Deere (NYSE: DE) quarterly results for the third quarter of 2022 have just been released and with that, everyone is rushing to the appropriate narrative to explain the recent movement in the share price. Bottom From full-year net earnings forecasts, to more lingering supply chain disruptions and external macroeconomic factors, there are many reasons why the company’s share price may not rise. not behaving well today.
But as the title suggests, none of that matters so much when investors fall in love with a gripping narrative and momentum trading hijacks a company’s valuation. For starters, today’s results are nothing short of spectacular.
But of course every sane analyst will point to the fact that the market is looking to the future and the stock price was already forecasting even stronger results and therein lies the problem that many market players don’t not fully understand. It’s not the actual trading performance that counts, it’s the assumptions about the future that the stock price already factors in.
Rosy expectations for Deere’s future
As we all know, the narrative around Deere has been on an exceptionally high note lately. The company was billed as the “Tesla of agriculture” and inexperienced investors suddenly flocked in, lured by videos of self-driving tractors. The company even ended up being included in the ARK Space Exploration & Innovation ETF (ARKX), an ETF that invests in companies that should be committed to the investment theme of space exploration and innovation.
Contrary to all of this, in March 2021, I first laid out my investment thesis on Deere and showed why the stock price faces low expected returns even as the company continues to deliver. At the time, the stock price was trading at $372, which is still above current levels.
Although there is a clear seasonality in Deere sales, the current results are significantly higher than those last reported when I was first writing about Deere.
At the same time, the full year guidance (i.e. expected future results) for fiscal year 2021 was as follows at the time of writing.
Now compare that to Deere’s current forecast for the current fiscal year.
These are significantly higher across the board, although the high end of the net income forecast has been trimmed slightly in the last quarter and net operating cash flow is also expected to be lower. However, this still represents a significant improvement over previously expected results (as of March 2021).
On top of that, since my first think piece, Wall Street analysts have grown even more bullish on Deere, providing another tailwind for its stock price.
Agricultural commodity prices also continued their upward trajectory and so were expected to provide a macroeconomic tailwind for Deere’s products that we hadn’t seen in many years.
Even the broader stock market has posted high single-digit returns since March 2021 and yet Deere’s share price has fallen.
All of this is a perfect example of how everything could go well for a company and, at the same time, the share price could continue to disappoint once investors push valuations to extreme levels, depending on their optimistic expectations for the future.
A Sober Look at Free Cash Flow
Following the third quarter results released today, Deere’s free cash flow per share is now roughly in line with the company’s historical results and, in hindsight, the 2020/2021 increase was in unsustainable effect.
It should be noted that the above calculation is made on the basis of the company’s total operating cash flow less purchases of property, plant and equipment. It excludes the cost of equipment from operating leases acquired, which varies significantly over the years and is linked to the company’s financing operations.
These huge swings in Deere’s free cash flow were due to movements in the company’s working capital (see chart below).
* based on accounts payable, inventory and trade, notes and financing receivables
By breaking this down into three main components, we could see that over the years receivables and payables generally move in opposite directions as management uses them to smooth out rapid changes in cash flow that are beyond the control of the company.
This dynamic changed dramatically during the pandemic, however, when Deere’s cash flow benefited from both lower accounts receivable (positive cash flow impact) and increased accounts payable (positive cash flow impact). cash flow).
Changes in inventory levels, however, have been by far the main factor contributing to the outflows in recent months.
Supply chain issues were largely to blame, with inventory levels hitting new all-time highs in the past quarter.
While these should be resolved over the next few years, future working capital earnings will be much lower as Deere would need to maintain a high level of working capital to maintain its sales momentum.
Moving on to capital expenditures, Deere continues to spend at record highs on property and equipment purchases, while non-rental equipment purchases remain high.
In fact, the amount spent on fixed assets in the past year is always less than the company’s depreciation expense, which is unsustainable, especially if one expects the current sales momentum is maintained.
Relative to sales, capital expenditures are also at historic lows, suggesting that Deere is underinvesting in its business or that management expects sales to decline over the next few years.
In terms of business reinvestment, the amount spent on research and development relative to sales is also at historically low levels (see below), which is at odds with the company’s strategy based on acceleration of innovation.
Deere is undoubtedly an absolute leader in the field of agricultural machinery, which is also consolidating its existing competitive advantages and strengthening its brand by adding value-added services to its portfolio.
However, all of this does not necessarily translate into superior returns for shareholders given Deere’s valuation which is based on very optimistic assumptions about the future. At the same time, the company faces an increasing number of risks related to the normal economic cycle and significant pressure on free cash flow.