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Morningstar | As Farmers are Impacted by Trade and Weather in 2Q, Deere Focuses on Long-Term Technology Strategy

Deere stock dropped by 6% after management revised its fiscal 2019 outlook during the second-quarter earnings call by suggesting annual revenue would increase 5% compared with its prior forecast of 7%. Strong pricing and healthy demand for its road building equipment enabled Deere to increase quarterly manufacturing revenue 5% year over year to $10.3 billion, and exceed consensus estimates of $10.2 billion. EPS of $3.52 missed consensus of $3.63 due to higher costs and currency effects. Deere is heavily exposed to the North American farmer who has been hurt by poor weather and the trade war with China. While we applaud Deere’s investments in technology, we feel the global proliferation of advanced agricultural technology will ultimately constrain American farmers’ profits. Taking these trends and the revised outlook into account, we plan to modestly reduce our fair value estimate.

Despite numerous headwinds, Deere’s agricultural and turf segment managed to increase revenue in the second quarter by 3% to $7.3 billion while operating margin declined to 14% from 15%. Weakness in North America and Argentina was offset by higher price realization and penetration of high-margin precision agriculture technology in Brazil. Citing various concerns impacting U.S. farmers, management lowered its revenue guidance for 2019 with the new forecast incorporating 2% annual revenue growth for the segment versus its prior 4%.

Deere’s construction and forestry segment benefited from global GDP and infrastructure demand growth in the quarter, which drove revenue up 11.6% year over year with margins expanding to 11.6% from 9.6%. Healthy sales of Wirtgen road construction equipment were partially offset by lackluster housing starts that negatively impacted the demand for construction equipment and lumber products. Management lowered its 2019 revenue growth forecast for this segment as well, to 11% from 13%, citing weakness in some foreign markets and a product mix shift.

As part of its revised 2019 guidance, Deere management indicated that research and development expenditures would be increasing 6% in fiscal 2019 up from its prior forecast of a 5% annual increase. Deere also revealed that its digital operations center now has over 145 million engaged acres globally with the coverage area growing at a brisk but unspecified rate. We believe Deere’s positioning itself as the global leader in precision agriculture is strategically wise and should benefit margins in the near term. However, the rapid proliferation of such technology may boost yields on a global scale faster than demand requires. As a host of productivity-enhancing technologies provided by Deere and its competitors reach less sophisticated markets outside of North America, global crop prices are likely to experience further downward price pressure.

We are also becoming increasingly concerned that waning enthusiasm for biofuels along with broader adoption of electric vehicles will negatively impact the American farmer and Deere. In 2018, ethanol consumption in the U.S. declined for the first time in 20 years. The 14.4 billion gallons of ethanol produced accounts for approximately 10% of gasoline content and 40% of the corn grown in the country. Recent mandates in China for higher ethanol blend rates may help mitigate the impact to global corn demand. However, it isn’t clear that the American farmer will benefit as Chinese and Brazilian corn producers increase their yields and corn acreage.