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DE | Special K

10-K Review


The DE 10-K reinforces our view that DE management is betting on a FY17 market recovery, and will need to lower guidance mid-year.  We suppose that makes sense from their position: why take pain up front, when it might be avoided altogether.  There appears to be market anxiety throughout the 10-K, everywhere except in guidance.  If the underlying trends in DE’s performance don’t concern investors, perhaps nothing will.  We continue to see DE building an unsupported cost narrative, by relying on accounting changes, its balance sheet, and finance subsidiary to manufacture the results.  The complexity of the annual report is stunning, which should typically concern investors in a reasonably straightforward manufacturing company.


Consider some odd factors that should raise questions right away. 

  • Why is the balance sheet line item Inventories down nearly $500 million, but cash flow flows from inventories is negative $106 million? 
  • What are the trends in leases, which largely explain that inventory to cash spread, and how much inventory from matured leases is sitting on DE’s balance sheet? 
  • What are the trends in past dues, and do they portend another finance company income guidance miss? 
  • Why is square footage increasing and revenue per employee dropping sharply, if management is executing structural cost reductions? 
  • Where were the favorable decrementals in the equipment segment, and how much did a South America pre-buy impact sales? 
  • Should investors really view this cycle as better executed than the 1980s analogous decline?


For us, the answer to each of these questions reinforces our view that DE is stretching reality in its FY17 guidance, and left itself plenty of wiggle room in the underlying assumptions to drop the bar later in the year.  While we got the initial FY17 guidance wrong, we do, in fact, like the short more at current prices.  DE is a name held on faith in a management team that now needs an ag equipment rebound.  We don’t see a rebound coming, as the fleet is the youngest since the late 1970s, farm equity is falling, crop prices are lower year-over-year, and real equipment spending is still elevated.  Instead, this management has put shareholders at risk by implicitly writing puts on used equipment (leases), buying shares near the cycle peak, and loading the balance sheet with dubious finance assets.


Finance Subsidiary 

One of our main contentions is that DE investors are applying a trough multiple to earnings from a near-peak finance subsidiary, and that the finance subsidiary should be valued on a multiple of book. We expect the costs of deteriorating credit to hit Deere’s profitability on a lag, even though the ‘pig’ is already visible in the ‘python’.  Investors need to ask why DE is placing so much equipment with leases, and if DE is more broadly underpricing equipment financing in a period of deteriorating borrower credit. Or at least we think they do.  The trends are far from subtle.


Total Leased Equipment:  The value of Deere’s leased equipment has moved sharply higher, facilitating equipment ‘sales’ and giving the lessee a put option on the used equipment value. We think Deere may come to regret writing so many options, and suspect they are mispricing the terms – a reason why buyers like the total deal. 

DE | Special K  - DE 1 12 20 16


Depreciation Expense: Declines in the Depreciation expense as a percent of the book value of leased equipment had been a sizeable earnings tailwind, despite falling used equipment values and fairly constant lease duration.  Recent impairments of off-lease equipment suggest depreciation expense may turn to a sizeable headwind, as each percentage point is ~$60 million of annual finco operating income.

DE | Special K  - DE 2 12 20 16


Cheap Leases?  We suspect that the declines in leased equipment payments contributed to the attractiveness of leasing equipment, basically lowering future finance income and increasing financing risk to support equipment pricing.  Easing finance charges were a hallmark of DE’s early response to the 1980s farm equipment downturn – a choice that was later costly.

DE | Special K  - DE 3 12 20 16


Higher Residual Values: The discounting of leases can also be seen in what may prove unrealistic assumptions for the residual value of equipment off lease.  This is odd as large used equipment price declines have already been observed since around 2013, and DE has taken charges related to used equipment off lease.

DE | Special K  - DE 4 12 20 16


Impaired & Past Due Leases:  While the FY17 guidance seems to imply FY16 will be the worst of the lease issues, we suspect accumulating off lease inventory is sitting in the ballooning ‘Other asset’ balance sheet line.

