No one rules the global farm equipment market like Deere & Co. (NYSE:DE), but no business is perhaps as susceptible to the vagaries of the commodity markets like the tractor business is. And that's what makes being a John Deere investor so difficult.
Despite expectations for strong planting seasons in the U.S. and Latin America this year, Deere will likely find it harder to sell higher-premium tractors and combines, which could hurt both its bottom line and share price. Here's why.
When farmers aren't too sure, how can Deere be?
Farmer sentiment is a major driver of farm equipment sales. It's simple: If you're not too confident about your business, will you spend big bucks on machinery? Farmers in the U.S. have become increasingly cautious about agribusiness, and hence their economic fortunes, over the past year; and things might only be worsening. At least that's what the latest results of the DTN/The Progressive Farmer Agriculture Confidence Index suggest.
The index gauges farmers' level of optimism toward their business at present, as well as future expected conditions, by factoring three key aspects of farming: input prices, net farm income, and farmer household income.
As you can see from the chart above, farmers' confidence on present conditions slipped dramatically over the past year and a half, and has been in a broader downward trend since 2011. Worse yet, future expectations remain under the 100-score mark, indicating pessimistic sentiments (a score above 100 reflects optimism). So how could that affect Deere? Farmers may defer equipment purchases, buy only what's needed, and perhaps even pay less attention to the larger and more expensive machines. That could take a toll on Deere's sales.
Why are farmers so low on confidence? The next chart could hold the answer.
Less income, lower sales
Just as you keep a record of all your income and expenses, so do farmers. The net profit or loss, after accounting for all income from a farm and cash (as well as non-cash) expenses related to operating the farm, is simply termed net farm income. Naturally, the higher the expected farm income, the more optimistic farmers will be.
Unfortunately, the U.S. Department of Agriculture projects that total net farm income this year will slip by a whopping 26.6% from the projected level for 2013 of $130.5 billion. That would be the lowest since 2010, as shown by the chart below:
Net cash income (which considers only cash income and expenses) isn't as important when you're talking about a company like Deere, since tractors and other capital expenditures count as noncash expenses.
Nevertheless, the bottom line is that with less income at their disposal, farmers will cut back on purchases of farm equipment. In fact, lower expected farm income is the major factor why Deere projects that its agriculture and turf equipment sales will slip 6% in fiscal year 2014, while AGCO (NYSE:AGCO) expects to end the year with flat equipment sales. But why is farm income under pressure?
Golden days over?
Farm cash receipts, or the cash that farmers receive on the sale of commodities (crops) and in the form of subsidies from the government, form the most integral portion of farm income. And cash receipts are directly proportional to crop prices.
The following chart from Deere's February earnings presentation shows you where key commodity prices are headed.
Commodity prices across the board are clearly under pressure. The USDA projects that 2014 crop receipts will fall at least 12% year over year. Worse yet, government payments could drop a whopping 45% this year. That would be a major blow to farm receipts and income.
Expectations of lower corn acreage may have pushed corn prices up in recent weeks, but Deere was already projecting a shift toward soybeans over corn this year, so it perhaps factored that in while forecasting crop prices, as shown in the chart above. Moreover, according to the USDA, carryover stock from 2013 for corn in March was 30% higher year over year, which could keep corn prices under check. None of it bodes well for farmers or for Deere.
The Foolish takeaway
With the weather and crop prices becoming more uncertain, farmers may increasingly adopt the wait-and-watch approach when it comes to spending. Robert Hill, an economist at Caledonia Solutions who helped with the Ag Confidence Index survey, put it into perspective: "The big surge in capital expenditures on farm equipment and land is behind us. We have entered a period of more rational behavior on such expenditures."
In other words, Deere & Company could be headed for tougher times ahead. As AGCO CEO Martin Richenhagen summed up during the company's last earnings call, "2014 will be a challenging year for our industry." Deere investors should stay cautious.