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3 Reasons Deere Is Set for a Good Year

Lee Samaha, The Motley Fool

Shares in Deere & Company (NYSE: DE) have gone up nearly 60% in the last 12 months, but there could be more to come. After a difficult few years operationally, the company looks set for a strong 2018. I think there are three key reasons to like Deere this year. Let's look at why this could be the case.

Two farmers in a wheat field

Image source: Getty Images.

Deere's core market is turning

Management is guiding toward 9% net sales growth in its key agriculture and turf segment in its fiscal 2018, a figure merely matching that achieved in 2017. But don't worry, that's only a part of the story. The reality is that last year's sales growth was bolstered by a 20% bounce in South America agriculture machinery sales, while U.S. and Canada agriculture machinery actually declined -- a concern because it's Deere's core market.

However, Deere is forecasting 5% to 10% growth in net sales in U.S. and Canada -- a reversal of a declining trend. Moreover, it's most troubled areas, large agricultural equipment, is set for a bounce.

To put this into context, Deere generates nearly 60% of its equipment sales from the U.S. and Canada and around half of its overall agriculture and turf sales from large equipment sales. Unfortunately, sales of large agricultural equipment declined by 60% from 2013-2016, and the impact on Deere's overall sales and profit can be seen below.

DE Revenue (TTM) Chart

DE Revenue (TTM) data by YCharts.

Speaking on the last earnings call in November, Manager of Investor Communications Josh Jepsen said, "Despite current commodities prices the industry is experiencing stronger replacement demand for large equipment," and CFO Raj Kalathr went on to argue, "Even in 2018, with the sales on the upswing, we see the US market for things like large tractors, for example remaining over 25% below what we consider to be a mid-cycle level." In other words, the upside potential is significant.

Risk dissipating

Deere's forecast for a 22% increase in net sales in 2018 (excluding the Wirtgen acquisition it comes to around 10%) comes as the company appears to be over the worst in terms of potential risk from the amount of equipment it has on operating leases. It's an issue that has worried investors

Simply put, Deere has significantly increased the equipment it has on short-term leases (notably one-year) in the past few years as farmers have been reluctant to buy equipment outright. This creates a situation whereby a glut of used equipment could hit the market after the leases expire, and if this occurs in a period of weak sales, then the downward pressure on prices of Deere's new equipment could be significant.

Fortunately, as you can see below, peak growth in operating leases occurred in the first quarter of 2016, and Deere has dealt well with the issue. Going into 2018, equipment sales are set for growth, and operating leases, although still growing, are increasing at a slowing rate.

year on year growth of operating leases and sales

Data source: Deere & Company presentations.

Data source: Deere & Company presentations.

In fact, Deere's execution during the downturn has been excellent on the whole

Wirtgen looks like a good deal

Shares in Caterpillar Inc. (NYSE: CAT) have surged partly on the back of an improving outlook for infrastructural spending. Caterpillar's often seen as one of the best ways to play the theme, but Deere's intended acquisition of Wirtgen -- expected to close by the first quarter of 2018 -- will significantly increase Deere's exposure.

Based on Deere management's figures, the contribution of the construction and forestry segment's sales to overall equipment sales in 2016 would have been 30% with Wirtgen included, compared to 21% as reported. Moreover, Wirtgen is the global leader in road construction equipment (around 26% of Caterpillar's construction sales), so if you're buying Caterpillar as a play on growth in infrastructural spending, then Deere also deserves a close look.

Deere in 2018

While it's true that the company ultimately needs to see a return to growth in U.S. farm incomes (usually caused by higher crop prices) in order embark on multiyear sales growth, the immediate outlook for large agricultural machinery sales looks good -- farmers can't avoid buying equipment forever.

In addition, the company has managed the downturn well in terms of productivity improvements, inventory management, and equipment on operating leases, and the Wirtgen acquisition comes at the right time for believers in the infrastructural boom investment thesis. Deere looks set for a good year.

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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.