DE | Special K  - DE 5 12 20 16


Off-Lease Equipment, Or Lessee Exercising Put Option:  The JDCC 10-K discloses $184 million of off-lease used equipment that was tested for impairment as a Level 3 asset.  Of that, $31.1 million, or ~17% of the value was impaired.  That is nearly double the prior year’s $96.2 million, and it isn’t discussed why that off-lease equipment is different from all of the other equipment that will be coming off-lease.  This is also just the Level 3 assets, and is only JDCC, not all of DE.  Further large increases in equipment from matured leases seem likely given the trajectory of total lease values and our understanding of market trends.  The line on the chart below would likely have moved higher without the impairments. 

DE | Special K  - DE 6 12 20 16


Write-Off Net Of Recoveries:  Write-offs and Troubled Debt Restructurings both helped to stem the tide of rising past dues, but the trajectory in costs does not match the credit cost provision, in our view.

DE | Special K  - DE 7 12 20 16


Past Dues: Past dues across metrics are much higher than a year ago, a trend we expect to see continue.  A ramp in troubled debt restructurings and write-offs helped to slow the increase in FY4Q16, by our estimates.  The allowance for credit losses is lower than it was at the end of 2014, when past dues were far lower.

DE | Special K  - DE 8 12 20 16


Finance Income Guidance Looks High: In addition to higher credit and depreciation costs, funding costs appear higher and the portfolio is shrinking somewhat.  Last year, DE cut its Finco net income guidance substantially and we see a likely repeat in FY17.

DE | Special K  - DE 9 12 20 16


A History Of Abuse? If investors do not this DE would use underpriced credit to facilitate unit sales, they should consider this from 1982 JDCC 10-K. 

DE | Special K  - DE 10 12 20 16


Stepped on Financing Gas: It is also worth considering the unit sales financed during a time when industry sales were dropping sharply…

DE | Special K  - DE 11 12 20 16


Faux Cost Cuts?

We continue to believe that the favorable decrementals at Ag & Turf relate more to cheaper credit provision, lower steel and other input costs, changes in pension accounting ($175 million year-on-year benefit disclosed in the 10-K) and other non-operating factors.  Many industrials have benefited from similar trends, but most don’t pretend that they are structural.  Presumably, DE wants investors to believe that there was waste ready to be engineered out of the products.  Unfortunately for longs, the data in the 10-K do not support structural cost reductions.  It is worth noting that the, agricultural equipment margin in 1982, three years after the peak in 1979, was around 6.8% - not far off what DE has reported in this cycle.  It was the duration of the downturn in the 1980s, exacerbated by the ready provision of credit, which hit DE hard as time went on.  This cycle is not as different as investors think, in our view.


Square Footage:  If DE were cutting manufacturing costs, why is the footprint increasing?  We had understood that utilization was less than 50% of manufacturing capacity in some of their large AG facilities, so why the extra space?

DE | Special K  - DE 12 12 20 16


And it does not appear to be from moving facilities to low cost regions

DE | Special K  - DE 13 12 20 16


Headcount Not Keeping Pace:  While we do see some headcount reductions, those cuts are not keeping pace with the decline in sales.

DE | Special K  - DE 14 12 20 16


Steel Prices Look Set To Reverse:  To assume that steel wasn’t a tailwind is to assume that DE doesn’t buy steel and other commodities…

DE | Special K  - DE 15 12 20 16


Falling Parts Sales:  We continue to see declines in aftermarket parts sale, but…..

DE | Special K  - DE 16 12 20 16


Parts Should Be Helping Mix: To the extent that aftermarket tends to have higher margins, we would expect this mix shift to account for some of the favorable decrementals.

DE | Special K  - DE 17 12 20 16


Best Decremental Outside of Canada & U.S.:  On a geographic basis, we see the driver in the Ex-US and Canada results.  We suspect that an emissions pre-buy in South America was helpful.

