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DE | Incredible Guide

 

Takeaway:  DE gave low quality guidance that exceeded consensus, a strategy we think may backfire later this fiscal year.  While the key components of the guidance look conservative at first, the outlook assumes stabilization in collapsing unit sales – a very tall order given our view of industry trends.  DE’s outlook also benefits heavily from a convenient change in pension & OPEB assumptions.  Long-term, we think DE is trapped in a less severe version of the 1980s Ag Equipment down-cycle, offering perhaps ~30% relative downside from current levels. DE is increasingly shifting to an FY17 story, as well.  Shorter-term, we expect the report to pressure bears and allow us to repeat our ‘short-a-squeeze’ strategy.

 

 

Key Earlier Notes:

 

Replay & Materials From Ag Equipment Black Book

 

Best Ideas Addition (5/22/15)

Where To From Here (9/21/15)

Removing As Best Ideas Short (11/24/15)

 

 

 

Dissecting the Outlook

 

We’ll let others summarize DE’s quarter, as only one section of the release really matters: Guidance.  We think DE’s FY2016 guidance is truly incredible in that it is difficult to believable.  Management overshot with a back-end loaded $1.4 billion net income outlook, we think, which was puffed up with a “candidly…more accurate” change in pension & OPEB assumptions.  Ag Equipment demand in DE’s key markets is in free fall; management ought to have included a larger buffer to accommodate continued deterioration.  The outlook instead appears to assume stabilization at current run-rate levels. 

 

 

Short Squeezes: For longs, the aggressive, low quality guidance risks an outlook cut later in the fiscal year.  Who wants to buy DE shares on that? For the moment, the answer is weak longs and those trying to pick an Ag Equipment cycle bottom. We plan to wait for a fairly clear squeeze to add it back as a Best Ideas short, even though that strategy risks missing the next down move in the shares.

 

 

Big Picture: Our view is that the Ag Machinery industry is in a 1980s-lite scenario, a case we laid out in our Twin Peaks & Mid-Cycle Myths black book.  In major capital equipment downswings, management and investors are typically surprised at just how far demand can fall.  The recent downturn in mining equipment is a good example - sales of new equipment pretty much evaporated.  Used equipment often competes with new equipment just as deteriorating borrower credit disrupts financing.  If our view for the Ag Equipment industry is accurate, sales levels should continue to slip from the lofty 2013 peak.

 

DE | Incredible Guide - DE 1 11 25 15

 

DE | Incredible Guide - DE 2 11 25 15

 

 

Weak Guidance Strategy:  The character of the FY2016 guidance may prove to be another hit to management credibility* following the unneeded FY2Q to FY3Q guidance fiasco.  We would have expected management to guide to consensus, and then hope to ratchet the outlook higher over time.  Fiddling with actuarial assumptions and guiding higher than needed is likely to be unhelpful.  The guidance also assumes that the free fall in equipment sales abates, which may prove optimistic. 

 

DE | Incredible Guide - DE 3 11 25 15

 

 

Implied Decrementals Not Too Aggressive:  Maintaining current FY15 decrementals should prove challenging as DE cuts production to abnormally low utilization (e.g. single shift).  However, guidance assumes a drop in decrementals excluding the benefit of the Pension/OPEB assumption change. 

 

DE | Incredible Guide - DE 4 11 25 15

 

 

Yield Expectations Also Reasonable: Sure, yields could drop a bit.  

 

DE | Incredible Guide - DE 5 11 25 15

 

 

Lowering Costs Through New Pension/OPEB Assumptions:  A driver of the higher guidance relative to expectations is Pension & OPEB expense, a huge 2016 tailwind.  In late 2014, DE’s FY2015 guidance included a far smaller $85 million headwind. It is a low quality cost decline, but it has also been a market where accounting quality has been largely ignored.  It may push out the DE short case, which is increasingly shaping up as a late FY16/FY17 story.

 

DE | Incredible Guide - DE 6 11 25 15

Source: Company Filings

 

 

Units Likely Unreasonable: DE is a short thesis that is in the process of playing out, we think, and it is easy to mistake ‘new lows’ for a ‘bottom’.  Cyclicals also tend to look “cheap” all the way down.  Guidance assumes a significant deceleration in unit sales declines, by our estimates.  Sales are in a free fall from very high productivity adjusted levels.  In the late 1990s and early 1980s, unit declines continued at a pretty severe pace without much let up.  Early order indications for 2016 have been horrific vs. 2015 levels (which were already down).  Declines from peak look large, but can readily continue.  There is no quick cure for too much industry capacity/equipment.

 

DE | Incredible Guide - DE 7 11 25 15

 

 

Too Reliant On Deere Financial, Especially Into FY17:  The 2016 profit outlook also relies heavily on Deere Financial.  Credit quality is likely to follow softening metrics like farm values, used equipment prices, and past dues.  As the portfolio shrinks into FY17, in our estimates, Deere Financial may prove an uncertain source of a high percentage of DE’s profitability.

