As Deere & Company's (NYSE:DE) fiscal year 2016 has progressed, its management has lowered full-year earnings and cash flow forecasts. Moreover, competitors such as Caterpillar Inc. (NYSE:CAT) in construction machinery and AGCO Corporation (NYSE:AGCO) are both seeing weakening conditions. That said, all of the stocks mentioned are outperforming the S&P 500 on a year-to-date basis as I write.
What's going on with Deere in 2016, and does it's poor relative performance mean it's time to buy the stock?
Deere & Company's 2016
Since the company's fourth quarter, Deere management has reduced its full-year net income guidance from $1.4 billion to $1.2 billion, and cash flow from operations guidance from $2.6 billion to $2.1 billion -- both significant reductions. Clearly, the market has been in a forgiving mood, but let's take a closer look at segmental performance in order to better gauge its earnings trends.
The following table breaks out the full-year 2016 guidance at the end of each quarter. As you can see below, the big changes have come from its construction & forestry and financial services operations -- somewhat surprising given that agriculture conditions have been weakening in 2016.
|Metric||Q4 2015||Q1 2016||Q2 2016|
|Agriculture & Turf||
Construction & Forestry
|Worldwide Financial Services||
Net Income ($millions)
Net Income ($billions)
However, the numbers don't tell the full picture, and Deere's prospects are actually challenged in each segment.
Construction & forestry
As you can see above, currency-adjusted net sales guidance is trending negatively in 2016. Moreover, Caterpillar reported a 19% decline in construction industries sales in its recent first quarter, with "declines in construction activity related to oil and gas" resulting in "availability of construction equipment for other purposes."
The resulting pricing pressure felt by Caterpillar (partly as a consequence of dealers aggressively reducing inventory) is likely to be affecting Deere as well. Until conditions improve with oil & gas capital spending, it's hard to see a significant improvement in Deere's fortunes.
Agriculture & turf
Agriculture is Deere's core operation (responsible for nearly 80% of machinery sales in the first half) and key to its long-term growth. Unfortunately, the headline net sales figures don't tell the full story. Although adjusted net sales growth guidance has stayed the same, Deere referenced a less favorable product mix of sales in the second quarter.
Essentially, large agricultural machinery sales (which tend to be higher-margin products) are floundering, while small and mid-size tractors are, according to AGCO Corporation's first-quarter earnings release, generating higher sales, helping to partially offset the decline in large agricultural equipment. However, what's good for overall sales isn't necessarily good for the company's margin, so don't be fooled by Deere's maintenance of underlying agriculture & turf sales guidance.
On a brighter note, Deere does appear to be managing its overall inventory quite well. Here's a look at inventory levels divided by the next quarter's sales. As you can see below, the ratio started rising -- relative to previous years -- throughout 2015, but the first two quarters of 2016 have seen comparable ratios to previous years -- Deere is reducing inventory well.
Worldwide financial services
This is arguably the most problematic segment for Deere, and as you can see in the first table, management has reduced full-year net income expectations by $70 million (12%) already in 2016. The reasons are threefold:
- Less favorable financing spreads
- Increased provisions for credit losses
- Higher losses on residual values
There is little Deere can do about interest rate movements, but management deserves more scrutiny on the other two issues. As you can see below, Deere continues to see strong growth in the equipment it has on operating leases (as opposed to buying equipment, and given the weakness in the industry, it's inevitable that credit losses will increase while residual values are likely to be pressured.
Deere's management raised its 2016 forecast credit loss provision to 0.23%, compared to 0.17% at the end of April. It's still below the 10-year average of 0.26%, but that's little solace as financial services have grown in importance to Deere as equipment leases have grown. Moreover, the incremental increase in credit loss provisions is hurting profitability.
To be fair, Deere's management is taking action by "significantly restricting our short-term lease offerings, and increasing risk sharing with dealer," but until end-market conditions improve, the company is likely to see more pressure on its financial earnings.
The bottom line
Until the agricultural sector -- meaning crop prices -- turns upwards, it's likely Deere will continue to face headwinds in all three segments. Management is making the right moves, and Deere's inventory management is the best in its class, but pressure continues to build on its business. Cautious investors would be best advised to monitor end-market conditions before buying stock in Deere.