By Adam Fleck
Although AG machinery manufacturers may reap weaker 2014 results, we think Deere's (DE) narrow moat is intact.
The 2013 U.S. grain-growing season has to date proved to be a polar opposite of the drought-riddled harvest of 2012. Although several weeks remain before farmers are able to see the final fruits of their labor, estimate from the U.S. Department of Agriculture currently put this year's corn production volume among the highest in history. Similarly, soybean yields and tonnage should improve from last year. Concerns about an early frost, prevented plantings because of earlier wet weather conditions, and the recent Midwestern heat wave could weigh on ultimate production levels. Nonetheless, we expect much better U.S. volume and rebounding South American tonnage to continue to damp global prices in the medium term.
While we remain concerned about the resulting farm equipment sales environment, we don't believe the potential headwinds will damp Deere's narrow economic moat rating or AGCO's (AGCO) positive moat trend. We believe the long-term potential for farm equipment manufacturers remains positive, given climbing farming marginal costs (boosting minimum crop prices compared with historical levels) and emerging-market mechanization advancements. As such, we recommend investors keep a close eye on both companies for potential margins of safety, especially in light of their offsetting construction (for Deere) and countercyclical grain storage and protein production (for AGCO) businesses.
Farmers' Success More Than Corn Prices, but Sentiment Can Weigh on Shares
Many analysts and investors home in on prevailing near-term corn futures prices (as traded on the CME) for a read on Deere's equity valuation. History has shown a strong correlation between the price of the crop and Deere's shares; we calculate the trailing 10-year correlation at roughly 83%. Based solely on this historical correlation, we estimate that, all else equal, Deere's share price could slide to $60 if $5 per bushel corn remains the new norm.
Deere's Share Price Strongly Correlated With Corn Futures
We understand why the positive relationship exists: Corn is the most important crop for U.S. farmers, composing about a third of total crop cash receipts, and tends to drive sentiment in other products like soybeans and wheat (together another 28% or so of crop receipts). Planted corn acres are commonly seen as a bellwether for U.S. farming, and resulting production and price can drive planned planting in other regions such as South America and Europe. For Deere in particular, North America also constitutes the largest portion of the company's revenue, at about 50%-60% of the core farm machinery segment (itself more than 80% of consolidated sales) in fiscal 2012.
Nonetheless, the correlation seems to have broken recently, and we don't necessarily expect Deere's share price to suddenly plummet alongside corn. Our fair value estimate remains $87 per share.
We think three major aspects of Deere's business have changed that will drive better performance that prior down cycles: (1) Increased supply means farmer cash receipts will remain historically high (though lower than 2012-13), even though prices have fallen. Similar to last year, crop insurance should also help to buoy corn farmers' revenue should prices slide well below support levels. (2) The USDA estimates total domestic demand for corn will rebound 9% this marketing year after falling 4.4% in 2012-13 and 2.1% in 2011-12, driven by increased meat production and resulting feed consumption. Combined with rebounding exports, the agency projects a 13% rise in total corn use this year. (3) At about 19% of revenue and offering lower profitability, the construction segment has less impact on Deere's bottom line than the core farm machinery unit. Still, we expect positive revenue growth contribution from this segment in fiscal 2014, thanks to multiyear highs in the homebuilder sentiment reading and the Architecture Billings Index, as well as better economic prospects.
Downside does exist, however. One concern we've heard is that U.S. corn demand growth has permanently leveled off. U.S. domestic demand (excluding exports) has indeed already shown signs of sluggishness outside of ethanol.
Ethanol and Exports Can't Save the Farm Industry
From 1992 through 2002, domestic corn usage grew at a 1.5% compound annual growth rate; this metric ticked up to a 3.2% yearly rate over the next 10 years. However, the vast majority of this growth stemmed from the onset of corn-based ethanol production in 2003-04; we calculate underlying demand excluding this source grew at a 0.7% annual growth rate from 1992 to 2002 but actually ticked down to 0.5% each year from 2003 to 2013.
Partly, this slowing domestic demand was a result of the lower available supply, which drove up feed prices and led to reduced meat and poultry production versus the record year in 2008. However, we note that red meat and poultry production has seen slowing gains as well. Although feed demand should rebound this year given lower feed prices, U.S. meat production has grown at just a 1.6% annual rate since 1993 and a 0.9% CAGR over the past decade. With population growth expected to slow further (per U.S. Census Bureau estimates), we don't anticipate major gains from this source.
Ethanol production is also set to provide more-limited demand growth for corn. The Energy Information Administration estimates that roughly 99% of corn-based ethanol consumption stems from E10--ethanol blended into gasoline at a 10% rate. Although the Environmental Protection Agency has approved the use of E15, car manufacturers are reluctant to support engine warranties with such fuel blending, given the potential that the input could cause undue wear and tear. Similarly, E85--a replacement fuel for traditional gasoline--has not enjoyed rapid adoption because of concerns about fuel economy and limited distribution infrastructure.
