With the latest round of tariffs on U.S. imports of Chinese goods, and the consequential retaliation from China, one industry seems to be getting the brunt of the problems… agriculture.
It’s true that U.S. farmers have had an extremely tough go of things. China has now declared it will not import any crops from the U.S. On top of that, a rough patch of weather at the start of the year left many fields empty or lost due to flooding.
Things have gotten so bad, these farmers are now being bailed out by a special subsidiary from the Trump Administration.
So, you would think that for a company like Deere & Co. (NYSE:DE), it couldn’t get much worse. Farmers are producing less product, making less money and just trying to weather through this downturn. They certainly aren’t buying new equipment.
To a degree, that’s been the case. Deere dealers are reporting first-half 2019 sales dips of between 15% to as high as 50%. But that’s not the whole story.
You see, Deere is also in the business of servicing equipment, selling replacement parts and manufacturing a whole host of non-agricultural products.
Still, you could say that the company – and its competitors – have had their share of worries from this whole farm trade situation. They’ve all experience some declines in revenue and earnings.
Argo, maker of Massey Ferguson, Challenger and Fendt, saw sales dip 4.5% during the second quarter. CNH Industrial, maker of Case, Steyr and New Holland brands, reported a 5.9% sales dip during the most recent quarter.
True, both of those companies are more European-centric and dealt more with recent heat waves over there. But each has felt specific declines in their U.S. businesses.
Deere, however, is much larger. It certainly does have international sales. But it is by far the biggest U.S. player. And it reports at the end of this week.
Now, you might think this presents a great opportunity to short Deere or buy put options on the company. After all, it is doomed to report flat-at-best and more likely decreased earnings.
In truth, analysts expect a little growth. But even if they’re wrong, and the company does slip, there’s something different about Deere… two things actually.
First, consider its product mix. Agriculture is no doubt a huge part of its business. But earlier I mentioned its other groups.
Parts and servicing of equipment is important. While farmers might not break out the checkbook right now to pick up brand-new equipment, they still need to service their older ones.
The company also has a financing business to help farmers pay for upgrades and maintenance. And while it seems unlikely, this group has a remarkable record in terms of write downs. The company’s finance wing is quite successful.
And finally, non-agricultural products. Here, there’s a real chance for the company to break out.
You see, gold is at six-year highs right now, with a price tag of over $1,500 per ounce. Silver too is rocketing higher. The mining companies that live and die by those prices have been sitting on their hands for years. Now, with better prices, they have to go out and buy equipment to take advantage.
Deere has an enormous business in dozers, crushers and screeners. This could be a real surprise when the company announces its most recent quarter on Friday… and its forecast for the second half of 2019.
Of course, relying on these other businesses isn’t enough to place any long bets on the company. After all, those dealers have noted just how bad sales for its main ag business have been.
So, we take a look at one final piece to this strange puzzle. Earnings history. After all, nothing moves a stock quite like earnings surprises. If a company beats estimates, its stock typically does very well shortly after announcing. Likewise, missing expectations can truly drown a stock in red. But again, Deere is different.
The company has missed analysts’ targets each quarter over the last year. Shares should tank, right? The opposite, however, seems to be the case:
Each announcement, which proved worse than analysts expected, somehow sent shares up, rather than down. And not just a little bit…
As you can see, we’re talking about short-term gains of 11.3%, 8.4%, 6.3% and 25.9% following these misses.
The real answer comes from outlook and these alternative businesses. But investors still seem to forget leading up to each announcement. Lately, shares have shed that monstrous 25.9% gain following its last quarter’s numbers. Now, they are prepared to repeat this performance again.
And, if the company somehow does grow despite the negativity in the sector, that could send shares even higher… at least in the short term.
We have an opportunity to play this strange phenomenon. And fortunately, there’s a far better strategy at our disposal than simply buying shares of this ag equipment giant.
A Strategy For a Post Earnings Rally
A bull call spread is a type of options trade that involves buying a near-the-money call option and selling a second one with a higher strike price.
The income from that second call helps offset the cost of the first, which for DE is incredibly important. Right now, with such a volatile trading chart, option traders have to pay a premium for new positions. But with a reduced cost for this particular type of trade, that offset makes it far easier to enter one.
That does mean that potential profits are capped. While you could go out and simply buy a call and hope for another 25.9% stock rally, that’s an expensive bet. Instead, using a bull call spread offers a far better risk-reward setup.
You can see how this kind of strategy plays out:
Source: The Options Industry Council
Now, with earnings so close to August options expiration, we do have to increase our time horizon a bit. Adding just a month makes the trade a hair more expensive. But it gives this post-earnings rally time to play out.
Let’s look at a specific example of a bull call spread trade on DE to see exactly how the numbers break down.
A Specific Trade on DE
Right now, a trader could buy a September 20 $155 DE call for $6.35 per share and sell a September 20 $160 call for $4.11 per share for a cost of $2.24. Since each represent 100 shares of DE, that’s a net debit of $224.
Now, that’s the most the trader could lose on this trade. If the company reverses course and falls following Friday’s crucial earnings, that’d be the total loss.
However, if the company’s alternative businesses and post-earnings performance plays out again, the trader stands to make even more than that.
To find his maximum profit potential with this bull call spread, take the difference in strike prices ($160 – $155 = $5), and subtract that cost ($5 – $2.24 = $2.76). On 100 shares, that’s a potential return of $276.
In other words, the trader would be looking at a 123% return on his risk. Shares would have to jump to $160 to collect that full payoff. But that only represents a move of 3.2% over the next six weeks.
Considering it has moved between 6.3% and 25.9% following each of the last several post-earnings periods, that’s nothing.
In short, Deere is not what you might expect. It might just be the most contrarian play in the market right now. But it has a tremendous history of paying off for contrarian investors. And this specific trade offers a great way to be one.