Running Like A Deere

When crop prices are high, there is a go-to line-up of stocks for theme investors to play. Fertilizer names like Potash (NYSE:POT) and Mosiac (NYSE:MOS) usually catch a bid, as do seed companies like Syngenta (NYSE:SYT). And then there are the machinery companies - stocks like AGCO (Nasdaq:AGCO), CNH Global (NYSE:CNH) and the biggest of them all, Deere (NYSE:DE). Whether the logic always works out as expected (high crop prices produce more cash for farmers who can buy new equipment) or not, these have been bullish times for crops and bullish times for Deere's stock.

The Quarter That WasWhether the byproduct of high crop prices, better credit access, more optimism among farmers, or some combination, Deere delivered another strong quarter. Revenue rose 30% this period to over $5.5 billion, with agriculture (and turf) up 21% and construction (and forestry) up 81% from a low base. Although that was a solid jump in sales, it was nevertheless below the average analyst estimate of $5.67 billion.

Like most heavy machinery manufacturers, Deere's business is more profitable when the factories have solid throughput. To that end, higher revenue helped enable improved gross margin (up about 150 basis points from last year). Deere's management also deserves praise for holding the line on operating expenses, as operating income more than doubled and the operating margin expanded by more the four points. As a result, though Deere came up short on revenue the company handily surpassed the average EPS estimate. (For more, see 4 Things to Know About Earnings Season.)

The Look AheadThese are good times to be a farmer in the western hemisphere. Floods have damaged crops in Australia and Africa, while droughts have severely damaged yields in Russia and Ukraine this year. That has all contributed to much-publicized jumps in food prices and unrest in many parts of the world. Couple that with improved credit conditions in North America and Brazil's ongoing willingness to subsidize loans for its farmers, and the demand picture over here is rather healthy.

At some point, though, it is worth wondering if Deere is going to see a squeeze from cost inputs. Companies like AK Steel (NYSE:AKS) and Nucor (NYSE:NUE) have pushed through steel price increases and they seem to be sticking. What's more, component companies like Eaton (NYSE:ETN) and Titan (NYSE:TWI) are looking to pass on their own cost/price increases as well. So with Deere having increased its production tonnage by 41% this last quarter, how long will it be before costs squeeze margins? (For more, see Prepare Your Portfolio For Higher Food Prices.)

The Bottom LineWhen a theme trade is running, it is almost pointless to talk at much length about valuation and fair prices for stocks. Deere is the biggest and quite possibly the best-run agricultural machinery company out there, so it seems pretty clear that the stock is going to attract buyers when investors want ag exposure. AGCO, CNH and Kubota (NYSE:KUB) all look cheaper than Deere, but there is no particular reason to think there will be a big catch-up trade on the basis of valuation.

If investors have a particular notion that European demand will pick up (relatively better news for CNH) or that Asian demand will be strong (good for Kubota), that could be a valid reason to trade away from Deere. Failing that, so long as the ag trade remains popular, it's likely that Deere's stock will stay popular. (For more, see Deere Keeps Plowing.)