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Looking Through Deere's Q3 'Beat': Signs Point To Trouble Ahead

Summary

Q3 headline results mask ongoing weakness.

Operating lease maturity may start giving Deere indigestion as soon as Q4.

Absent one-time and non-operating adjustments, full year guidance is largely unchanged.

Rich valuation and deteriorating credit quality make Deere a risky proposition at current levels.

Q3 results ahead of expectations

Deere (NYSE:DE) reported Q3 earnings before the open on Friday, and at first glance, the headline results looked impressive. Despite a slight top line miss, earnings were well ahead of market expectations and the stock was up 13.5% for the day.

Total sales and net revenue were down 11.4% versus a year ago, But net income was $488.8 mn, and as a result, EPS was actually marginally up on last year at $1.55 per share (vs. $1.53 last year). Pre-tax margin improved 76 basis points despite much lower revenue. The margin improvement was a result of the big jump in Ag & Turf profit ($571 mn), up 21% year over year.

So the headline numbers looked impressive, but what do we find when we dig a little deeper?

Most of margin improvement attributable to SiteOne Sale

However, it's important to note that most of this improvement can be attributed to the sale of 30% of Deere's stake in SiteOne Landscape (NYSE:SITE) during the quarter for a pre-tax gain of $75 mn.

Absent this gain, overall pre-tax margin would have been 100 bps lower than reported (9.5%, vs. 10.5% reported and 9.7% in Q3 2015) and down year over year.

Price realization positive, but reasons to be skeptical

Price realization was also positive by 2%, consistent with the first half of the year. Absent the pricing improvement (and gain on sale of SiteOne), the year-on-year decline in pre-tax margin would have been approximately 260 basis points. The sustained improvement in price realization may be surprising given the depressed ag and construction equipment market, but it may be at least partly explained by the fact that Deere's seems to have found a relatively price insensitive customer in... itself.

During the current downturn, Deere has increasingly turned to utilizing operating leases, with sales financed via Deere's finco (JDCC) as a way to sustain demand in the wake of a very challenging environment for farmers. Operating leases as a % of sales have grown from 2.1% in 2011 to 8.3% in 2015 and have averaged a fairly staggering 9.8% for the first 9 months of 2016.

This has almost certainly had the effect of not only boosting sales via pulling forward some new equipment demand from farmers that would have otherwise deferred purchasing, but also improving margins via cost absorption.

This large year-over-year increase in the use of operating leases makes one wonder how valid the price realization trend is, given Deere is effectively selling an ever-increasing percentage of machinery to itself. But more importantly, when those leases start to mature, Deere may have a problem.

What happens when all...


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