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Is It Time to Turn Bullish on Deere?

By Lee Samaha - Mar 2, 2020 at 9:31AM

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The agricultural machinery company has had a tough few years, but management's execution has been excellent and it's well positioned for any abatement in external headwinds.

If it isn't falling crop prices acting as a headwind on farm income, it's the trade conflict hurting U.S. soybean export. If it isn't the trade conflict, it's African swine fever impacting underlying demand for soymeal used feeding hogs. If it isn't African swine fever, then it's the coronavirus possibly impacting Deere & Company's (DE 4.49%) supply chain. One way or another, the company has had to deal with a significant number of headwinds in the last few years. However, throughout it all, the company has demonstrated it's one of the highest quality operators out there, and the stock is worth consideration from long-term investors. Here's why.

A farmer in a soybean field.

Image source: Getty Images.

Deere's earnings resiliency

Probably the best way to see the relative strength in Deere's performance is by looking at its net income over the past years. As you can see below, the company's net income has proved resilient in the face of a lot of external headwinds in recent years. The chart also shows the company's guidance range for $2.7 billion to $3.1 billion for 2020.

Deere adjusted net income.

Data source: Deere presentations. Chart by author.

The bad news for Deere

At this point, it's important to detail some of the impacts on Deere in the last few years. The chart below shows the fall in key crop prices over the last seven years or so.

US Soybean Price Chart

US Soybean Price data by YCharts

In addition, U.S. farm income has gone nowhere in the last few years, and income from crops in 2020 is actually forecast to be down 10% on the $220 billion generated in 2013 -- not an environment that encourages large machinery purchases.

The impact of the trade conflict and African swine fever -- a disease that significantly reduced China's hog herd, causing a drop in demand for soybean meal -- on U.S. soybean production can be seen in the chart below. The chart shows how the combination of the two events has disproportionately hit soybean production in the U.S. farm sector. The U.S., Brazil, and Argentina are the leading soybean producers in the world. 

Soybean production

Data source: United States Department of Agriculture. Marketing year runs from September to October. 

Finally, the coronavirus is also threatening to impact matters. Indeed, during the recent earnings call, Manager of Investor Communications Brent Norwood outlined that "the biggest potential impact to Deere is in relation to the supply base that serves our international operations." In other words, Deere could see some disruption, and ultimately cost increases, coming from an inability to effectively source products from China.

The case for buying Deere

Against all these headwinds, Deere's profitability has held up and the best investment case for buying the stock is based on the potential for improvement when some of these headwinds start to abate. There are four key arguments:

First, operational performance has been excellent, with management highlighting how margin expansion in the recently reported first quarter led to a 4% rise in net income despite a 6% fall in sales. In addition, Norwood said that "the actions we took in 2019 resulted in desirable field inventory-to-sales ratios that are significantly below the rest of the industry." In plain English, this means that when sales pick up Deere should be able to benefit from pricing power because there isn't a glut of equipment on the market.

Second, there's already some evidence that the easing of the trade conflict is positively impacting Deere. Norwood talked about "early signs of stabilization" and improved sentiment after the passing of phase one of the trade agreement. Furthermore, the latest data from the USDA shows that the spread in soybean export prices between the U.S. and Brazil has all but disappeared after blowing up when the trade conflict started.

Third, Deere continues to make progress with its so-called precision agriculture solutions -- web-enabled technologies (onboard computers, telematics, sensors, and data analytics solutions) that allow farmers to improve productivity. Deere's leadership in the field is adding a long-term revenue growth opportunity and possibly a margin expansion one too.

Fourth, the headwinds in the last couple of years appear to have held back an underlying, and natural, cycle of replacement demand from coming through. During the earnings call, Director of Investor Relations Josh Jepsen said, "in the U.S. in particular when you think about age of fleet, we are now pushing past kind of what has been the historical equilibrium going back to, say, 2000."

Is Deere a buy?

There's certainly potential for some near-term weakness in Deere's stock price, but the company is doing all the right things to position itself for growth in the future. The company is excellently run and given improving sentiment over the trade conflict, Deere is well placed to benefit from any improvement in crop prices, and/or a cycle of replacement demand coming through. It's the sort of stock investors should be looking to take advantage of given any significant market-led weakness.

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