It’s time to discuss John Deere’s (DE) second quarter earnings. After I considered the stock a good buy in February (right before COVID-19), the stock has taken a deep dive and is currently down 19% year-to-date. The just-released earnings show an ugly picture as global growth has been slammed due to the global lockdown. Unfortunately, weakness will continue and result in a bad full-year according to the company’s guidance. Regardless, the stock has approached an attractive valuation and a good risk/reward for a starter position if you’re not already long.
Source: John Deere
Q2 Earnings Were Bad, But Not That Bad
Let’s start by getting the obvious statements out of the way. The company’s second quarter of the 2020 fiscal year was weak, very weak. Total adjusted EPS fell from $3.52 in the prior-year quarter to currently $2.11. That’s a decline of 40% but well above expectations of $1.91. Unfortunately, it ends the start of what would very likely have become a strong rebound in the fourth quarter (the calendar year 2020) as economic indicators started to accelerate right before COVID-19 hit.
Weak earnings started all the way at the top as net sales declined by 18% to $9.25 billion in the second quarter. Net sales from equipment operations declined by 20%. The company’s biggest segment, worldwide agriculture and turf, saw a net sales decline of 18% as volume/mix was down significantly. The volume/mix decline impacted operating profit by $439 million while better pricing partially offset this fall by adding $108 million to operating segment profit. Lower production costs and lower SG&A spending added another $204 million, resulting in an overall operating profit reduction of 22.1%.
Deere’s other segment, worldwide construction and forestry, saw a worse decline. Net sales declined by 25% as this industry is simply put way more cyclical than the agricultural segment. As a result, operating profit in this segment declined from $347 million to a mere $96 million, or 72.3% as the volume/mix decline of $192 million made it pretty much impossible for a higher price and lower production costs to significantly reduce the damage.
One of the worst things for me, is that pretty much all companies withdrew guidance. I get that, but it takes away one of the best reasons to cover companies during earnings season: their outlook and industry insights. However, Deere has published guidance and commented on agricultural developments. On a full-year basis, Deere expects net income to come in between $1.6 and $2.0 billion. This forecast includes expectations that worldwide construction and forestry sales will fall by 30% to 40% with operating margin down to 2.0% to 4.0% from 10.8% in the FY2019. Worldwide agricultural and turf sales are expected to fall by 10% to 15% with operating margin down from 10.6% to the 8.5% to 10.0% range. In other words, agricultural sales will be steady while construction will (obviously) continue to feel the pressure from an imploding economy.
That said, I am happy that Deere is providing some valuable insights into the agricultural business from its own perspective. Right now, the company is seeing a strong rebound in planted acres for soybeans, with corn acres reaching the highest levels since 2012. Good spring weather has resulted in higher planting progress. Unfortunately, and this is where COVID-19 comes in, agricultural commodities are down as demand is down. People stay at home, restaurants are empty and meat production plants were/are still shut. Additionally, the slow aerospace industry and low miles traveled for cars have resulted in lower ethanol demand, which is pressuring corn prices even more.
As a result, agricultural commodities (graph below) are down 16% over the past 12 months. Deere benefited from the fact that higher production numbers and lower fertilizer costs stimulated machinery demand.
Right now, the biggest bull case for agricultural companies like equipment providers, fertilizer producers, and support companies are higher agricultural commodity prices. I expect that the bottom is in. We will see upside momentum once ethanol demand accelerates again with support from an ease in global lockdown measures.
While I am writing this, Deere’s stock price is down 19% year-to-date. The stock is trading at 14x earnings. The company did better than expected in its second quarter, thanks to a somewhat stable agricultural segment, which continues to benefit from healthy planting conditions. Unfortunately, prices remain suppressed as economic growth is weighing on demand.
I believe the stock will bottom between $120 and $140. I know this is a somewhat large range, but the market remains volatile and any sell-off could easily push this stock down $10 to $15. Nonetheless, I strongly believe in an agricultural rebound and expect Deere to outperform its industrial peers (the Industrial ETF (XLI)) going forward.
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