 

DE | Incredible Guide - DE 8 11 25 15

 

DE | Incredible Guide - DE 9 11 25 15

 

 

ICYMI - Why the strong quarter?  Continuing the low quality theme, much of the beat relates to a lower tax rate. 

 

DE | Incredible Guide - DE 10 11 25 15

 

 

Upshot: DE gave low quality guidance that exceeded consensus, a strategy we think may backfire later this fiscal year.  While the key components of the guidance look conservative at first, the outlook assumes stabilization in collapsing unit sales – a very tall order given our view of industry trends.  DE’s outlook also benefits heavily from a convenient change in pension & OPEB assumptions.  Long-term, we think DE is trapped in a less severe version of the 1980s Ag Equipment down-cycle, offering perhaps ~30% relative downside from current levels. DE is increasingly shifting to an FY17 story, as well.  Shorter-term, we expect the report to pressure bears and allow us to repeat our ‘short-a-squeeze’ strategy.

 

 

DE & Segment Margins

 

DE | Incredible Guide - DE 11 11 25 15

 

DE | Incredible Guide - DE 12 11 25 15

 

DE | Incredible Guide - DE 13 11 25 15

 

DE | Incredible Guide - DE 14 11 25 15

 

 

*To clarify, we believe management is doing very well with what they have.  Unfortunately, outside of subject experts, few market participants are likely to notice as the cycle overwhelms excellent execution.

 

 


Can’t Sneak #GrowthSlowing Past the Goalie

Takeaway: Domestic economic growth continues to slow on a trending basis, effectively threatening the consensus 2016 recovery narrative.

2016 U.S. Consumer Recession?

I’m off today flying back to Seattle to spend five days with my family. While our profession + modern technology = you’re never truly offline, I generally try to shut it down this weekend given that I don’t see them very often. That said, however, I can’t help but smell the stench of this morning’s #GrowthSlowing data from 35,000 feet in the air.

 

The most important U.S. economic data release we’ve received in 4Q15-to-date came out this morning in the form of Personal Income & Spending data for the month of OCT. From the prospective of our rate-of-change framework, the key takeaways from the release are two-fold:

 

  1. Real Personal Consumption Expenditures – which account for 69% of GDP – decelerated a fair amount, settling at +2.7% YoY from +3.1% in SEP. Real household consumption growth is now decelerating on a sequential, trending and quarterly average basis.
  2. Real Disposable Personal Income held flat at a healthy +3.9% YoY, but the +30bps sequential uptick in the Household Savings Rate to 5.6% caused growth in the headline consumption figures to decay.

 

Can’t Sneak #GrowthSlowing Past the Goalie - REAL PCE

 

Can’t Sneak #GrowthSlowing Past the Goalie - REAL INCOME

 

Can’t Sneak #GrowthSlowing Past the Goalie - PERSONAL SAVINGS RATE

 

Point #2 above corroborates the trending deceleration we’ve seen in consumer confidence, as most recently highlighted by this morning’s University of Michigan reading for the month of NOV, as well as the Conference Board reading which was released yesterday morning. True to its volatile form, the former index showed sequential strength in NOV, while the latter plunged and is now decelerating on a sequential, trending and quarterly average basis.

 

Can’t Sneak #GrowthSlowing Past the Goalie - UMich CONSUMER CONFIDENCE

 

Can’t Sneak #GrowthSlowing Past the Goalie - CONSUMER CONFIDENCE

 

While the aforementioned volatility in the UMich index makes the data set less substantially predictive of forecasting recessions, the somewhat linear nature of the Conference Board index makes it one of the key indicators for timing peaks in the economic cycle.

 

Can’t Sneak #GrowthSlowing Past the Goalie - CONSUMER CONFIDENCE CYCLE

 

With consumer confidence slowing in conjunction with dramatically steepening base effects for Real PCE growth and sharply receding base effects for Headline CPI, the most likely scenario with respect to domestic economic growth is that the U.S. consumer continues to decelerate – perhaps meaningfully – from here.

 

Specifically, the next four quarters of compares for Real PCE growth are the toughest since the four-quarters ending in 3Q08 and the next four quarters of compares for CPI are the easiest since the four quarters ended in 4Q11. It’s worth noting that Real PCE growth decelerated sharply from +2.7% YoY in AUG ’07 to -1.2% in SEP ’08 and Headline CPI recorded a massive acceleration from +1.1% YoY in NOV ’10 to +3.9% in SEP ’11.

