100 level is a more appropriate target over a shorter horizon
  • Over the past several years we have seen significant buying interest in DE around $80
    • Even after a disappointing quarterly result and a market meltdown, the stock has stabilized in that range (the yield at current levels is 3%)
  • Downside may be limited and we think the stock could again trend higher, but meaningful upside will require a turn in investor sentiment or the underlying agricultural markets
    • The Brazilian ag market was marked down in DE’s guidance, and US farm incomes are expected to remain constrained through 2016

Exhibit 1

Source: Capital IQ and SSR Analysis

Valuation At Trough Levels

Our skepticism index analysis in Exhibit 1 shows DE in essentially the same spot as when we last looked at this chart in late May. The stock gained modestly after that report, but has followed the market down recently and is back at its valuation lows – Exhibits 2 and 3.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

DE Insulated From Chinese Pressure

We previously noted several areas of the Capital Goods space that have experienced a deteriorating trade balance vs. China over the past decade – metalworking machinery and specialized vehicles for instance. A notable exception has been the tractor market, where the US trade balance has actually improved in recent years – Exhibit 4.

Exhibit 4

Source: Capital IQ and SSR Analysis

China may eventually develop competitive tractors, but we expect Deere’s scale will enable the company to capitalize on the big data movement, adding a further technological buffer by linking its machines to an analytical support system. To this effect, the company earlier this year added to its board a member with 30 years of technology experience (Cisco, HP) and a focus on big data initiatives. Deere’s R&D spending is the highest in the space, and on a larger base of sales – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

Pricing Remains Robust

With sales down 20% year over year in the first two quarters of 2015, DE has managed to maintain pricing – further evidence of its product quality. 2% price realization in calendar quarters 1 and 2 (Deere’s fiscal Q2 and Q3) are encouraging after gains appeared to be stalling in the back end of 2014 – Exhibit 6.

Exhibit 6

Source: Capital IQ and SSR Analysi

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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