Deere – Earnings Risk Still Significant, But Likely Priced In

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

August 18th, 2014

DeereEarnings Risk Still Significant, But Likely Priced In

  • Deere (DE) is currently trading at a price that is anticipating significant further deterioration in returns. While farm economics remain concerning (as the company itself noted in its earnings release), next twelve months EPS would have to fall to the $3.50-$4.00 range (consensus has $7.39) to warrant the current discount in the stock, based on both normal relative values and a review of prior trough multiples – Exhibits 1 and 5.
  • Working against further downside in DE:
    • The stock’s relative multiple is approaching the lower bound of its historical range (Exhibit 3).
    • Valuation divergence versus the broader Capital Goods sector is near a historical peak (Exhibit 4).
  • Much like we saw limited downside in CAT, which had held the $80 “floor” level for some time, we see support for DE at around the same level, given its dividend yield and the valuation factors noted.
  • With about $5 risk to the downside in our view, DE’s upside is hard to ignore – currently trading nearly one standard deviation below the valuation its historical return on capital trend would suggest, a move to “fair value” on our model implies a share price of upwards of $120.
  • The seasonality of DE’s agriculture business is evident in its sequential sales growth cycle – while sales should remain weak for the next two quarters, historically this has been priced in before the fact, and DE has mostly been an outperformer in the second part of the year following Q2 earnings – Exhibits 4 and 5.
  • We still see significant risk to earnings (consensus for 2015 is likely too high) – a record corn crop this year could put more pressure on pricing and general farm economics next year – perhaps causing fewer acres again. We think that this risk is largely priced in to the stock today.

Exhibit 1

Source: Capital IQ, SSR Analysis

Valuation

In March we
published a set
of pieces on
global agricultural dynamics
. Our view then was that DE’s valuation discount was warranted by weak farm economics, and we saw the risk of further downside and negative revisions. The stock has underperformed the S&P by over 10% since that report. We now see a number of stabilizing valuation factors that should limit the risk of further downside.

In absolute terms, DE has only been this inexpensive a handful of times since 1990, and the stock is approaching what has traditionally been the lower bound of its valuation discount – Exhibit 2. Returns are currently below trend, but not by the magnitude that valuation is suggesting. Note in Exhibit 1 that even if ROC falls further below trend, valuation has little room for further downside at the current level of discount.

Exhibit 2

Source: Capital IQ, SSR Analysis

Relative to the broader market, the stock is nearing its all time trough earnings multiple. The longer term trend is downward, but since the early 1990s DE’s relative multiple has consistently bounced around between 0.4 and 1.1 – Exhibit 3.

Exhibit 3

Source: Capital IQ, SSR Analysis

Versus the broader Capital Goods space, DE is well above the average it has oscillated around since 1990, and near to, but not quite, at all time peak divergence. (The analysis in Exhibit 4 is derived by taking the number of standard deviations DE is below normal value on our model and subtracting the equivalent number for our Capital Goods index.)

Exhibit 4


Source: Capital IQ, SSR Analysis

Trough multiple analysis would suggest that even with a collapse in earnings – i.e. a very bad 2015/16 – the downside in the stock is limited. If we measure absolute multiple versus earnings relative to normal, we get the relationship summarized in Exhibit 5. Multiple rises quickly as earnings fall relative to normal. This supports our view that DE is bouncing around a floor value today. Earnings could fall meaningfully without a material impact on valuation. Note that CAT hit a low of around $80 per share in July of 2012, and while it bounced a few times it never broke through that level. In July of 2012 the consensus estimate for 2014 was almost $13 per share. It subsequently dipped below $6.00 per share before recovering to current levels.

Exhibit 5

Source: Capital IQ, SSR Analysis

Agriculture Sales & Second Half Performance

In Exhibit 6 we repeat a chart from our broader ag piece from March, borrowed from our colleague Rob Campagnino who we published the piece with jointly.

Exhibit 6

Declining farm income contributed to DE’s weakest Q1 agricultural earnings growth since 2006. The seasonality in the Ag segment is evident in the sequential sales growth chart below. We can expect the next quarter to be flat to up modestly, followed by a seasonal trough in Q4 before a rebound in Q1 2015.

Exhibit 7

Source: Capital IQ, SSR Analysis

This seasonality in the agriculture business, in particular the weakness in Q3 and Q4, has historically been well priced in before the fact. Excluding circumstances beyond the company’s control (i.e. ex. 2008), the stock has been a solid outperformer in the months following Q2 earnings, averaging 7% in excess of the S&P.

Exhibit 8

Source: Capital IQ, SSR Analysis

We believe patient investors can buy shares at this level, and collect the 2.8% yield while waiting for a turn in farm incomes. If history is any guide, we may even see a leg higher as we move through the second half of 2014. With downside limited in our view to around $5, or about $80 per share, the upside (not all of which may be achieved by year end) is considerable – our return on capital driven model has a normal value of over $120.

Risks

DE has a not insignificant amount of debt coming due over the course of the next few years – Exhibit 9. A material negative move in earnings could rattle confidence in the company, but we believe cash flow is strong enough to allow DE to meet its obligations as they come due.

Exhibit 9

Source: Bloomberg, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

©2014, 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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