Without a substantial shift in policy among producers and automotive original-equipment manufacturers, it seems unlikely that ethanol demand growth over the next 10 years will match that of the past decade. In fact, without mandates from the government, there's potentially substantial downside. The EPA recently said it has flexibility to adjust Renewable Fuels Standard-mandated minimums, but some in the government and the oil industry have called for a full repeal of the act; while we don't expect such a drastic move in our base case, the lack of government-required ethanol blending would most likely materially drive down corn-based biofuel production. We'd expect some ethanol production to remain in this case, given the fuel's use as an oxygenator (as a replacement for MTBE) in gasoline, but this minimum level is likely to be well below current production rates.
Still, in its latest baseline 10-year forecast the USDA pegs ethanol use (including dried distillers grains) at about 5.4 billion bushels of corn, compared with 4.7 billion estimated for 2012-13. The resulting CAGR is just 1.5%, well below the 17% annual rate in the prior decade, suggesting future corn demand growth will be much closer to underlying food and livestock feed usage.
With limited domestic demand growth, it makes sense to look outside U.S. borders, but corn and soybean exports have stalled in recent years as the United States has lost substantial share in the global market. Partially, this stems from the challenged yields seen in North America that stemmed from weather issues, but expanded acreage in Brazil and Argentina has probably permanently shifted the worldwide landscape.
We think there is potential for upside to exports if the U.S. is indeed set for near-term oversupply in the domestic market, but the aforementioned secular shift isn't likely to abate over the long run, given the high probability for continued increased Brazilian production combined with potential for increased corn and soybean acreage in other regions.
The rise of South America as a corn and soybean grower offers equipment manufacturers growth opportunities abroad, but we're concerned that slowing global demand could limit total prospects. We believe many of the potential gains from an expanding middle class and resulting higher income in China have already occurred. We don't see compelling evidence that China's growth in caloric intake per capita over the next decade will be all that different from the previous 10-year period.
Deere has pointed to a 2011 U.N. study that suggests the world may reach 9 billion in 2045, five years ahead of the original projection. The resulting demand for food is expected to double, implying about a 2% compound annual growth rate over the 35 years from 2010, compared with annual growth north of 3% for corn and soybeans over the past 15 years.
On top of this slowing demand environment, an abundance of new-equipment inventory on dealer lots could harm OEMs' revenue in the near term as well. Based on monthly reports from the Association of Equipment Manufacturers, inventory of new row-crop and four-wheel-drive tractors (combined) stands at its highest level since 2009 as a percentage of trailing 12-month unit sales.
Deere Best in Class, but Valuation Has Room for Downside
What does this all mean for Deere? Overall, we expect some near-term downside to Deere's results in an environment of declining cash receipt growth, and we model sales and earnings declines for fiscal 2014. In 2009, we saw corn prices plummet on increased production, drawing down cash receipts, and Deere's ag business (and its stock price) fell as well, even as domestic corn demand increased 8.5%. But we don't envision a repeat of that period's detrimental credit issues or sharply declining European markets, helping to mitigate some of the negative effects.
We currently forecast a 7% decline for Deere's farm equipment segment top line (compared with a 14% drop in 2009), a product of lower volume offset by positive price realization. However, our 5-star price (roughly $61 per share) considers a downside scenario in which the company's results suffer materially in a low-cash-receipt environment. Here, we project two years of revenue declines, combined with operating margins in the farm machinery segment falling back to levels seen before 2008. Our downside case suggests fiscal 2014 earnings per share falling to roughly $6.50 (compared with $7.89 in our base scenario and our $8.80 2013 estimate); our resulting $57 pessimistic fair value estimate pegs Deere at an earnings multiple of about 8.8 times, lower than the current 11 times metric, but above the roughly 8 times level the company saw in the nadir of 2009.
Uncertainty remains, primarily related to prevailing weather conditions in any given year, but we currently see more downside than opportunity at current prices. We doubt Deere's markets would stay depressed over the long run, and the company has exhibited best-in-class performance for return on invested capital, free cash flow, and profitability versus its peers. We urge investors to watch Deere closely, given the lower probability we stake in our longer-term pessimistic modeling; we continue to believe the potential for long-run gains in the farm equipment industry remain strong, and margins of safety can appear in this stock during market downturns.
CNH and AGCO Face Similar Sluggish Prospects
Although Deere holds the highest amount of North American exposure among the agricultural equipment manufacturers we cover, CNH (CNH) and AGCO would also probably face a difficult environment in the case of falling U.S. cash receipts. We don't think farmers globally are immune to the negative price effects of the predicted strong U.S. crop, and the key markets of Brazil and Europe could see headwinds next year in a low-crop-price situation.
Admittedly, Brazil is enjoying several structural positives: The country has gained share in the global crop market, farmers enjoy costs in Brazilian reais but revenue in U.S. dollars, and government support (primarily through subsidized low interest rates) has been a major boon to the machinery industry. However, following what looks to be a double-digit growth year in the region, ag machinery OEMs will face difficult comparisons next year, combined with a strong probability that interest rates will rise while farmers see lower income.