 

Can’t Sneak #GrowthSlowing Past the Goalie - Real PCE Comps Chart

 

Can’t Sneak #GrowthSlowing Past the Goalie - CPI COMPS

 

While we’re not anticipating a similar crash in household consumption or a commensurate rip in CPI, we do think the principles of differential calculus are in our favor with respect to our anticipation of an outcome that is decidedly worse for Real GDP growth over the intermediate term (i.e. growth in the key driver “C” slows, while the GDP deflator accelerates). In a meeting yesterday, a very astute client summarized our analysis perhaps better than we could have:

 

“… If you’re saying Real PCE growth slows to 1% annual growth over the next 6-9 months, the U.S. economy could indeed experience a technical recession with the S&P 500 down -20% on that.”

 

Bingo. Why would you care to make it any more complicated than that?

 

Not All Is Bad, However

Since we are data nerds, however, we do care to sweat the small stuff. In the week-to-date, there has indeed been a few data points that have made us less right on our cyclical outlook for the U.S. economy, at the margins:

 

  • Growth in the New Orders components of Durable Goods and Core Capital Goods ticked up in OCT. Despite this, both series are still contracting on a YoY basis – effectively implying a continuation of the domestic industrial recession as most recently highlighted by the NOV Markit Manufacturing PMI reading;
  • The YoY growth rate of the 4-week rolling average of NSA Initial Jobless Claims decelerated to -8.2% YoY from -6.5% prior, which implies continued improvement in the domestic labor market; and
  • Corroborating continued improvement in the domestic labor market were the sequential upticks in the Markit Services and Composite PMI readings for the month of NOV given that SMEs account for 98% of total U.S. employment.

 

Can’t Sneak #GrowthSlowing Past the Goalie - DURABLE GOODS

 

Can’t Sneak #GrowthSlowing Past the Goalie - CAPITAL GOODS

Can’t Sneak #GrowthSlowing Past the Goalie - MARKIT MANUFACTURING PMI

 

Can’t Sneak #GrowthSlowing Past the Goalie - MARKIT SERVICES PMI

 

Can’t Sneak #GrowthSlowing Past the Goalie - MARKIT COMPOSITE PMI

 

Can’t Sneak #GrowthSlowing Past the Goalie - U.S. Employment by Firm Size

 

All that being said, the 2016 outlook for a recovery in domestic economic growth largely hinges on continued strength in household consumption. To the extent Consensus Macro is wrong on its outlook for the U.S. consumer, you can expect negative revisions to both top-down GDP and bottom-up EPS estimates for 2016E.

 

For our latest thoughts on why a U.S. (and potentially global) recession is likely to commence in 2016, please review the following presentations and research notes:

 

 

Enjoy your Thanksgiving weekend with your respective families!

 

DD

 

Darius Dale

Director


Cartoon of the Day: Gobble Gobble

Cartoon of the Day: Gobble Gobble - FED cartoon 11.25.2015

 

All eyes are on the Fed as we head into December. Will they or won't they raise rates? 

 


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McCullough: What QE Actually Did Was Pay The Few And Crush The Many

 

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Full Plate | Housing Goes 3 for 3 Pre-Holiday

Takeaway: The late-Fall negative data tide appears to be turning in the housing sector as a recent spate of positive prints suggest emergent strength.

Our Hedgeye Housing Compendium table (below) aspires to present the state of the housing market in a visually-friendly format that takes about 30 seconds to consume.

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - Compendium 112515

 

Today’s Focus: New Home Sales for October, FHFA HPI & MBA Apps

 

In Short:  Purchase Demand held above trend for a 2nd week, New Home Sales in October retraced the Sept cratering and FHFA HPI confirmed the acceleration in Prices.

 

We’ll try to keep it tight here in reviewing the pre-holiday data deluge in housing.

 

Purchase Applications:  Purchase demand dipped -0.5% WoW and accelerated to +24% YoY, providing some soft confirmatory evidence that last week’s +11.9%  gain was more than just statistical noise in a holiday week (Veteran’s day).  Two weeks of strength now have 4Q tracking +0.3% higher QoQ and accelerating to +21.2% YoY.   

 

Alongside (what the Fed hopes is) the most well-telegraphed rate hike in history, its more probable than not that we’re seeing some measure of demand pull-forward with prospective buyers pulling the purchase trigger in fear of further financing based affordability declines.   

 

While comps remain easy the next 5-6 weeks and the data should remain good on balance, discerning a clear trend in the underlying data during the holiday period is challenging as imperfect statistical adjustments can push the data either way in any given week. 

 

New Home Sales:  New Home Sales rose +10.7% MoM in October following the bomb of a print in September  (-12.9%, which was revised further lower).  What happened in September is unclear but we do know a couple things: 

 

First, NHS is the most volatile housing series there is and carries a large standard error with significant subsequent revisions. 

