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3 Reasons Why Deere & Company Stock Can Rise

Lee Samaha, The Motley Fool

Deere & Company (NYSE: DE) stock is up more than 80% in the last three years, but investors shouldn't start thinking about selling just yet. The company's first-quarter results were a positive, and earnings at companies like Caterpillar Inc. (NYSE: CAT) had some encouraging signs for its non-agricultural segments. Deere shares have room to run -- here are three reasons why.

two hands parting wheat in a field

Image source: Getty Images.

Key markets are turning

Deere generated nearly 70% of its operating profit from its agriculture and turf segment. Around 60% of the segment's equipment sales come from North America -- in turn half of equipment sales go to the large agricultural machinery market.

Unfortunately, Deere's North American agricultural machinery sales have been in decline since 2013; sales of large agricultural machinery, in particular, have slumped. The impact on Deere's operating results can be seen below. 

Deere Equipment Sales by Segment

2017 Revenue

2013 Revenue

2017 Operating Profit

2013 Operating Profit

Agriculture and turf

$20.17 billion

$29.13 billion

$2.48 billion

$4.68 billion

Construction and forestry

$5.72 billion

$5.87 billion

$340 million

$38 million

Total

$25.89 billion

$34 billion

$2.82 billion

$5.06 billion

Data source: Deere & Company presentations.  

However, the good news is that North American demand is growing again, in particular, large agricultural machinery demand. In fact, management raised its forecast for full-year sales growth as "the industry is experiencing stronger replacement demand for large equipment," according to Brent Norwood, manager of investor communications.

Segment

Full Year 2018 Growth Forecast

Previous Growth Forecast

Agriculture & Turf U.S. and Canada ag retail sales

10%

5%-10%

Agriculture & Turf segment net sales 

15%

9%

Data source: Deere & Company presentations. 

It's a good sign that Deere's core marketplace, and its most important equipment market, is growing again.

Guidance looks conservative

Deere raised its guidance across the board -- but there's reason to believe that it's too conservative. First, here's a look at the formal guidance given during the earnings presentation:

Full Year 2018 Guidance

Forecast

Previous Forecast

Agriculture and turf total net sales

15%

9%

Construction and forestry net sales

80%*

69%

Total company net sales

29%

22%

Net income

$2.85 billion**

$2.6 billion

Net operating cash flow

$4.4 billion

$3.8 billion

Data source: Deere & Company presentations. *Includes 54 points due to the Wirtgen acquisition. **Excludes impact of U.S. tax reform; on an as-reported basis net income is forecast to be $2.1 billion

It's worth taking the time to understand what happened to net income guidance and why it makes Deere's forecast look conservative.

During the first quarter, Deere had charges of $965 million in relation to recent tax reform, but thanks to a more favorable tax rate through the year, management expects the full-year impact to be just $750 million. Of course, if you add the $750 million to the $2.1 billion as-reported figure for net income, you will get the $2.85 billion figure quoted in the table above.

However, management said the $2.85 billion net income guidance was assuming a 29.5% full-year tax rate -- but this rate doesn't reflect the impact of the tax law changes. Here's the tricky part: Deere's effective tax rate for the rest of the year and the following years is expected to be in the 25%-27% range. If we assume a 25%-27% tax range for 2018, then Deere's net income would be in the $2.95 billion-$3.03 billion range.

There's room for upside in equipment sales

There's reason to be optimistic about both segments.

Regarding agricultural equipment, Norwood said customers were expressing "their equipment demand in terms of need versus want." This means farmers are buying Deere's equipment out of necessity, rather than because of any upturn in the market.

In fact, many of the factors usually associated with an improving end market for Deere aren't actually in place as yet. For example, management expects total U.S. farm cash receipts to fall 1% to $372 billion in 2018, and global stocks-to-use ratios for wheat, soybeans, and cotton remain at elevated levels -- a bearish sign for prices.

In a nutshell, this means that Deere still has upside potential for machinery sales should inclement weather -- and the climate is very hard to predict over the course of a year -- reduce crop output and prices are driven higher. As a rule, farmers tend to buy more machinery when crop prices and income rise.

In the construction segment, the latest retail sales data from Caterpillar and Deere is bullish for 2018. For example, Caterpillar's global construction equipment retail sales were up 27% on a three-month rolling basis in February, with North American sales up 25%. Similarly, Deere's construction and forestry equipment retail sales were up double-digits in February -- the fifth consecutive month of double-digit increases.

Is Deere a stock to buy?

Deere's guidance is arguably conservative as its end markets are doing well enough, despite ongoing difficulties with low crop prices. The replacement cycle for large agricultural equipment looks set to drive agricultural machinery sales, and any increase in crop prices would potentially provide an additional boost. Throw in some booming construction markets and the company is well-placed to have a strong year in 2018.

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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.