1 Chart Shows Why Deere & Company Will Feel the Pinch This Year on Its Home Turf

Ag equipment major Deere  (NYSE: DE  ) is bracing up for some tough times ahead as demand for ag machinery is weakening in North America. To make matters worse, current projections by the U.S. Department of Agriculture (USDA) as well as other agencies indicate that the weakness may be spread across multiple years. This comes as a red flag for Deere, which has more than 50% market share in the U.S. and Canada, and sounds alarm bells for investors. What's behind this current downturn? And where does this leave Deere?

All signs point toward a demand drop
The USDA has forecast that crop cash receipts will decline 12% in 2014 from last year's levels, and the weakness will continue till 2016. Crop cash receipts are the cash that reaches the farmer's pocket, through sale of agricultural commodities or by government payments provided as subsidies. It has a direct bearing on the farmers' liquidity position.

The chart below, put together by Bloomberg analysts, shows that cash receipts for most crops are down year to date. In 2014, Bloomberg expects cash receipts for corn to fall by 18.2% and soybeans by 15.4% year over year. Further bad news is that government payments are also expected to plunge by a whopping 45% this year. This could create huge pressure on farmers, and negatively affect their ability to purchase new equipment.

 
Source: Bloomberg

Already farmers have started taking loans to fund their working capital requirements, which is restricting their ability to take additional loans for buying new farm equipment. This is further suppressing demand for ag machinery. According to Bloomberg, farm equipment loans dropped by 29% in the first quarter of 2014 compared with last year. 


Source: Bloomberg.

Sales result and outlook remain weak
Deere's ag and turf equipment sales fell 12% in the company's second quarter, reflecting weak demand. In fiscal year 2014, the company expects its agriculture and turf retail sales to go down by 5%-10% in North America from last year, while its overall revenue is expected to be down 4% year over year. 

The data from Deere's "May retail sales comment" shows that industry retail sales volumes are down severely for most product categories other than utility tractors, and Deere is feeling the heat even more than the industry. In the first quarter, Agco's tractor and combine production volume dropped 9%; the company predicts full-year sales to fall 5% in this space.


Source: Company presentation (link opens a PDF)

Deere is well grounded
At the beginning of this year, Deere CEO Samuel Allen stated that the new set of ExactEmerge and MaxEmerge planters would be game changers that will help farmers to achieve better yields. But with such a dull capital spending scenario persisting, this sort of silver lining is fading. If farmers are not earning profits, how would they buy expensive Tier 3 and Tier 4 farm machines?

A prolonged down cycle is not good for Deere, as sales could be hurt for the next few years. However, encouraging demand for ag machinery from developing countries and revival in the domestic construction market could partially compensate for such weakness.

The company is also fundamentally strong -- its focus on asset management, productivity improvement, and investment in research and development has created a strong operations base that could help it sail through these troubled times. The following are some encouraging numbers from Deere's March/April investor presentation (link opens a PDF):

  • The company lowered its working capital requirement by roughly $8.5 billion in 2013 from 1998
  • Despite tripling of sales from 1998, it maintained its receivable level in 2013
  • The company has increased its revenue generated per employee at a compound annual growth rate of roughly 6% in the past 30 years
  • R&D as a percentage of net sales has increased from about 2% in 2000 to more than 5% in 2013

Quite remarkably, Deere has increased its forecast for 2014 cash flow from equipment operations to $4 billion from its earlier guidance of $3.9 billion. 

Foolish takeaway
Deere derives most of its revenue from selling agriculture machinery in the domestic market, and a drop in crop cash receipts for consecutive years can take a big toll on its sales. However, the bellwether has exercised its wisdom in casting a cautious outlook from the beginning of the year, which has helped in planning. Deere is also looking for sales increases from developing countries and the improving construction market. But its worries are far from over.

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