Deere Gets Caught in the Headlights

When does one of Wall Street's most coveted business attributes -- visibility -- become a liability? For Deere (DE - commentary - Cramer's Take), the answer is right now in a highly inflationary environment.

The company missed the quarter during one of the great agriculture booms of our generation, stunning the Street and sending the stock down 8% this morning. EPS of $1.75 missed by a penny, and sales of $7.47 billion came up short of the $7.61 billion consensus.

These numbers do reflect a strong quarter:

• Sales are up 19%, driven by a 30% production increase in ag equipment.
• Management raised growth guidance for the balance of the year, noting equipment sales should grow 20% this year on production growth of 17% vs. previous expectations of 17% equipment sales growth on 15% production growth.

But profit guidance is unchanged.

Deere management is being surprised (and is surprising investors) by soaring material costs. This encompasses all aspects of production (steel prices, fuel for transportation, etc.). For a company whose business is booming due to commodity inflation, it is sweet irony to be nipped by it as well. Management is struggling to grasp the expected cost increases and is offering a wide range of an increase of $400 million to $500 million of incremental costs this year, most coming in the third quarter. This guidance is double its previous expectation for cost increases.

Here is the crux of Deere's problem: backlog. Normally, Wall Street loves the visibility provided by a large backlog, but, in this case, Deere is not able to raise prices to offset material price increases, resulting in pinched margins. The company is only seeing 2% "price realizations," far below the inflation rate on the production side. The good news is that this situation will reverse in 2009, as orders being taken now for next year are being priced higher. Management is not yet offering 2009 guidance, but analysts should figure that margins could soar in 2009.

Before investors get overly enthusiastic, though, they should also figure in the risk from currency movement. Deere is a huge beneficiary of the weak dollar, which contributed nearly one-third of the growth in equipment sales, and is expected to contribute 4 points to the growth rate next quarter. Beware a falling dollar, which would hurt the company's foreign exchange translations, but also its end markets, which are booming due to commodity price inflation.

---

At the time of publication, Dvorchak was long Deere, although positions can change at any time.

Gary Dvorchak is a managing partner of Aviance Capital Management, a Sarasota, Fla.-based institutional asset manager that manages $200 million in growth and value equities and fixed income. Dvorchak holds a master's degree in business administration from Northwestern University and a bachelor's degree in computer science from the University of Iowa.