John Deere (NYSE:DE) on Wednesday morning released its 2014 first-quarter earnings report. The company reported record profits of $681 million versus $650 million a year ago. The increased profit along with the company’s large stock buyback program resulted in a 10 percent increase in earnings per share from $1.65 to $1.81.
But despite this record earnings figure, investors sold off shares of John Deere. In fact, John Deere shares have been relatively weak more generally as of late. In the last year, the S&P 500 is up nearly 20 percent, whereas Deere shares are down more than 7 percent. This is despite the fact that John Deere shares trade at just nine times earnings versus the S&P, which trades at nearly 22 times earnings. (Data taken from the iShares S&P 500 ETF (NYSEARCA:IVV) webpage.) What is more anomalous is the fact that industrial stocks have traded 25 percent higher over the past year — outpacing the S&P 500 — based on the performance of the SPDR Select Sector Spider Industrials ETF (NYSEARCA:XLI).
Why is John Deere so weak?
A primary reason for this weakness is the fact that John Deere makes agricultural equipment, and agricultural commodities have performed poorly over the past couple of years. As agricultural commodity prices fall, farmers have less money with which to buy tractors and other farm equipment made by John Deere and its competitors. This has led the company to provide a weak outlook for 2014 sales in the company’s agricultural segment — in the press release referenced above, management predicts that the company’s sales will fall by 6 percent in 2014.
Nevertheless I think that the weakness in agricultural commodities and by extension the weakness in Deere’s agriculture segment is temporary. As the world’s population grows, demand for agricultural commodities will grow, as well. At the same time, arable land is finite. Therefore companies such as John Deere, which make products that increase the efficiency of farmland, should perform incredibly well. Furthermore, John Deere is in a unique position to benefit from this trend given its strong brand recognition and its reputation for creating quality tractors and related agricultural machinery.
Thus the weakness in the company’s share price on Wednesday along with the longer-term weakness that we have seen over the past year is, more likely than not, creating a buying opportunity for longer-term investors. The investment case appears more compelling as we consider that John Deere pays a 2.3 percent dividend versus a 1.9 percent dividend for the S&P 500. Furthermore, John Deere returns far more capital to shareholders through share repurchases — since 2010, the company has reduced the number of shares outstanding from more than 420 million to about 375 million.
Before investing, investors should note a couple of things about John Deere. First, while its guidance for its agriculture segment is relatively weak, its guidance for its construction machinery segment is not weak. Therefore it has a higher hurdle to overcome in order to meet these expectations. Construction is more sensitive to the economy than agriculture because people can forego fixing roads and building new buildings in a weak economic environment. Investors who are expecting economic weakness in the coming quarters may want to hold off on purchasing Deere shares despite how inexpensive they are relative to the broader stock market.
Second, John Deere gets about a quarter of its profits from its financial division. The company lends its customers money to buy machinery from it. So unlike most other agriculture companies, John Deere is sensitive to the credit markets, and if there is a credit crunch, John Deere is vulnerable and may see losses.
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