You wouldn't normally associate Deere & Company (NYSE:DE) with commodities, but a slump in prices of agricultural crops like corn and soybean can severely dent the farm equipment giant's sales and profits as we've seen in recent years. 2016, however, brought investors relief as Deere's stock sprung back to life to end the year with 35% gains, outperforming AGCO Corporation (NYSE:AGCO) and nearly matching Caterpillar Inc.'s (NYSE:CAT) gains.
The only, but an important, difference was that while Caterpillar's stock was strong through 2016, Deere revived during the latter half. So did the agricultural cycle turn toward the end of 2016? Not quite, but with several analysts predicting the U.S. agricultural market to bottom this year, investors were quick to scoop up Deere's stock while it was still cheap.
But have farm fundamentals really improved to propel Deere shares higher or will the stock have a tough time maintaining momentum this year? Surprisingly, if there's anything that can propel Deere's stock higher, it isn't an improving agricultural market.
Agriculture wasn't Deere's weakest segment in 2016
Deere crushed analysts' estimates in each of its four quarters in 2016, with the third and fourth quarters standing out in particular. For instance, Deere turned a profit of $0.90 per share in Q4 versus Wall Street's profit estimates of only about $0.40 per share. Note that as Deere follows a November-October financial year, its fourth quarter and fiscal 2016 ended Oct. 31, 2016.
Investors clearly overlooked the fact that Deere's net income dropped almost 19% year over year in Q4 on 3% lower sales, or that its full-year sales and EPS came in 21% and 16% lower, respectively, compared to 2015. Investors, perhaps, took a positive cue from the decelerating pace of decline in the company's revenues in Q4. How else do you explain the stock's rally when Deere's management expects 2017 to be worse than 2016, having projected 8% lower profits for the year?
To be fair, I wouldn't say it's entirely wrong to be optimistic about Deere. One reason is management's efforts to maintain margins in one of the most challenging years. Picture this: Deere's operating profit from its core agriculture and turf segment edged 3% higher in 2016 despite 7% drop in sales as the company took advantage of strong demand for smaller equipment like mowers and lawn tractors while scaling down costs. That's no mean feat given how demand for high-horsepower tractors -- which are also highly profitable products -- is deteriorating.
You may wonder why Deere still ended fiscal 2016 with such a big drop in profits. Blame its construction and forestry business. Operating profits from the division -- which contributes a little more than 20% to the company's top line -- tanked 66% in 2016 as sales slumped. That means whatever money Deere lost on its equipment operations last year was because of weakness in construction and not agriculture. That's not to say the agricultural markets have bottomed.
Agricultural markets may not recover in 2017
Demand for Deere's equipment is directly related to farm income, which is simply the profits that farmers earn from selling crops. So when crop prices fall, farmers cut back purchases of farm equipment as they have low income at their disposal. Deere's stock has thus traditionally moved in tandem with crop prices. 2016, however, was an exception, indicating that the stock is priced as if a stronger agricultural market is already a given.
However, going by industry projections, the bottom isn't here yet:
- The United States Department of Agriculture (USDA) foresees net farm income to drop 8.7% in 2017, marking the fourth straight year of decline.
- AGCO projects industry conditions to "remain near the bottom of the agricultural equipment cycle in key markets" in 2017.
- Deere projects industrial sales of agricultural equipment in the U.S. and Canada to fall 5%-10% this year.
The only silver lining for Deere is strong demand for tractors and combines from South America and for turf and utility equipment in general. Also, unlike Caterpillar, which remains cautious about the North American construction markets for 2017, Deere expects its construction equipment sales to improve a percentage point compared to 2016. Overall, Deere expects its sales for 2017 to decline only about 1% compared to 2015, which is encouraging. Meanwhile, management continues to focus on costs, targeting savings worth $500 million by 2018.
Given its recent rally and the unlikelihood of agricultural markets recovering soon, Deere's stock looks fairly or even a little overvalued. With earnings expected to contract this year, a forward P/E of 24 isn't cheap no matter which way you look at it. In fact, the stock's trading at levels higher than when Deere's revenues were at peak. Long story short, you could be disappointed if you believe 2017 will be another great year for the stock.