RD's Picks

In addition to serving as inspiration for one of the greatest country songs ever, you may be aware that Deere & Co. (DE) makes farm and construction machinery. Over the past two years, the stock has run from about 37 to over 90 earlier this year. It's now pulled back to 65 and change, about where it was one-year ago.

The company looks cheap, trading at 13.5 times ttm earnings and 11 times estimated 2009 earnings. Early in the first round of the Strategy Lab Open, Ken Kam asked us to explain why conventional wisdom about a stock's price is wrong in our blogs. In this case, I wasn't able to turn up a reason why the market pricing on DE is wrong.

The stock is trading at a substantial discount to the overall market, but there are several risks to explain the discount and little good news that isn't already well known.

The bull case is that the strong agricultural business will continue to translate into higher tractor and machinery sales and there is evidence to support that. In the 13 Aug conference call, DE management stated that the 8000 and 9000 series tractors have orders extending through July and Sep '09 respectively and that 70% of next year's expected combine sales have orders. The company also has invested in production capabilities and will have increased capacity for combines coming on line in 2009 and tractors in 2010. Deere's other big machinery segments, forestry and construction, are weak but profitable.

Currency translation is expected to add about $150 million, or about 7%, to '08 earnings. With the dollar strengthening, currency translation may very well turn from a positive to a negative. At a minimum, DE will be hard pressed to duplicate this year's currency gains going forward.

A stronger dollar will also benefit foreign competitors. The 19 August Wall St. Journal included an article on a joint venture between Mahindra & Mahindra of India and China's Jiangsu Yuenda Yancheng Tractor to produce tractors. Japan's Kubota (KUB) and Europe's CNH Global (CNH) would also benefit from a stronger dollar.

If US politicians end mandates and subsidies pushing ethanol, corn prices would drop as corn based ethanol production falls.

Input cost inflation will put pressure on margins. During the conference call, several analysts asked about costs and management indicated they've been able to pass most of the higher input costs along to customers.

I don't have a good handle on the farm equipment replacement cycle, but I doubt farmers rush out and buy new tractors and equipment every time there's a great year. A logical cycle would something like a big sales gain in a boom year with smaller gains in subsequent strong years. That may not be the case, but if it is, Deere has probably already seen the biggest chunk of growth in this cycle.

DE is a strong company that's been executing well. The stock seems to be fairly valued at 65 and change, but it's tough to call it a 'buy' with some of the potential headwinds on the horizon.

I normally prefer trying to pick out the best stocks in a sector rather than using an ETF, but since the driving factor behind the bull scenario is a strong and growing agricultural business, the Market Vectors Agribusiness ETF (MOO) might make more sense for an investor considering DE. Since DE makes up nearly 8% of the ETF, you still get some John Deere power in the mix.

Comments: View Comments |  Wednesday August 20, 2008