The companies should enjoy a bit easier European comparisons; the market is projected to decline this year on the back of poor weather conditions in northern regions and continued economic malaise in Southern Europe. That said, the region is largely a price taker for major row crops. The European Union represents just 7% of worldwide corn production and a slim 0.5% of global soybeans. It is a larger player in wheat (at 20% of world production), but this commodity currently sits in a healthier supply situation than corn and soybeans. Europe's dairy and livestock sector could enjoy a rebound with lower feed prices, but sales into this end market tend to provide a negative mix shift for equipment OEMs because of the smaller size and lower horsepower needed. Still, we don't expect a major drop in equipment sales in 2014, given the volume decline for tractors and combines expected this year.
We don't project negative top-line prints for either CNH or AGCO, but we do expect revenue growth to slow. CNH's high degree of European exposure (roughly 33% of sales, compared with less than 20% at Deere) should help to offset North American weakness, and rebounding housing and commercial real estate spending should benefit the firm's construction equipment segment (about 17% of revenue in 2012) as well. We believe AGCO could see continued share gains at the margin in North America, given its still-low penetration there. Also, it boasts a somewhat countercyclical grain storage and protein production systems subsidiary, which benefits from increased grain production and lower crop prices. However, we don't believe either company has carved an economic moat.
Near-Term Downturn Not Negative for Economic Moats
We don't expect destructive price competition that will threaten the farm equipment manufacturers' current moat ratings, especially Deere's narrow economic moat. Although we anticipate weaker cash receipts in the U.S. and Canada to drive lower farm equipment sales next year, we don't foresee resulting damaging price wars. The three major OEMs have proved disciplined in the past, most notably in 2009 when they increased prices in the mid-single-digit range, even in the face of aforementioned severe volume headwinds. In fact, although acute competitive pressures have existed at times over the past several years, we estimate that each of the companies has enjoyed positive annual contribution from pricing since at least 2005. In addition, planned new product introductions (in light of updated EPA-mandated Tier 4 final engine emission standards) drive a rational pursuit of higher prices; the companies have an incentive to pass on heightened R&D costs and have generally outlined low-single-digit hikes for next year.
The major driving force behind Deere's competitive advantage lies in its dealership quality. We think the company enjoys a network effect of having more contact points with customers and strength from intangible assets such as brand quality, which is reinforced by the dealership presence. We don't expect a downturn to impede this advantage, given the consolidation that has already occurred among Deere's dealers over the past several years and the health these distributors showed in the 2009 recession.
Similarly, AGCO's positive moat trend is driven by the firm's continued effort to reduce its dealer count by promoting ownership consolidation, which improves the quality of remaining dealers. It's possible a farming downturn could accelerate this consolidation as underperforming dealership groups look to exit the industry. Given this combined with a clear plan for continued cost-cutting, product rationalization, and share gains, we think AGCO is working to strengthen its underlying sources of competitive advantage.
Near-Term Concerns Aren't Terribly Meaningful
We caution that rising interest rates could pressure profitability at the OEMs' captive finance arms. We don't envision this issue as an opportunity for one company to gain market share, however; financing options are relatively widespread across the firms, and AGCO, Deere, and CNH generally operate with extremely conservative underwriting practices. In addition, we think CNH's goal is to reach investment-grade ratings on its bonds, likely preventing an overleveraging of its finance arm's balance sheet.
The OEMs we cover have noted that the incremental costs to Tier 4 final conversions will be less than the original Tier 4 interim requirements from a few years ago. The interim step brought about major changes to engine technologies, input fluid needs, and product redesigns, but Deere has said the Tier 4 final progression should prove easier. However, we caution that the industry may see a pre-buy of prior engine technology ahead of price increases in the near term. Each of the machinery manufacturers holds credits from exceeding the prior emission requirements, and thus plans to delay new-product launches until roughly mid-2014.
Also, Congress hasn't yet approved a farm bill. In its current form, the proposed bill aims to eliminate so-called direct payments (which subsidize crop farmers every year) while providing continued support for insurance subsidies. There is still a great deal of political difficulty surrounding potential cuts to food assistance, which the farm bill governs, not to mention continued support for farmers who are currently enjoying record net incomes.
Although there remains substantial uncertainty surrounding the eventual date the law will be enacted and the amount of government support provided, we note that direct payments over the past five years (including conservation-related payments) have averaged a small 4% of crop cash receipts. In addition, the majority of these payments (more than 75%, per the Environmental Working Group) went to just 10% of farms in the United States--those that are already the largest and most profitable.
We've found that most in the industry seem resigned to the fact that they will operate without direct government payments going forward, and we expect this sentiment, combined with the offsetting impact of continuing insurance subsidies, to prevent a major headwind when the new farm bill is eventually passed.