Perhaps even veteran observers of agriculture and construction equipment manufacturer Deere (NYSE:DE) have been surprised at the company's share performance this year. Despite a contraction in global gross domestic product -- the World Bank estimates that global GDP will decrease 5% in 2020 -- Deere's stock has raced ahead by 18% so far this year, consistently setting new all-time highs. What's fueling the current confidence in such an economically sensitive, cyclical stock?
The company's fiscal third-quarter 2020 earnings, issued on Aug. 21, provide plenty of clues. Let's look at three details from the release that clarify why the market is reluctant to bet against Deere.
1. Strength in agricultural products
Deere's agriculture and turf segment, which makes up just under two-thirds of total company revenue, experienced a year-over-year sales decline of 4.6% in the third quarter, and through the first nine months of fiscal 2020, sales have decreased 10% to $16.1 billion. In last week's report, management chalked in an expected full-year sales dip of 10% in the agricultural segment. This cheered investors because it's an improvement over the range provided in the second quarter of a 10%-15% decline.
The revised outlook is also impressive because it essentially falls within Deere's original estimate of a 5%-10% sales retracement in the agriculture division this year -- a forecast that was initiated before the COVID-19 pandemic.
The agricultural business has avoided a steep decline so far this year because of pricing power that has partially offset lower volumes. The segment has also received a boost from higher retail sales of small tractors and mowers, as demand from home and property owners has soared during the pandemic.
The company anticipates that demand for retrofit solutions and replacement needs for an aging global farm fleet will assist equipment volumes in 2021. In addition, Deere continues to see rising uptake of its precision agriculture solutions. In the third-quarter earnings conference call, management cited strong results in its early order program for next year's tech-enabled planners and sprayers as an indication of high interest in yield-enhancing equipment.
2. A rebounding bottom line
In tandem with a healthier agricultural outlook, Deere's total net income outlook has improved as it heads into the last quarter of the fiscal year. In its earnings release, the organization advised investors to expect net income to land at $2.25 billion in fiscal 2020. This is a significantly rosier picture than the $1.6 billion to $2.0 billion projection issued in the second quarter.
There are several factors driving the healthier outlook and the market's sentiment. First, the organization has kept a tight lid on operating expenses during the pandemic. Research-and-development and general and administrative expenses have both declined in the first three quarters of the year -- total operating expenses are tracking roughly 3.5% below the prior-year period.
Deere has also held its cost of sales steady despite a weaker top line. Gross margin on equipment sales has improved by a small but significant 50 basis points through the first nine months of the fiscal year, to just under 24%.
Investors are additionally taking care to view certain operating expenses in context. For example, the company has recorded $138 million in costs related to a voluntary employee severance program offered to employees in the first quarter of 2020. But Deere expects to realize $85 million in ongoing annual savings from this program, including $65 million in savings that will be realized by the end of this year.
In another example, the manufacturer has booked significant but reasonable provisions against expected credit losses in its financing arm this year, suggesting that COVID-19-related charge-offs on financed equipment will be relatively minor. To date in 2020, Deere has recorded a total provision of $123 million to cover near-term anticipated credit losses. While more than double the $58 million loss provision recorded during the same period last year, this still counts as only a fraction of the company's $33.3 billion in finance receivables.
3. Managing a vital asset
Perhaps the biggest clue that the blue-chip multinational can capitalize on renewed earnings momentum in 2021 derives from its handling of an extremely important asset -- inventory. Deere has responded to the pandemic by curbing equipment and machinery production. This tactic reduces inventory carrying costs, keeps the balance sheet from ballooning during an unfavorable selling environment, and improves cash flow.
During the third-quarter earnings call, management relayed that it's right-sizing field inventory within the agriculture and construction divisions to current sales levels. This has been a theme all year, but in the company's latest report, inventory dropped by nearly 10% over the prior-year quarter to $5.65 billion. This number also marks Deere's lowest third-quarter inventory level since 2017. Keeping a slimmer equipment line-up now will enable the company to respond flexibly to emerging high-demand product lines as the global economy recovers. And the discipline Deere is displaying in 2020 is likely to pay off in the form of enhanced profitability as early as next year.