Earnings Drought May Stunt Deere and Agro's Growth

Agriculture is one of the most prominent long-term themes according to my investing standpoint; we've been involved in some shape or form since day one of the fund/blog. While I like to use fine instruments (individual equities) rather than broad [ETFs] in most cases, for readers who wanted an easy "one stop shop" way to play the theme, we outlined Market Vectors Agribusiness (MOO) [Sep 7, 2007: This MOO for You? An ETF to Play the Global Agriculture Boom] Within this ETF, you get fertilizer, equipment, seeds, irrigation - the whole crew

One of the themes the fund is currently investing in is the secular agricultural boom as people in developing economies upgrade their food quality, as their incomes grow. Thus far, I have been focused mostly on the fertilizer companies, although the equipment and seed plays have also done great.

I saw the greatest disconnect between what analysts thought would happen versus what I thought would happen in fertilizer [Oct 23, 2007: Analysts Still Doubting the Fertilizer Stocks - I'm Adding Potash Ahead of Earnings] , but I also made some equipment plays in both Agco (AG) and CNH Global (CNH). However (and this seems like a lifetime away but it's only 3 quarters ago!) by spring 2008, I became very nervous about the parabolic rise in steel and how it would hurt input costs [Apr 24, 2008: Three Agricultural Stock Earnings Reports this AM]

I sold my agriculture equipment makers to focus on fertilizer back in January 2008 [Jan 23: Closing Last of CNH Global]. Just easier to play the same trend in a more focused manner with the fertilizer. Input costs are rising for the equipment makers with costs of their raw goods rising

[May 14, 2008: Deere Earnings - Why I'm Avoiding Equipment Stocks]

Major ag equipment player Deere (DE) - I don't own the equipment stocks anymore; at some point the rising cost of steel, petrol products and the like will be hurting the bottom line unless they can pass all the costs along to farmers. Over the next year, if inflation does not abate, this is the type of company who could see profit margins squeezed simply from the constant increase in input costs.

[May 17, 2008: WSJ - Fast Rising Steel Prices Set Back Big Projects]

Relentless increases in the price of steel are halting or slowing major construction projects world-wide and investments in shipbuilding and oil-and-gas exploration, setting the stage for a potential backlash against steelmakers.

This strategy allowed us to benefit from the "ag trade" for about 90 days longer than the average bear, as fertilizer and equipment stocks began to diverge in a sharp way February 2008 through the summer. And then the bottom fell out on the whole trade - we got hit on the tail end.

With Agco reporting last week, and Deere on tap this week - I thought it would be a good time to update where things stand from a fundamental basis.

Agco

• Farm equipment manufacturer Agco Corp. said Monday that strong retail sales and improved margins helped push fourth quarter profit up nearly 26 percent, beating Wall Street expectations even as sales slipped.
• But the company said it expects sharp declines in both earnings and sales in 2009 as a result of "significant uncertainty and softening demand in all major farm equipment markets." It said it expected industry sales to fall 5 percent in North America, 5 to 10 percent in Western Europe and 20 to 30 percent in South America and it warned that results for the current quarter would be "significantly lower" than those reported during the comparable quarter last year.
• ....expected tight credit conditions to weigh on several key markets in 2009, including Eastern Europe, Russia and South America

A solid story via Reuters on Deere

• But as the headwinds facing the farm sector intensify, analysts are beginning to warn the leaping deer may be headed for a hard landing. Last Monday, JP Morgan analyst Ann Duignan lowered her estimates for Deere's full-year 2009 earnings. Among her biggest worries: the "rapid deterioration" in South American demand reported by Agco in its quarterly results as well as a growing sense among farmers in North America that they should wait for the economic dust to settle before making any big capital purchases.
• When the U.S. Department of Agriculture's Economic Research Service released its initial outlook for 2009 farm sector income two days later, Duignan, long a leading bull on the sector, jumped off the fence. With the agency estimating a 20 percent year-over-year decline in net farm income, Duignan declared "2008 ag machinery sales were likely a peak."
• As part of a report issued last week, the USDA said that in addition to falling farm incomes in 2009, crop receipts are also expected to decline. Given the high correlation between receipts and equipment purchase, Robert McCarthy, an analyst at Robert W. Baird & Co, called the forecast "another negative indicator for machinery demand and manufacturers' production schedules."
• The decline in U.S. farm incomes -- the first in a decade -- is not the only problem on the ag front for the Moline, Illinois-based Deere. The ethanol industry that sent grain prices soaring last year is looking wobbly, a victim of overcapacity, weak demand and poor margins. [NYT: Ethanol - Recently a Savior, is Now Struggling]
• The trouble is no one is expecting that market to rebound in 2009. Last week, Terex warned [Feb 12: Terex Warns of Losses, Job Cuts, and Covenants] as it released disappointing fourth-quarter earnings that the deterioration in that market was in fact accelerating and that it was getting slammed by order cancellations and delays in acceptance of deliveries. (well no one, other than pundits who can see "the recovery in 6 months")

All this doom and gloom and we are just 4.5 months away from the beginning of the "2nd half 2009" recovery I've been hearing for 3-4 months now. July 1, 2009 - good times ... soon enough! (for newer readers I was mocking the exact same players a year ago who were telling me about '2nd half 2008' recoveries - just change the year, and repeat the Kool Aid; one day you are going to nail this call!)

Disclosure: No positions

Comments

[ETFDesk dot...:]

Mark, good article and use of piecing together various sources. I would tend to think to Ag co's don't really take off until oil starts to firm- I would expect there has to be strong correlation with corn prices due to ethanol / oil- and therefore corn prices probably has a large trickle down effect on other Ag products. While my commodities knowledge leaves much to be desired, I would also assume names like PXJ etfdesk.com/fundDetail... and PKB etfdesk.com/fundDetail... to also run with MOO when the time comes.
Lastly, good call with the "Kool Aid" comment

Feb 17 11:52 AM

[TraderMark:]

With the credit issues, and high prices of fertilizer it seems we have a lot of potential issues shaping up in terms of crops for summer/fall 2009. We'll see how it shapes up - but lack of investment in food is the last thing we need. So far corn, wheat and the like have not made a move up so keep an eye on those.

Feb 17 06:15 PM