I watched in amazement (and chagrin) as Deere & Company (NYSE:DE) popped after wrapping up fiscal 2016 on 11/23/16. The company beat by 60 cents on EPS, but what got my attention was earnings guidance for 2017, which came in at $1.4 billion.
Working with 6 years historical financials, plus guidance for 2017, and weighting in favor of recency, 7 year average EPS works out to $6.41, well in excess of TTM at $4.81.
Applying a PE7 multiple of 15, typical for high quality cyclicals, a value of $96 is returned. This is a substantial reduction from my previous estimate of $116.
What Management’s Economist Said
Here’s Chief Economist J.B. Penn, on the F3Q 2016 conference call:
I would begin with a bit of context that might be useful as we ponder the outlook. Slide 6 shows the strong tailwinds that now drive the global agricultural economy. Major changes in agriculture and food markets began occurring sometime around the turn of the century and that ushered in a dozen or so unparalleled years characterized by strong demand growth, record high prices in farm incomes, food price spikes, expanded investment and innovation and increased trade. (emphasis added)
My point in bringing in this quotation is quite simple. These unparalleled years are unlikely to recur for some time. Any assessment of the company’s future prospects that relies on a repeat of 2011-2014 is questionable. My methods rely on historical performance, but these years are rapidly receding in the rear view mirror. As such, I weighted the average heavily in favor of more recent years.
The magnificent profits of the boom years relied heavily on the sale of large tractors. The definition is somewhat imprecise: at one time, over 100 hp was big, now that might be over 200 or 220 hp.
In general terms, the unparalleled years brought forward a lot of demand and the average age of the global tractor fleet is such that replacement sales will slow down until these new machines become obsolete or wear out. New sales create the problem of what to do with the trade-in. Values of used machinery trend down until the market stabilizes, and used competes with new.
There is data available to analyze this market: however, the source I found was $700 a year, not an amount worth paying for me as a small retail investor. As such, I’m at an information disadvantage. SA contributor Blue Pacific Partners has been bearish based on an analysis of the available data. I’ve been burned in the past in situations where I was at an information disadvantage.
All those machines sold from 2011-2014 are still out there, and will be for years. Design and materials have improved substantially in the automobile industry, and I conjecture the same has occurred in the agricultural equipment business. They aren’t going to wear out as fast as they used to.
When I worked in the machine tool industry as an accountant, we noticed that manufacturers frequently waited until they had paid off one machine before buying another. Possibly farmers, squeezed by lower crop prices, would like to take a few years without having payments to make.
In any event, based on anecdotal evidence and comparisons to industries that I’m familiar with, I don’t think the agricultural equipment business will go back to where it was for some time.
When a manufacturing company experiences reduced sales, it’s important to look at inventory levels. Sometimes excess production increases inventory, and costs that should have been expensed are capitalized, resulting in overstated profits.
I did an analysis, comparing quarterly inventory levels as a percentage of subsequent quarter’s revenue. I found that Deere has done a very good job keeping inventory consistent with future sales.
Using 4Q 2016 inventory, I projected 1Q 2017 revenue. The computation is, to divide inventory by its average ratio to one quarter forward revenue. The resulting revenue projection was 1% less than the same quarter last year, consistent with management’s view as presented on the call. No problems here.
Along with the earnings beat, management discussed a plan to reduce expenses by $500 million per year. There are upfront costs, and the full benefits won’t show up until 2018. From the F4Q 2016 earnings conference call, here’s CEO Raj Kalathur on how that will be achieved:
Here is some detail about where the $500 million in improvement is expected to come from. Number one, structural direct and indirect material cost reduction is the largest contributor of improvement, roughly one-third. Now, this is the result of leveraging existing supplier relationships, resourcing and designing cost out of our products. Second, people-related costs are the second largest category of reduction, about one-fifth of the total improvement. The voluntary separation program that Josh discussed is a significant example. Other areas of improvement include changes to our variable pay structure especially under trough conditions as well as lower R&D spending and lower depreciation associated with lower capital expenditures.
R&D and capex are necessary to the future growth of the company. I conjecture that pressure to maintain and increase the dividend and continue buybacks is behind their reduction. That’s not good long-term thinking.
Doing the math on $500 million pre-tax, that would $325 after tax, divide by 308 shares, and hypothetically earnings will increase by $1.05 per year. Well run companies adjust their expenses to keep them in line with expected revenue on a regular basis. Deere has been very thorough in this regard over the years, as shown by their strong performance throughout the cycle. This program is business as usual and investors should be cautious about projecting the savings into future years as additions to profit.
A Fine Company Fully Valued
My position when the stock surged was long Jan 2018 65 calls and short an equal number of Jan 2017 90 calls. I elected to close it, as I had little to gain holding until expiration of the short calls, and I wanted the money. IRR for the three years I was in the trade worked out to 29.9%, consistent with the use of leverage and some degree of success at buying low and selling high.
Obviously I was not real happy about the calls at $90, as it turned out I sold a lot of the upside. However, I was paid for what I agreed to do, which was to hold myself in readiness to provide the shares at the agreed price prior to or at expiration.
The company is well run and dominant in its industry. I would welcome the opportunity to re-enter at a price below my estimate of fair value.