DE | Special K  - DE 18 12 20 16


DE | Special K  - DE 19 12 20 16


It Isn’t Trough:  Perhaps the best evidence of this is that the fleet is very young, suggesting that recent sales values haven’t been below replacement demand.  Troughs coincide with old fleets, not young fleets.

DE | Special K  - DE 20 12 20 16


Decremental Trough & The Bull Story Peak:  We have discussed DE with a large number of investors since the last report, and the cost program of management is a key bullish factor.  We think it is not supported by the operating data, and is better explained by lower steel costs, pension accounting changes, and incentive compensation cuts (which is likely increase again, like it did in 2010). 

DE | Special K  - DE 21 12 20 16


Upshot:  There is a substantial amount of new data and disclosures in the DE and JDCC 10-Ks.  We haven’t hit on all of them, such as trade concerns around the change in administration.  We believe the trends in the finance subsidiary point to lower finance profits and ongoing, high risk support for the equipment operations.  We also believe that the only trough DE is likely to experience is in its decrementals, as key operating metrics are not supportive of structural cost reductions.  We expect DE to lower its back end loaded guidance during FY17.  The company’s efforts to fight the agricultural equipment cycle may prove very expensive for shareholders.


Feel free to ping us for a full discussion in our prior black books, most recently in November, and updated EQM model/dataset.

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WAB | No Bridge, Silence As Deception

Faiveley Deal In Current Form Is Probably Dead


WAB’s 1Q 16 earnings release and call were notable because of what they did not contain: a clear explanation the favorable decremental margin (materials are likely to prove mean reverting) and a disclosure that Faiveley was under significant scrutiny by antitrust regulators.  Given those omissions, we are interested to hear more about the Siemens PTC suit.  A failure to be forthcoming is deceptive, in our view.  We have met with several larger longs in WAB that place significant faith in this management team, and we wonder if those holders noticed those omissions.


Should Have Been Discussed: Given reports of DoJ concern that the Faiveley merger would reduce the number of passenger-train brake systems manufacturers from three to two, some management commentary was due on the call.  It is now increasingly clear that divestitures may be needed for LEY FP & WAB US to close.  Faiveley’s Braking & Safety Systems – the area most likely to generate overlap concern as we understand it – is about a quarter of LEY sales.  Divestitures would almost certainly undermine at least part of the strategic rationale for the transaction. 


Is The Faiveley Deal dead?  Probably, or at least the good part of it. Various obligations in the Exclusivity Agreement cease to apply 15 months after the agreement was signed, as we read it, and closing is likely to drag out longer than that now. We have yet to hear about DoJ concerns, which raised the initial flags in the press.  Agreement modifications should follow, particularly if divestitures enter the picture. Fees on break-up are minor, and we suspect the Faiveley family is unhappy about the public discount anyway.


When A French Manufacturing Acquisition Is Your Bull Story:  When a bull story hinges on the acquisitions of a French manufacturing company, we think investors should recognize a problem.  When undue investor faith is placed in a management team that, we think, is aggressively spinning a bullish narrative by leaving out bad news, investors should look to the exits. After Wabtec reported last week, investors were likely hoping that favorable decrementals would bridge profitability to the Faiveley merger, allowing for a new narrative and focus for the shares. Of course, this view is already a thesis drift from the “Freight will be fine” reply.  The revelation that the 1Q WAB EPS print was due to lower materials costs and a debt funded buyback leaves that bridge rickety at best.  Now that bridge would need to hold up all the way until fourth quarter to reach a likely different merger deal, if the deal happens at all.  Realistically, that is not much of a bull story in the face of 16.5% organic sales declines at the unit that represented 76% of 2015 operating profit. 


