Deere Is A Sell

Because of central bank intervention there has been a misallocation of capital. When you have the ECB buying corporate debt, it causes a search for yield which is unprecedented. Stocks which have poor fundamentals are bought because they have a dividend larger than the 10-year bond yield.

Dividend stocks have seen their stocks rally even with declining earnings. This is a terrible way to invest since a dividend is not a guarantee. You still have to do analysis on the future cash flows to, at the minimum, see if the dividend can be paid in the future.

As you can see from the charts below, yields of investment grade bonds eligible to be purchased by the ECB have been declining. It is purchasing 50% of the volume of bonds. These actions show the Fed ending QE has been made up by the ECB expanding its balance sheet. When the European corporate bond market ceases to be a market, this has ramifications on every asset class.

This my reasoning for why Deere (NYSE:DE) is overvalued. The stock rallied to near its 52-week high after reporting double-digit declines in its major businesses on a year-over-year basis. It has sold off recently, but still doesn't reflect the direction of the company. Even if you have the opinion that Deere is overvalued because investors are overly optimistic and not because of central bank action, you can still recognize my perspective on the stock.

While any unwinding of central bank balance sheets would have negative ramifications for Deere, it wouldn't be enough for a thesis to sell the stock because then I would be mimicking investors who are buying Deere for its consistent dividend; I would not be doing any company-specific analysis. By the way, I don't see any scenario where central bank balance sheets unwind.

As I said, the quarter which was just reported did not suggest Deere should be at a 52-week high. Agriculture and Turf sales fell 11% and Construction and Forestry sales fell 24%. Both were an acceleration of the declines seen in the first 9 months of the year. If you are buying the stock, you have to be working on the assumption that the company will show improvement in 2017. I don't think that will occur.

Investors may believe in this narrative that Deere is in strong shape and will have a bounce back year in 2016 if they just looked at the firm's presentations. While this is, at face value, a poor idea because every company is bullish on its future prospects even if they are grim, there is no doubt some investors don't look further to find out what is really happening. As you can see from the chart below, Deere is leading investors to believe farmers are doing well. The chart shows the farm sector's debt to equity ratio and debt to asset level at reasonable levels.

 

The chart Deere shows ignores the leverage farmers have undertaken. As you can see below, farmers are the most levered they have been in 34 years. When farmers are too levered, they don't have the cash to buy new Deere equipment. In fact, real farm incomes have declined 34% from their peak in 2010 and 14% from last year. This chart would indicate Deere is about to see another disappointing year in 2017.

The farmer is not healthy as this decline in net income and over-leveraging has caused a decline in capex which is what affects Deere. Capex is down 34% from 2014. This decline has borne out in the numbers reported so far this year. The key will be to determine what happens next year. The record debt which can even be seen in the chart Deere has is one factor.

Another factor can be seen below. Farmer's return on invested capital is at 2% which is the lowest in at least 56 years. This low return is unsustainable. In order to change this farm land prices have to decline or commodity prices have to rebound. Until either of these changes occur, Deere's principal customers will have weak demand for its products.

Part of the weakness U.S. farmers have been seeing is caused by the weak Chinese demand. I am of the belief that the Chinese economy is in a secular decline brought about by too much debt and negative demographics trends.

The double-digit growth it has seen in the past, will not be mimicked. China's debt to GDP is 250% and its working age population has already peaked. As you can see from the chart below, it is estimated China's working age population will decline 23% by 2050. This is not evidence of an economy which can repeat its past growth rates and drive demand for US crops.

One other small point worth mentioning is Deere overestimates U.S. GDP growth for 2016. As you can see from the chart below, Deere is using IHS data to predict GDP growth for 2016 will be 1.9%. Given that the first half of the year growth has been slightly less than 1%, growth would have to be near 3% in the second half to reach that estimate. The current average estimate of economists is for 1.5% GDP growth in 2016, so the estimate Deere has needs to be revised down yet again.

Conclusion

Deere is overvalued because money is sloshing around searching for yield. Deere's stock offers a 2.86% dividend, so investors have purchased it without regards for the fundamentals of the company. The fundamentals are grim as its two major business units have seen accelerating declines in growth. The likelihood of the agriculture unit improving is slim because farmers are over-levered and have seen an extremely low return on invested capital.

Deere has tried to gloss over this weakness in its earnings slide, but it won't be able to do so when it reports more declines in 2017. In the long term, Chinese demand will not rebound to the pace it was at in its bubble days as its economy has too much debt and will soon have to deal with an overall decline in population.