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Morningstar | DE Updated Forecasts and Estimates from 18 Apr 2019

Wide-moat Deere reported first-quarter fiscal 2019 earnings well below Street expectations due to higher costs and unfavorable product mix. GAAP EPS of $1.54 missed consensus of $1.74. Revenue in the quarter of $6.94 billion was up a healthy 16.2% year over year, beating consensus of $6.84 billion. We view the issues in the quarter as largely unique and not impacting the long-term outlook for Deere. Management stands by its 15% midcycle operating margin target, which it expects to reach by 2022. Taking these factors into account, we are adjusting our revenue forecast and raising our fair value estimate to $164 from $161.

Demonstrating the double-edge sword of advanced technology, Deere experienced significantly higher warranty costs in the quarter as several new products introductions ran into unspecified trouble. Yet, we view Deere’s investment in technology favorably as it will elevate customer switching costs and improve margins. During the earnings call, Deere cited technology adoption as a motivating factor for multivendor farmers to switch to all Deere equipment, which is consistent with our long-term perspective. We view the operational benefits of farmers relying on a single technology platform outweigh any savings from selecting equipment with lower upfront costs. Farmers appear to agree as take rates during the quarter on offerings such as Deere’s ExactApply increased as much as 50% year over year.

Operating margin during the quarter increased to 8.1% from 6.8% in the first quarter of fiscal 2018, which is below what we anticipated. Moreover, management reduced its ag and turf annual operating margin forecast to 12% from 12.5% due to anticipations of unfavorable product mix. Farmers are taking a wait-and-see approach to purchasing larger, higher-margin equipment as trade issues persist. Due to these concerns, we are reducing our operating margin estimate for the fiscal 2019 to 11.7% from 12.8% but maintain our midcycle operating margin of 12.2%.

Several additional factors impacted Deere’s earnings during the quarter. We view most of these as having no long-term effect on the firm. As with many of the companies in the industrials landscape, higher shipping costs hit Deere in the quarter as it resorted to using airfreight to mitigate supply chain bottlenecks. Increased steels costs also produced a drag during the quarter. Both costs are expected to last into the third quarter. Despite the temporary nature of these headwinds, we continue to be less optimistic than management on Deere’s midcycle margin prospects. Specifically, we view the 15% target as more reflective of peak earnings with product mix including the most advanced, highest margin equipment. Yet, over the next decade, the USDA is forecasting declines in the real prices of most agricultural commodities. We think these declines will ultimately impact farmers’ ability to invest in feature-rich equipment and remain profitable.