World's largest agriculture machinery manufacturer Deere (NYSE: DE) has two major operating segments - agriculture and turf, comprising nearly 78% of its revenue; and construction and forestry. It recently released its results for the third-quarter ended July 31, wherein the top and bottom lines fell because of the sluggishness in the farm equipment sector, but were somewhat cushioned by the construction good show.
Revenue for the quarter dropped 5% to $9.5 billion from $10 billion reported in the year-ago period, as equipment net sales fell 6% to $8.7 billion. Deere's net income saw a steeper decline of 15% to $851 million from $997 million last year. However, analysts had expected worse and predicted $812 million net income and $8.72 billion revenue.
Management has lowered its sales forecast for the full year ending October 31. It now expects sales to fall 6% vis-a-vis the earlier projection of a 4% drop. The company has also trimmed its earnings expectations from $3.3 billion to $3.1 billion for the fiscal year.
Ag Recovery Nowhere In Sight
Deere's agriculture and turf segment sales were down 11% to $7 billion, and operating profit plunged 30% to $941 million from year-ago levels. Higher overall price realization couldn't offset the low shipment volumes, expensive material costs for production of Final Tier 4 emission compliant machinery, and negative foreign currency effect.
In the U.S., prices of commodities like soybean, corn and wheat are at two-year lows on expectations of record harvests this year. Bloomberg recently reported that prices for all the three afore-mentioned crops have gone down by more than 10% in Chicago in the past one year. This is hurting farmers' incomes and capacity to purchase equipment, especially the larger high-margin machinery. In February, the U.S. Department of Agriculture had predicted a 22% drop in farm net cash income. The next update is due later this month, but good news is unlikely as Deere now expects industry sales in the U.S. and Canada to dip 10% in its fiscal year ending October in contrast to a 5%-10% drop forecasted earlier.
What's worse is that analysts think that the slump will continue through the next couple of years. Lawrence T. De Maria, analyst at William Blair & Co, has warned, "This is the beginning of the weakness. We believe that the bigger downside will occur next year and the year after."
Outside the U.S., rising interest rates in Brazil and tight credit in Argentina are impinging upon sales in the South America. The company has lowered the region's industry-wide sales forecast for the year to a 15% decline from the 10% decrease predicted earlier. Due to the geopolitical unrest in CIS countries, sales are expected to be significantly low. On top of that, China's ag economy is slowing with the value of crop output going down. Deere has revised Asia sales forecast for the year from 'up slightly' to 'flat'.
All this put together has led the farm equipment major to slash its forecast for the segment to 10% sales decline in fiscal year 2014, from 7% fall seen in the past.
Construction Is The Sweetener
The economic recovery and higher housing starts in the U.S. are propelling a rebound in construction equipment sales. High shipment volumes and price realization boosted the segment's topline by 19% to $1.75 billion, and operating profit went up a whopping 80% to $194 million. The growth in operating profit is comparable to heavy equipment market leader, Caterpillar (NYSE: CAT), which posted 83% rise in operating profit from its construction segment in the second quarter.
Though China's construction market is receding, the strength seen in the U.S. may help the company achieve its yearly goals. Deere has maintained its guidance of 10% revenue increase in the segment for the fiscal year.
Immediate Measures Taken
To align itself with the decreased demand for ag equipment, Deere is "scaling back production" in the fourth quarter. Soon after the earnings release, the company announced the permanent layoff of 600 employees at four factory locations. The company may also go for seasonal and inventory-related shutdowns together with temporary job cuts in various factories.
Another initiative undertaken by the ag major to drive sales is the John Deere certified pre-owned program, which was launched in July. Slowdown in the ag sector has led to high levels of used inventory at Deere dealers. When this happens, dealers are not in a position to offer farmers trade-ins -- discounts on new machinery in lieu of old tractors or combines -- that discourages farmers from making new purchases. Under the program, used machinery would be certified by John Deere technicians to ensure they meet strict quality requirements, together with a one-year warranty. This will enable dealers sell more pre-owned machinery and thereby better manage used inventory. The company expects this move to be a complete "game changer".
Deere Is Financially Strong
The enormous world food demand cannot let agriculture lie low for long, but the true test for companies is to become more resilient to the cyclical lows. And this has been Deere's approach - it's improved its operating efficiency significantly since the past down cycle. In fiscal year 2013, Deere avoided $8.5 billion in working capital compared to 2008. It also maintained its 2008 receivable level in 2013 despite tripling sales.
Thanks to such measures it's looking to generate $3.7 billion cash from operations in fiscal year 2014, which is down from the May forecast of $4 billion, but significantly higher than the $1.4 billion generated in 2009, its previous cyclical low.
The company raised its quarterly dividend to $0.60 per share in May from $0.51 per share. CEO Samuel R. Allen said, "Our dividend increase reflects our confidence in Deere & Company's ability to generate strong cash flow throughout the cycle." It has a low payout ratio of 22.3% in the last 12 months and is targeting to pay 25%-35% of mid-cycle earnings in the long run. Deere's also actively buying back stock -- in December 2013, it approved an $8-billion share buyback program, and in the first three quarters of the fiscal year, it has bought back 18.4 million shares for $1.6 billion. Deere had substantial cash reserves of $3.1 billion at the end of the third quarter.
The improvement in construction business couldn't have at a better time, but the weakness in the ag sector could continue to weigh on Deere's revenue and profit prospects in the next couple of years. To combat the headwinds, the ag major is introducing strategies that will rein in costs and support the bottom line. The agriculture sector might be in gloom as of now, but Deere is a strong company with solid liquidity position. It's well equipped to fight the short-term challenges, till the times take a turn for the better.
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