Investors who bought into the "it's different this time" stories on major equipment and component companies such as Caterpillar (NYSE:CAT), Deere (NYSE:DE), Cummins (NYSE:CMI) or Joy Global (NYSE:JOY) got a hard lesson in 2012, as weakness in Europe, China and South America ultimately hit sales, profits and valuations. With the global Ag markets looking stronger relative to mining and construction, however, it's worth asking if Deere could be a solid stock to own on a macro rebound in 2013 and a lengthening of the Ag cycle.
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Closing the Year with Mixed Numbers
Deere had some interesting numbers for its fiscal fourth quarter. Overall revenue growth was strong at 14%, as was product revenue growth of more than 14%, better than analysts expected. Ag and turf revenue was particularly strong, growing 16% from last year, while construction/forestry revenue was basically in-line at 7% growth. As has been the case with most machinery OEMs, North American sales were quite strong (up about 26%), while OUS sales were soft.
Margins were less impressive, however, on higher production costs and SG&A. Equipment gross margin softened more than half a point from last year, while overall operating income rose approximately 8% and equipment operating income rose 10%. Deere also saw an interesting dichotomy between its segments - Ag/turf income rose just 7% (with soft incremental margins of 6%), while the construction/forestry segment saw 38% income growth and incremental margins of 31%.
Management Cautious (As Usual), but Will the Ag Cycle Go Another Year?
Bears have been waiting for the Ag cycle to peter out, as the last few years have seen many farmers taking advantage of better crop prices and tax subsidies to refresh their equipment. At the same time, the expansion of industrial farming in South America has made the markets of Brazil and Argentina considerably more valuable.
Deere's management seemed to offer up cautious guidance, but with some good news as well. Combine orders have come in well, with all available production for the next two quarters booked up. While Europe is going to be weak (as expected), North and South American demand is looking at least no worse than the bears had projected.
Nevertheless, the question remains as to whether 2012 is going to be the peak year for the cycle. So far, Deere has not had to worry about new entrants into the market, with CNH (NYSE:CNH), AGCO (NYSE:AGCO), Claas and Kubota (NYSE:KUB) representing the bulk of the competition. What's more, agricultural production forecasts continue to point up for the foreseeable future and many emerging markets have significant untapped demand for modern equipment.
Consequently, while I think there is some risk that North American demand may be past the peak, I don't think that means Deere's business goes over the cliff. Speaking of North America, yields below 130 bushels per acre have typically been a significant breakpoint, and 2012's yield for the U.S. was about 122 bushels per acre.
SEE: A Primer For Investing In Agriculture
The Bottom Line
All things considered, I still like Deere among the large and popular heavy equipment OEMs. Unlike Caterpillar, Terex (NYSE:TEX) and Joy, Deere really doesn't have to worry about new entrants into its markets from China. Moreover, I think the company's extensive R&D will serve it well and I think rivals such as AGCO have more to worry about from Deere in markets such as Brazil than the other way around. Likewise, I could see Deere taking share from CNH and Claas in Europe.
Unfortunately, Deere seldom gets all that cheap, and today is no exception. Even if I project free cash flow (FCF) growth in the high-single digits or low teens (which is quite aggressive for a company in what are cyclical businesses), the stock only looks about 10% undervalued. As a result, I'd need to see more investor worries about the Ag and construction markets (and a pullback in Deere's share price) to get really excited about these shares.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
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