(By Mani) Shares of Deere & Co. (NYSE:DE) fell 6 percent after it reported lower-than-expected quarterly earnings on weak international demand and product launch related manufacturing inefficiencies. However, the company is expected to turn the tables when higher commodity prices drive demand for Deere's agricultural and farming equipment.
Illinois-based Deere makes agricultural equipment, industrial equipment, and commercial and consumer equipment. Its Agriculture and Turf segment accounts for 75 percent of sales, its Construction and Forestry segment represents 17 percent, and the rest comes from its Financial Services.
With agricultural commodity prices at record levels, farmers globally would seek to maximize yields to take advantage of strong prices. One way to do that is through increased and improved mechanization. This upcoming trend bodes well for Deere, which gets significant revenues from selling farming equipments.
"We expect DE to benefit from strong global ag demand, driven by record ag commodity prices. Also, we believe NA construction equipment demand will continue to rebound over the next few years," UBS analyst Henry Kirn wrote in a note to clients.
The key concern on shares of agricultural equipment OEMs is that the North American agricultural equipment cycle could be peaking, leading to a substantial decline in 2013.
Commodity prices remain supportive of solid equipment demand. Changes in corn prices have been a reliable coincident indicator of Deere's share price relative performance since the mid-1970s. Since 1977, corn prices and Deere's relative performance to the S&P 500 have moved in the same direction on a year-over-year basis in 74 percent of the quarters.
"In the 73 periods in which the price of corn rose, DE outperformed the S&P 73% of the time. Corn prices are up 12% YoY," Kirn added.
Recent checks indicate price increases are holding firm and should be a meaningful tailwind going forward.
"Our channel checks indicate industry participants nearly unanimously expect to realize mid-single digit price increases on ag equipment in 2012. DE forecasts net pricing of ~4% in 2012, which is supported by our dealer visits and surveys," Kirn said.
Company equipment sales are projected to increase by about 13 percent for both fiscal 2012 and the fourth quarter compared with the same periods a year ago. Including an unfavorable currency-translation impact of about 3 percent for the year and about 4 percent for the fourth quarter.
This year's drought could positively influence demand as it spotlights the need for John Deere's highly productive agricultural equipment and Deere is well-positioned to capitalize on favorable global agricultural trends over the long term.
"Despite strength in recent years, our channel checks (including our 30th semiannual ag dealer survey) suggest the cycle has longer legs than investors generally expect," the analyst noted.
Industry sales for agricultural machinery in the U.S. and Canada are forecast to be up more than 10 percent for 2012. Full-year industry sales in the EU27 are now forecast to be flat as strength in the northern European market offsets weakness in the South. Sales in the Commonwealth of Independent States are expected to be up strongly in 2012.
Asia's Industry sales are projected to be down moderately for the full year due to softening in India and China. In South America, industry sales are projected to be down 5 to 10 percent as a result of uncertainty in Argentina and drought conditions earlier in the year in parts of the region.
As a result of dry weather, global grain supplies are expected to tighten further. This supports higher commodity prices and should result in robust field activity in the 2013 crop year in markets throughout the world.
Deere noted strong sales to the rental end markets as a key driver for Construction & Forestry demand in 2012. Deere's worldwide sales of construction and forestry equipment are forecast to increase by about 17 percent for 2012, and construction equipment sales in the U.S. continue to show strong recovery.
Meanwhile, investor concerns on the manufacturing inefficiencies will likely remain elevated until Deere can prove that they are behind it. However, Deere has historically been one of the most efficient and reliable manufacturers that we cover when it comes to managing production schedules. The company says it is now running the factory at full speed so there was no down-time to get caught up once it fell behind.
"We expect margins to rebound as Deere corrects the manufacturing inefficiencies over the next few quarters. While we acknowledge limited visibility (for now), we are confident that the production inefficiencies will likely prove to be a transient issue," Kirn said.
Moreover, the time is apt for buying Deere at a discount as its P/E multiple is a multi-decade low and shares are poised to outperform over the next few quarters. At 9.3 times its 2012 consensus EPS, Deere's P/E is in line with 1994 levels and the lowest absolute multiple over the last 20 years.