What about buybacks?  Can WAB offset the failure of Faiveley with a huge repurchase?  Sure, but levering up at a major cyclical inflection point is incredibly risky, we think, and would leave us more optimistic about our short view. Investors don’t usually pay a big multiple for debt fueled financial engineering. Covenants restrict them to a bit over $2 billion in debt at current profitability – capacity the company likely needed to fund the cash portion of Faiveley.  We should expect a big repurchase or similar move if Faiveley fails more formally.  It would likely be a good opportunity to fade a rally.


WAB | No Bridge, Silence As Deception - WAB 1 5 2 2016



Important Questions For Large Longs To Answer:  Was the favorable decremental from “[management’s] ability to respond to changing marketing conditions, with actions to decrease cost and increase efficiencies” per the chart below?  Will Faiveley really close in its current form by 4Q? 


WAB | No Bridge, Silence As Deception - WAB 2 5 2 2016



Upshot:  We continue to see WAB as a promising short, and expect 2016 EPS ex-Faiveley below $4/share as the company’s core freight market enters a multi-year downturn.


WAB | Release Not Very Useful, But One Thing Stands Out (First Look)

Wabtec’s earnings release is generally not helpful for understanding the quarter.  For example, the topline is not particularly helpful without the backlog numbers.  How gross margin increased on negative mix and a sales decline is also unclear – were accruals reversed, pre-production costs capitalized, unsustainable inventory builds that lowered unit costs, or the like at play?  Last quarter, traders were crushed by relying on the initial release, and this release similarly lacks critical data.


One item of note, however, is that with year-on-year declines in sales and net income, Wabtec is no longer a growth company and may fail to meet the criteria for some growth funds.  This is a key step in the growth to value transition we continue to anticipate for WAB shares. Growth investors are unlikely to rely on financial engineering like debt funded buybacks in establishing investment criteria.  If that take is right, we would look for growth holders to have shares on offer following today’s sales miss.


Unfortunately, we won’t be able to understand WAB’s results without the rapid-fire earnings call disclosures and the 10-Q.  

UAL | Turned Around?


While only a single quarterly report, we think that our UAL short thesis is supported by first quarter results.  Excess capacity growth in a lower fuel price environment meshes poorly with UAL’s high cost position.  We think Munoz is an ethical, high quality CEO but will lack the operating flexibility to fix UAL’s competitiveness.  The reporting behavior of prior management has likely set an unrealistic profit expectation for investors.   We will let others summarize the quarter, and instead update a few key charts below.  Feel free to reach out for our UAL EQM Model/Dataset that updates our suite of metrics and charts.





Liquidity Tightening:  Perhaps most disturbingly, UAL has moved to what the company has previously defined as its liquidity threshold.  John Rainey has guided that “The liquidity balance we need to run our business is between $5 billion and $6 billion and that includes the $1.3 billion revolver that we have today that allows us enough cash to manage some of the uncertainties in the business, but also deploy any excess cash in a way that is more shareholder friendly.”  (6/2015). Draining liquidity at peak profits is not a great way for a highly cyclical, leveraged, cost disadvantaged competitor to position ahead of what may be a recessionary environment later this year.

UAL | Turned Around? - UAL 1 4 22 16



UAL Domestic Share Loss Rate Unsustainable:  We see the introduction of Basic Economy and a portion of the differential PRASM guidance as an effort to stem share loss.  Reduced market share devalues UAL’s network relative to competitors.

UAL | Turned Around? - UAL 2 4 22 16



Frequent Flier Accounting No Longer Fluffing-up Results:  Comparisons to periods when frequent flier accounting assumptions change should prove difficult for UAL. 

UAL | Turned Around? - UAL 3 4 22 16



Costs Heading Wrong Way, Still:  UAL’s labor cost growth continues to outpace competitors.

 UAL | Turned Around? - UAL 4 4 22 16


Fuel Hedging Down With Oil Low:  Reductions in fuel price hedging may increase short-term earnings volatility, particularly if oil prices continue to move higher.

UAL | Turned Around? - UAL 5 4 22 16