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. 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 downwards and FY18 estimates to move below FY17.
As investors price in the reflexive unwind in this commodity-related capital equipment industry, we expect to see another ~50-60% relative downside in shares of DE.
INTERMEDIATE TERM (TREND)
Foreign crop prices surged last year helping drive Deere’s South American equipment sales and we vastly underestimated the impact of that on Deere, an omission bulls should not repeat on the way down. Corn tends to lead unit sales in Brazil by 4-5 months, so the downswing here should start to be impactful shortly.
DE is already producing a bit above retail in F1H 2017, so we aren’t entirely clear how further increases won’t add to inventory. Inventory metrics just don’t look appropriate for a big production ramp, whether on government, industry, or DE data. Last quarter was the highest inventory to sales ratio for 100+ 2WD tractors, so a production ramp didn’t exactly seem likely. Our take is that dealer inventory to sales metrics will continue to deteriorate if DE ramps production amid down YoY crop prices and softer credit metrics.
LONG TERM (TAIL)
Deere is not an acquisitive company, and this Wirtgen deal is a major strategy shift. If Ag Equipment was about to surge back, why wouldn’t DE go after a big Ag and Turf acquisition? Exiting both a core market and a supposedly winning strategy is not a great idea, especially when the deal’s valuation rationale is explained via 2022 synergies. While some saw it as a positive, accretive development, we see it as a piece of confirming evidence that DE cannot rely on its core Ag equipment market as the down-cycle continues.
ONE-YEAR TRAILING CHART
