Every day, Wall Street analysts improve certain stocks, degrade others and “initiate a hedge” on a few others. But do these analysts even know what they are talking about? Today we take a high profile choice from Wall Street and put it under the microscope …
2019 has been a confusing year for investors in the U.S. agriculture industry (but aren’t they all?).
Until April 2019, the United States had its Wettest 12 Months in U.S. History, according to data from the National Oceanic and Atmospheric Administration – bad news for farmers. It was also bad news for companies like caterpillar (NYSE: CAT) and Deere (NYSE: DE), two of most famous names sell heavy equipment to farmers.
But last month the news took a positive turn – or at least negative to say the least. A late-summer heat wave helped reclaim the soggy cornfields of the United States. And forecasts from the US Department of Agriculture in August showed that corn production fell only about 4% from 2018 levels. Soybean production is still expected to be in. significant drop – up to 19% year over year – but the news from the cornfields must have been a relief.
Over the past month, Caterpillar shares have risen 14% and Deere shares have risen 12% almost as impressive – and are now surpassing S&P 500 by a good eight percentage points over the past year as well!
So why are the Wells Fargo bankers downgrading the shares of both caterpillar and Deere today?
Cat and Deere downgrading
The answer, in a nutshell, is construction.
Wells Fargo Cites “A Relatively Dull Q3 19 Construction Dealer Channel verification results’ as the primary reason Caterpillar and Deere shares are downgraded today. As the analyst explains, “The demand for construction equipment in the United States is at or near its peak and will likely decline in 2020 due to the flattening of activity and a shift to equipment rental from purchase. So even if the companies’ respective agricultural equipment businesses hold up reasonably well, this will put “downward pressure on earning capacity”.
It should be noted that Wells Fargo’s forecast contrasts with the forecasts of others. As recently as July, for example, the American Institute of Architects predicted that non-residential construction activity in the United States in 2020 would be slower than in 2019, but would still increase by 2%.
Caterpillar decommissioning, in particular
That being said, Wells Fargo has other reasons to doubt the attractiveness of Caterpillar and Deere stocks, in addition to a general sense of apprehension regarding the construction industry. On the Cat share, for example, the analyst said StreetInsider.com Today, the company’s energy and transportation division sales will decline “modestly” in 2020, offsetting growth in “average” sales figures for the resource industries.
More importantly, Wells Fargo is concerned that a weak sales environment for construction equipment could complicate Cat’s efforts to reduce “global distributor inventory by $ 900 million” as of this year. Weak demand will further reduce backlog levels. As Cat strives to unload unwanted equipment, this could put downward pressure on prices and hurt profits.
Deere downgrading, in particular
Like investors in general, Wells Fargo appears to prefer Deere stocks over Caterpillar. (Indeed, over the past 12 months, Deere stock has outperformed the S&P 500, while Cat stock has underperformed.)
Oddly enough, given the tough year the agriculture industry has gone through, the reason Wells Fargo prefers Deere over Cat seems to be Deere’s focus on selling farm equipment (which accounts for 62% of annual sales of Deere, according to data from S&P Global Market Intelligence). “We still like the cyclical positioning of large North American agricultural equipment [and] potential of precision farms, ”writes the analyst.
That being said, while this year’s harvest may not be as miserable as it initially looked, Wells Fargo warns that “visible catalysts are in place to increase demand for agricultural equipment in North America in [fiscal year] 2020 “are lacking. This would appear to call into question Deere’s ability to grow profits at the 10% annual rate most analysts expect to see over the next several years.
Promote Caterpillar and Deere
Looking at the two side by side: I see Caterpillar shares trading for just 11.7 times today’s earnings with a projected growth rate of 13% over the next five years. This looks more appealing than Deere trading at 15.3 times earnings with a 10% five-year growth rate – a rate that could be jeopardized if the agriculture industry takes a turn for the worse. While the higher expected growth rate gives Caterpillar a higher bar to cross, there’s likely a reason analysts believe Caterpillar will grow faster – it still has a lower PEG ratio than Deere.
I also prefer Caterpillar’s richer dividend yield (3.2% vs. 1.8% for Deere) and higher free cash flow ($ 4.6 billion generated in the past 12 months, vs. negative free flow at Deere). If the construction slowdown turned out to be less serious than Wells Fargo fears, or if the agricultural slump worsened, I would expect Caterpillar shares to outperform Deere.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.