 

Second, the NHS estimate methodology is particularly sensitive to the impacts of TRID implementation.  NHS estimates are imputed based on permits data but many new homes have a sales contract prior to permit issuance – and any TRID related pull-forward would mostly likely show up as un-permitted, signed contracts. 

 

In any case, at 495K in October, NHS sit exactly on the TTM average and just below the YTD average of 499.6K with sales thru October running +15.2% over the same period last year.  So, on net, perhaps some marginal weakness the last two months with the latest month rebounding back to Trend. 

 

FHFA HPI:  The FHFA HPI series accelerated +50bps sequentially to +6.1% YoY.  With the Case-Shiller series also registering acceleration yesterday, all three of the primary price series are telling a congruous, positive 2nd derivative HPI story.   We reviewed the Case-Shiller data and the supply situation yesterday (HERE) and we’ll get our first look at October price data with the CoreLogic HPI release next week.  

 

 

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - FHFA HPI YoY

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - NHS   SF Starts TTM

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - NHS to EHS ratio

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - NHS Inventory

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - NHS LT

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - NHS Median   Mean Price

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - NHS Units   YoY TTM

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - Purchase 2013v14v15

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - Purchase Index   YoY Qtrly

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - Purchase Monthly

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - Purchase YoY

 

Full Plate | Housing Goes 3 for 3 Pre-Holiday - 30YFRM 

 

 

 

About New Home Sales:

Each month the Census Department releases the New Home Sales report, which measures the number of newly constructed homes that have been sold in the month. The difference between the New Home Sales report and the Starts and Permits report is that New Home Sales only includes single family spec homes built and sold by builders, and does not include condos, apartments, or owner-built units. This is why New Home Sales typically run at roughly half the rate of Starts.

   

 

About MBA Mortgage Applications:

The Mortgage Bankers’ Association’s mortgage applications index covers more than 75% of mortgage applications originated through retail and consumer direct channels. It does not include loans delivered through wholesale broker and correspondent channels. The MBA mortgage purchase applications index is considered a leading indicator of single-family home sales and construction. Moreover, it is the only housing index that is released on a weekly basis. 

 

Frequency:

The MBA Purchase Apps index is released every Wednesday morning at 7 am EST.

 

 

Joshua Steiner, CFA

 

Christian B. Drake

 


CLAIMS | ENERGY - THERE WILL BE BLOOD

Takeaway: Energy states continue to show accelerating deterioration in labor conditions relative to the rest of the country.

As an oilman, I hope that you'll forgive just good old-fashioned plain speaking.

 - Daniel Plainview, There Will Be Blood (I'm An Oil Man Speech)

 

CLAIMS | ENERGY - THERE WILL BE BLOOD - Oil pic

 

Below is the breakdown of this morning's labor data from Joshua Steiner and the Hedgeye Financials team. If you would like to setup a call with Josh or Jonathan or trial their research, please contact 

 

Let's speak plainly. The trend in energy state claims (chart below) shows the spread between indexed claims in energy states and the country as a whole has steadily increased from a low of 3 in early July to 34 as of the most recent reading for the week ending November 14. Energy hedges are rolling off broadly as the end of 2015 approaches. We expect this emergent acceleration in the deterioration in labor conditions throughout  the energy patch to continue into 2016. 

 

The takeaway here is that company's with high relative exposures to energy hubs like Houston and Calgary will see headwinds continue for some time. 

 

Meanwhile, the rest of the country continues, for now, to exhibit decent performance as evidenced by the fact that non-energy states are collectively more than offsetting the weakness in the energy footprint. Overall, initial jobless claims showed week-over-week improvement with the SA figure falling from 272k to 260k and the year-over-year rate of change in rolling NSA accelerating slightly from -6.5% to -8.2%. 

 

CLAIMS | ENERGY - THERE WILL BE BLOOD - Claims18 2

 

The Data

Prior to revision, initial jobless claims fell 11k to 260k from 271k WoW, as the prior week's number was revised up by 1k to 272k.

 

The headline (unrevised) number shows claims were lower by 12k WoW. Meanwhile, the 4-week rolling average of seasonally-adjusted claims was stable at 271k.

 

The 4-week rolling average of NSA claims, another way of evaluating the data, was -8.2% lower YoY, which is a sequential improvement versus the previous week's YoY change of -6.5%.

 

CLAIMS | ENERGY - THERE WILL BE BLOOD - Claims3

 

CLAIMS | ENERGY - THERE WILL BE BLOOD - Claims4

 

CLAIMS | ENERGY - THERE WILL BE BLOOD - Claims5

 

CLAIMS | ENERGY - THERE WILL BE BLOOD - Claims6

 

CLAIMS | ENERGY - THERE WILL BE BLOOD - Claims7

 

 

Joshua Steiner, CFA

 

Jonathan Casteleyn, CFA, CMT

 

 


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