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The 2 Things Worrying Deere and Company Investors

By Lee Samaha - Sep 16, 2015 at 8:04AM

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Deere's sales are falling, its inventory management is a concern, and its increasing amount of leased equipment could create pricing pressure in future.

In a previous article, I looked at the current trends within Deere & Company's (DE 3.80%) trading environment and concluded that the near-term risk was rising, even if the long-term case for the stock was still intact. For the benefit of readers looking for a deeper outline of the near-term risks, I've a created a graphical depiction below of what these rising risks are.

Let's take a closer look at what's going on.

Deere's near-term risks
In a nutshell, the company's major near-term risks come from two sources. First, the possibility of a decline in sales, leading to the need to reduce its inventory via price cuts.

Second, the company has been increasing the amount of equipment it leases to farmers -- who may be holding out on outright purchases of equipment due to a fall in cash receipts -- and the subsequent creation of a glut of used equipment.

Pricing will take a hit in both cases, and given that Deere's management continues to forecast 1% positive price realization for 2015, pricing difficulty could hit the stock hard.

Inventory to sales ratio
I've touched on this subject before: Deere's inventory-to-sales ratio is notably better than that of its competitors, such as AGCO Corp or CNH Industrial NV. While Deere deserves credit for this, if its rivals get aggressive on pricing -- due to carrying too much inventory -- then Deere will be pressured to respond.

I decided to take a look at Deere's inventory position compared to its next-quarter sales. For example, the last data point in the third quarter of 2015 -- in light blue in the chart below -- represents Deere's inventory position at the end of the current quarter of $4.32 billion, divided by the analysts' forecast for $6.15 billion in sales for the fourth quarter.

I'm using analyst forecasts because we don't know what the sales figure will be yet. It's useful to separate the data by quarter in order to reflect any seasonal effects.

Data source: Deere & Company presentations; author's analysis. 

As you can see in the chart above, the data suggests that Deere's inventory position in the third quarter of 2015 looks a little high on a historical basis.

Equipment on operating leases
As the following chart demonstrates, Deere has significantly increased the amount of equipment it has on operating leases. In fact, the figure has more than doubled since the start of 2012.

According to Deere's last 10-K filing, the terms on its equipment on operating leases range from four to 60 months, and the 10-K states that future payments to be received in 2019 total just $35 million, compared to $635 million in 2015 and $448 million in 2016. These figures suggest that Deere tends to lease equipment on a relatively short-term basis:

Data source: Deere & Company presentations. All data in millions of U.S. dollars. 

The following chart shows how leasing activity has increased while sales growth has slowed:

Data source: Deere & Company presentations. 

The risk is that at some point, Deere will face a situation where it will have to aggressively sell off the used equipment created by its leasing activities, therefore pressuring pricing for its new equipment. Indeed, management has already outlined that reducing used equipment inventory "continues to be a challenge."

The takeaway
Deere is doing a pretty good job of reducing inventory, but based on the analysis in this article, its current inventory is higher than usual. Meanwhile, its growing amount of leased equipment could create problems in the future.

In other words, the near-term risk is rising for the stock. But that shouldn't detract from the long-term potential for the company's earnings to improve in future -- given an increase in crop prices and sentiment toward spending on agricultural machinery.

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