As ever, investing is about balancing risk and reward, and there is certainly downside risk to agricultural and construction equipment company Deere (DE 1.03%) in 2019 -- not least from an escalation of trade conflict from China. On the other hand, there's also substantive upside potential, and the key takeaways from the latest earnings report served to highlight them. Let's take a look at them and why Deere is an attractive stock for 2019.
Reasons to be positive on Deere
There are three separate, but related arguments.
- The China/U.S. trade dispute is creating substantial difficulties for soybean exporters, but it's being more than offset by strong conditions in other crops, and management's commentary suggested that U.S. farmers can deal with the tariff issues.
- Deere's precision agriculture, or precision Ag, solutions are creating a revenue and margin growth opportunity.
- Deere's guidance, although positive, looks conservative and leaves room for upside potential.
Tariffs won't harm Deere
Probably the biggest single indicator of Deere's future prospects is U.S. farm income -- when farmers have growing incomes, they are more likely to buy Deere's machinery, but they tend to hold off on purchases when their income is declining.
A stronger outlook for corn will help U.S. farmers offset near-term difficulties with soybean. Image source: Getty Images.
Given the worries created by trade tariff actions -- China is the largest single export market for U.S. soybeans, and export sales have plummeted 94% as a result of tariffs -- it was reassuring to hear Deere Management of Investor Communications Brent Norwood say, "through 2019, principal crop cash receipts are estimated to be about $120 billion, roughly flat with 2018. Record yields and higher prices for corn are forecasted to offset softness in soybean prices."
Norwood went on to outline the possibility that Brazil, Argentina, and Paraguay would substantially increase soybean exports to China, but U.S. farmers can fill the gap created by the shift and sell into the "former trading partners" of the South American countries.
In a nutshell, the worst fears over tariffs are likely to prove overblown -- and that's good news for Deere.
Precision agriculture will drive sales and margin growth
Farming and agriculture might not be the first industries that spring to mind when thinking about the Internet of Things (IoT) revolution, but Deere's precision Ag solutions are fast becoming a must-have technology for farmers.
CFO Raj Kalathur outlined how Deere's technological solutions (IoT sensors, telematics, onboard computers, and precision hardware solutions) are helping generate value for farmers. As a consequence, "such products should allow us to not only generate higher revenues, higher share but also much higher margins," according to Kalathur.
Moreover, precision Ag solutions are likely to drive "a much higher share of the aftermarket business going forward," according to Kalathur, and Deere's dealers have an opportunity to provide continued support to farmers as they use their equipment -- this should boost Deere's aftermarket revenue.
During the earnings call, Bank of America Merrill Lynch analyst Ross Gilardi suggested that "precision Ag is a $500 million revenue business for Deere today" -- Deere has generated $33.5 billion in equipment sales in 2018. Director of Investor Relations Josh Jepsen didn't confirm or refute Gilardi's figure, but said, "it's a big picture right now," and it's surely a large part of the reason Deere expects price realization to increase by 3% in 2019 -- overall net equipment sales are forecast to increase by 7% next year.
Guidance looks conservative
Management's guidance for net income can be seen in the chart below. As you can see, Deere's net income is forecast to increase to $3.6 billion -- a level last seen in 2013.
Data source: Deere presentations. Chart by author.
The guidance looks good enough, so why does Deere's financial guidance have upside?
The key point is that price realization is forecast to add 3% to net sales, but Deere is only forecasting agriculture and turf equipment sales to increase by 3%. Within that figure, North America agriculture and turf sales are only forecast to increase in the 0% to 5% range. That looks a bit conservative considering that Deere is currently in a replacement market -- in other words, demand is coming from replacing old equipment rather than demand from expansion.
Any upside from an improvement in crop prices, or any positive development on trade negotiations could lead to Deere raising its sales expectations. Meanwhile, the margin expansion implied by increased precision Ag sales suggests that any sales increase will leverage into a bigger increase in profits.
The key takeaway
Putting all of this together, tariff fears are overblown, U.S. farm income is set to be stable, precision Ag will help drive equipment sales growth, and Deere has good underlying sales from replacement demand. All told, investors have more reason to be positive than negative regarding Deere's prospects in 2019.
