This

Deere

(DE) - Get Report

is bucking trends -- but for how long?

The tractor maker reported strong fiscal fourth-quarter earnings that sailed past the company's recently increased guidance for the period ended Oct. 31. But signs are that Deere may have driven U.S. sales by lending money to dealers to buy Deere's products. If so, such a strategy would be hard to sustain, setting the company up for an earnings shortfall in 2003.

Investors appear to have no such worries, however, as Deere's highflying, high-multiple stock moved up $1.75, or 3.6%, to $49.81 Tuesday.

Digging

In its fiscal fourth quarter, Moline, Ill.-based Deere made 28 cents a share, reversing a $1.36 loss in the same period of 2001, when it took substantial charges. In early November, the company told investors to expect earnings of 26 cents for the fourth period, which was way up on its original guidance of a break-even quarter. Detox

examined why the company may have been able to boost its forecast so drastically.

A Deere press release Tuesday attributed the robust profits performance to "broad-based improvements" like higher sales and tight cost control. A Deere representative didn't return a call seeking more detailed comment.

While lower expenses may have had a role, the increase in sales deserves closer scrutiny. The mystery about Deere is how it managed to increase U.S. sales at a time when industrywide surveys show a drop in sales of farm equipment due to prolonged softness in the farm sector. Deere is by far the dominant manufacturer of farm equipment in the U.S.

Deere doesn't precisely break out its U.S. sales of agricultural equipment, but subtracting overseas sales of all types of equipment from the agricultural equipment total gives a conservative approximation. That calculation produces estimated U.S. agricultural sales of $876 million in the fourth quarter, up 8.6% from the year-ago period. Compare that with an industrywide drop of 4.7%, according to numbers from the Association of Equipment Manufacturers.

What is Deere doing to be able to ride out the slump? The company's press release attributes the overall higher sales to a "favorable customer response to new products," but didn't specify whether that occurred in the U.S. On the Tuesday conference call, a company executive mentioned Deere's ability to realize strong prices on its products, but wasn't overly willing to attribute it to market-share gains when asked if that were the case.

This sort of vagueness could mean the U.S. gains are due to a phenomenon called channel stuffing, which refers to a manufacturer pushing an unsustainably large amount of product to dealers to boost sales. Deere's dealers may be willing to take on more than they need if some of their purchases are financed by loans from Deere's lending arm, John Deere Capital Corp. And if that is the case, channel stuffing could explain the mismatch between industrywide retail sales, which measure sales to end users, and Deere's sales, which are primarily to dealers.

Rolling Backlogs

Thankfully, the AEM also supplies numbers for dealer inventories -- and they do show a recent rise in the high-margin machines that Deere makes a good chunk of its profits on, like 100-plus horsepower tractors, four-wheel machines and combines. For example, the number of 100-plus horsepower machines held in dealer inventories rose 8% in September, the most recent month available, from August -- compared with a 4% sequential monthly rise in September 2001. Four-wheel drive machines were up 16% from August after being flat a year earlier. And the drop in combines this September was much less pronounced this year than last.

Moreover, Deere's loan portfolio shows it is lending more to dealers. In its third fiscal quarter of 2001, John Deere Capital had $723 million of dealer loans, and had added a net $145 million by the end of July this year, excluding $2.2 billion of receivables it bought from the Deere parent. Over the same period, retail loans declined. (Deere hasn't yet specified dealer and retail loan totals for its fourth quarter.)

Deere may be pricing its dealer loans at attractive rates, but at some point the dealers, if they are taking on too much inventory, will get sated and cut their borrowing. This would hurt margins both at Deere's manufacturing arm and at John Deere Capital.

There are other reasons to be wary of Deere. It has taken big charges recently, which could explain some of the cost improvements. And its earnings guidance for 2003 looks shaky. The company has affirmed its guidance for fiscal 2003 of $500 million to $600 million, which works out at a range of $2.05 to $2.50 per share. However, Deere could expect a tough fiscal first quarter because it's predicting break-even to $50 million in earnings. By contrast, Wall Street analysts expect $47 million. If the quarter comes in closer to zero, the yearly guidance could end up tilting toward the low end.

Deere stock is not cheap at around 22 times the midpoint in the company's 2003 earnings range. It's no leap to say this stock looks vulnerable even after Tuesday's numbers.