By Kris Rosemann
The agricultural equipment industry is dependent on a global economy that remains mired in mediocrity. Durable goods orders fell in both April and May 2015 - as well as 9 of the 10 months prior - and the solid 3.4% increase in June is misleading due to the extraordinary number of aircraft orders. Excluding transportation orders, the increase for the month of June was a slight 0.8%. Economic conditions in the US, if construed as positive, in the words of Caterpillar (NYSE:CAT), the global economy "remains relatively stagnant," with ongoing weakness in China and Brazil and uncertainty across the Eurozone given the crisis in Greece.
Weak commodity prices are not suggestive of a near-term recovery for the overall economy either. Crude oil prices are expected to remain under pressure in light of a global supply glut and concerns that economic sanctions being lifted on Iran, and mining markets, including the iron ore market, remain weak with participants dedicated to increasing production through thick and thin. BHP's (NYSE:BHP) iron ore production, for example, grew 14% in fiscal 2015, results released July 22, and output is expected to increase another 6% in fiscal 2016.
Meanwhile, average realized prices for iron ore were more than 40% lower during the fiscal year. The outlook for a sharp recovery in iron ore prices remains bleak. Averaged realized prices in BHP's fiscal 2015 for copper (down 14%), coking coal (down 20%-21%), and thermal coal (down 22%) continue to offer stiff headwinds. Equipment manufacturers such as Caterpillar are feeling the pressure as customers cut spending on new machines.
Commodity prices have been similarly unfavorable in the agriculture markets. Prices for corn, wheat, oats, and soybeans all remain well below their post-financial crisis recovery highs, and some are at or below half of those peaks. As is the case in the mining and drilling industries, farming equipment manufacturers are realizing the downside of low commodity prices.
Caterpillar, AGCO (NYSE:AGCO), and CNH Industrial (NYSE:CNHI) all reported significant top line pressure in the face of reduced customer spending in the calendar second quarter of 2015. AGCO noted a "significant drop in high-horsepower tractors, combines and sprayers" and pointed to the UK, Finland, France, and Germany as particularly weak markets. Lower industry volumes in the row crop sector and dealer inventory destocking hurt CNH Industrial's agricultural equipment sales.
Though industry participants are confident a recovery is coming, we would expect any improvement to be led by a recovery in commodity prices, the timing of which remains uncertain. In the meantime, manufacturers are busy attempting to control costs and inventory. AGCO, for example, reported a near-25% decline in revenue in the second quarter, results released July 28, and accordingly cut engineering spending and SG&A expenses.
CNH Industries reported a 10% decline in total revenue (down 22% on a reported basis) in its second quarter, results released July 29, and also cut its R&D and SG&A expenses significantly. Despite attempted cost control, both firms witnessed their operating margins decline by ~2 percentage points or more during the period.
Caterpillar was much less aggressive in its cost cutting in its second quarter, results released July 23. R&D spending was relatively flat, and SG&A fell only 3%, compared to double-digit declines at AGCO and CNH Industries in both expense categories. Caterpillar reported revenue falling 13% in the quarter, compared to the year-ago period, and the company remains adamant that it will continue to fund R&D close to record levels in 2012. CAT was within its target of operating income falling 30% or less of the magnitude of decline in revenue in the second period, however.
We're not rushing to add exposure to the agricultural equipment space nearly seven years into an economic recovery and weeks after a sharp drop in share prices across Chinese markets. Caterpillar and Deere & Company (NYSE:DE) remain our favorite plays to gain exposure to this arena, but we'd be cautious, in any case. Both have fantastic dealer networks, significant brand strength, and vast experience navigating cyclical operating environments. We're keeping them firmly on the watch list, however.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.