For our 100th Seeking Alpha article, I decided to cover Deere & Company (NYSE:DE). Since our previous coverage, Deere has underperformed significantly as the inflation risk we outlined came to fruition.
However, I believe the company provides the necessary resilience required to outperform the broader market during a stagnating economic period. How you decide to play it is your choice; however, we’re looking at this asset as a lucrative option to buy into during a market dip as its fundamentals allow for lesser losses in a bear market and excess returns in a bull market.
Without further ado, let’s get into it.
Recent Operational Overview
I think it’s safe to say that the global economy has entered a downturn. For instance, inflation rates across major economies are surging (except China). Additionally, real GDP growth is heading into a contractionary phase, which could lead to a decline in consumer spending. Furthermore, the yield curve in the U.S. shows that near-term spot rates are out of control, conveying that the market thinks that the Federal Reserve would have to contract the economy by a significant amount to curb inflation.
Nonetheless, some sectors could sustain their strength. For example, the consumer staples space is non-cyclical. Thus investors could opt to shift capital into its domain. This could benefit Deere as its operations hold a correlation with the upstream staples environment.
According to Wells Fargo (WFC) analyst Chris Carey, consumer staples will outperform given their resilient nature and ability to face economic headwinds. Again, I see this as an indirect influencing factor for Deere.
Deere’s operating results are inextricably linked to agricultural and construction/forestry activities. The chart below indicates that agricultural exports from the U.S. are at a multiyear high, with record commodity prices being significant tailwinds for primary producers. Furthermore, building permits have dipped recently. However, they remain at a multiyear high, suggesting that construction equipment sales are still a possibility.
The figure below illustrates Deere’s 2021 market positioning in its primary business unit, farm machinery. The company held a dominant position in the market last year, which has been a recurring trend. Some of Deere’s competitors include the likes of Caterpillar (CAT), CNH Industrial N.V. (CNHI), and Kubota Corp. Japan (OTCPK:KUBTY). I’d opine that this is an industry with high barriers to entry; thus, Deere will likely face moderate competition and, in most instances, an industry stronghold.
Although Deere’s second-quarter (year-over-year) gross dropped from 34.3% to 33.3%, the company’s gross and operating margins remain above its 5-year average (YCharts doesn’t reflect Q2 earnings, see the 8-K screenshots below). The firm’s wide range of products has undoubtedly helped secure a large portion of the agricultural equipment spending during the past few years. Another critical aspect to note is Deere’s ability to cope with a tight labor market as its net income per employee ratio is substantially better off than its sector peers’.
The company’s well-diversified. First of all, Deere’s entering a new paradigm with the integration of autonomous features. This is an extremely necessary addition, in my opinion. I say this because farming is shifting to a smaller-terrain, higher volume trend, which requires precision farming/small-turf products.
Furthermore, Deere’s recent launch of its 8R tractor will add much value to the company’s general farming target market as it’s expected to increase yield and improve cost structures in the farming industry.
Deere’s presence in the construction and forestry industries is also becoming increasingly important, with the segment now making up more than 25% of the firm’s revenue mix. Deere offers several forestry products, with its new 768L-II Bogie Skidder thought of as an innovative machine causing much optimism within the forestry & logging industry.
Lastly, Deere’s acquisition of Bear Flag Robotics in 2021 adds much value as its autonomous driving technology is compatible with both Deere’s older and new to market products. Acquisitions such as these allow for vertical integration, in turn, providing Deere with lucrative product differentiation and cost-saving advantages.
Key Valuation Metrics
Relative valuation is probably the best method to use for Deere stock. I say this because a DCF model would be difficult to regress given the inconsistency of growth rates during the pandemic. Furthermore, an absolute valuation doesn’t help, in my opinion, as I enjoy regarding cyclicality rather than observing earnings versus dividend trade-offs.
From a relative vantage point, Deere stock seems undervalued as it’s trading at a discount relative to its normalized price multiples. Additionally, the stock’s PEG ratio is at a 3.7x discount to benchmark, indicating that Deere’s earnings-per-share growth isn’t priced by the market.
I had a look at a few factor models to determine how Deere stock relates to the current climate. First of all, the first chart in this section illustrates investors’ bias towards high dividend, value, and quality stocks, while growth and momentum plays have lagged. The explanation for this is simple, factor model testing has discovered that short-long terms datasets illustrate a skewness towards risk-averse assets prior to a possible recession.
To provide some substance to my claim, According to Goldman Sachs (GS) analyst David Kostin, we’re 35% likely to see a near-term recession. In addition, Kostin states that “during the 12 months before a recession, defensive sectors and ‘quality’ factors have generally outperformed. Across 5 recessions since 1981, the average experience saw Energy (XLE), Consumer Staples (XLP), Health Care (XLV), and Utilities (XLU) outperform the index.”
The second and third charts in this section illustrate a cross-sectional analysis of Deere’s stock performance during different market circumstances. The models were created by Eugene Fama, Kenneth French, and Mark Carhart to identify stock types that would outperform the market during certain market climates. I related my findings to the economic outlook and the factor analysis that I started this section with.
I discovered that Deere stock outperforms a general bull market, outperforms a value-orientated market, outperforms a small-cap stock bull run, underperforms a momentum run, outperforms a market that seeks profitable stocks, and outperforms a market that seeks stocks with high re-investment rates.
Thus, Deere stock mostly performs better than the market unless the market is momentum seeking, which it isn’t at this stage.
Lastly, Deere stock’s profile matches the current market sentiment, which is geared towards quality, value, and dividend yield-seeking. The firm’s current and quick ratios exhibit solid solvency and liquidity, and its income statement is robust, with an EPS growth that exceeds its sector benchmark by 79.64%.
The primary risk for Deere is related to materials. Spikes in ferrous metals and polysilicon prices make life difficult if you’re looking to build heavy-duty machinery with integrated semiconductors. There’s a risk that the global supply-chain issues could persist, possibly leaving Deere’s profit margins suppressed.
The Bottom Line
Deere is the type of stock that could bypass a market sell-off while also outperforming on the upside. The company’s strong market position could help it take advantage of a surge in farming activity, which could give rise to its stock. Additionally, the stock seems undervalued, and its price metrics are attractive on a cross-sectional basis.