THE HEDGEYE EDGE
We see DE as a highly cyclical, capital equipment supplier to a mature, zero growth industry. Deere’s key, high margin franchise is large, North American ag equipment. Prior to 2014 or so, that market experienced a decade long surge in equipment sales, driven by soaring crop prices, increasing land values, and comparatively easy credit. Since peak, these factors have begun to roll over. We expect the hangover – elevated new & used equipment inventories, excess manufacturing capacity, tightening farm credit, and declines in farmer equity – to be a prolonged affair that gradually takes equipment sales below ‘normalized’ demand.
We expect total North American agricultural equipment sales to drop roughly 2/3s peak to trough, and FY15 results are only about half way there. Newer downside drivers appear likely to come from tightening credit, decreasing land values, declining farm equity, and lower crop prices. As those factors influence equipment sales, we expect FY17 estimates to move to <$3.00 vs. current consensus of about $4.10. As investors price in the reflexive unwind in this commodity-related capital equipment industry, we expect to see another 30%-50% relative downside in shares of DE.
INTERMEDIATE TERM (TREND)
While most of FY16 is baked into the share price, there are a couple of noteworthy items concerning DE and its customers. New and used inventories, dealer sentiment and credit metrics are deteriorating. Further credit tightening can pressure residual equipment values and Deere’s Finance subsidiary which has seen an uptick in past due loans. These indicators show that the Ag downturn is still underway and not approaching ‘trough’ levels as consensus believes in 2016.
LONG TERM (TAIL)
We agree that FY16 is about right, give or take ~10%. But the differentiator versus consensus is for FY17. We think that FY17 estimates are far too high and expect an FY17 reset as a downside catalyst. We do not think that a 60%+ NA Ag equipment spending decline peak to trough is what the market is expecting. Bullish analysts still think that FY16 is roughly trough, and is well below ‘normalized’ demand. As a result, some see DE as a relatively defensive machinery name. We expect that optimism to fade, just as it has for other commodity production capital equipment shares (e.g, CAT, JOY).
ONE-YEAR TRAILING CHART
