Normally, when a company forecasts a 15% drop in sales for the following year, investors' immediate reaction is negative, but the rules of investing logic with a highly cyclical stock like Deere & Company (NYSE:DE) are very different. Indeed, analysts at JPMorgan and Wells Fargo subsequently upgraded their ratings for the stock after the recent announcement. Essentially, the bullish case for Deere & Company rests on the idea that 2015 will see a cyclical trough in key crop prices, and therefore end demand for its agricultural machinery will pick up. If this happens, Deere could soar, as the best time to pick up a cyclical stock is before the rest of the market realizes the upswing is about to take place.
The farming cycle could turn
First, farmers could reduce crop acreage in 2015, leading to higher prices in 2015-2016. A quick look at some long-term charts for key crops such as corn, wheat, and soybeans reveals just how cyclical these markets tend to be.
The up-and-down cyclicality isn't just a coincidence. The demand and supply for crops is determined by vagaries such as the weather, subsidies, legislation, or even dietary and investment fads, but it also depends on farmer behavior.
When prices and income fall, farmers will be induced to reduce the amount of acreage planted. If this occurs, then the supply of crops could moderate (assuming crop yields don't go up), and prices and income could start to rise again. Of course, when farmers' income rises, they tend to buy more farming equipment.
Looking ahead to 2015, Deere is forecasting a 14.2% decline in U.S. net farm income, following a 9.6% decline in 2014. The decline in net income in 2015 is expected to impact Deere's agriculture and turf segment sales -- the company is forecasting a 20% decline -- and it's also expected to negatively impact acreage. Deere's director of investor relations, Tony Huegel, said on the earnings call regarding corn: "[M]ost analysts now expect U.S. corn farmers to reduce acreage somewhat next year. So if you assume smaller acreage trend yield, that would be very supportive of both corn prices and would likely boost cash receipts."
In other words, a classical cyclical pattern could form, resulting in lower supply relative to demand, leading to higher crop prices in 2015-2016 -- good news for Deere.
Indeed, Huegel went on to answer a question on Deere's sales:
I think if you look historically as well in prior downturns, to expect another significant step-down next year would imply you'd have three years in a row with pretty strong reductions. That would not be the norm, as you look historically. In fact there's only really one period if you look from 1965 forward where we saw three sequential years of lower sales.
There is no guarantee that the cycle will play out in line with the historical playbook, but if it does, Deere will have a better year in 2016 -- and the market will waste no time in pricing this into the stock.
Exceptionally good weather might not occur again next year
Second, the effects on crop yields from weather is a given, and the last two years have seen favorable conditions for yields in key crops, such as corn and wheat. However, the weather may not be so accommodative for crop yields going forward.
Indeed, in discussing weather and its effects on yields in 2015, Huegel argued on the earnings call that, given "normal weather" next year, its chief economist, J.B. Penn, "would say [that] you would see stock levels come down, commodity prices move up, and that would be supportive of cash receipts."
So, while the strong harvest of 2014 is expected to hold prices down in 2015, it could be a different story with the harvest of 2015. Even a period of "normal" weather could lead to prices rising, at least according to Deere's management.
Deere adjusts early to the downturn
Third, the company has made some impressive adjustments in preparation for lower sales next year. Deere has reduced its inventory in order to adjust to an anticipated 20% decline in sales in its agriculture and turf segment. In other words, the company shouldn't need to cut prices in order to clear inventory. Indeed, management hopes to achieve a price increase of 2% in 2015 -- impressive stuff for a company facing a severe fall in sales. With the adjustments made early, the company is in a position to benefit if its end markets turn out better than expected.
Deere has prepared well for an expected fall in its sales, and provided the weather isn't exceptional for crop growing, and farmers curtail their acreage, then investors can hope for 2015 to be a trough year for Deere's sales and income. If this turns out to be the case, then now might be a good time to pick up some stock.