Farm and construction equipment major Deere & Company (DE +1.43%) is facing weak demand in its core agricultural equipment business. And there's nothing to be excited about the sales outlook for the next quarters. But, does this mean the investors should stay away from the company? Not necessarily. There are good reasons to believe that the current lull could be just a passing phase.
John Deere 8345R, Source: Deere.
Ag equipment sales could recover once buying power returns in the U.S.
Deere's outlook for its ag equipment business reveals the tremendous challenge before it. The company continues to expect a 5%-10% decline in the demand for ag equipment in the U.S. and Canada for the remaining year. But now it has also forecast sales to be hit by 5% in Europe, as farmer sentiments are tepid, and import policies are constantly hurting crop demand in the Russian and Belarus markets. South America is close to a recession, and sales could be down 10% from last year's levels.
Deere has slashed its sales outlook for ag equipment to a 7% decline; its earlier estimate was for a 6% decline. Given that the company derives more than three-fourths of its revenue from agricultural equipment sales, these challenges are weighing heavy on investor confidence.
Source: Deere Press Release. Chart prepared by author.
We would like to remind investors that although the problems that Deere is facing in Europe and South America are more fundamental, the current weakness in North America, which accounts for the lion's share of sales, is mostly on account of cyclicality.
In 2014 the production of grains in the U.S. is expected to be up resulting in lower prices of commodities, such as corn and soybeans, which will reduce farmers' net income. The U.S. Department of Agriculture forecasts farm cash receipts to go down 12% in 2014. With budget constraints, farmers are likely to postpone their purchases of high-horsepower farm equipment. But once the buying power returns, there will be considerable pent up demand to support sales growth.
Source: John Deere May, 2014 Earnings Presentation.
Deere also has its hopes tied to developing economies such as India, where the "mechanization wave" could lift sales. India, as a nation, is highly dependent on agriculture and a huge portion of the country's GDP (13.7% in 2012-2013) comes from there. The country is gradually adopting more advanced western techniques in irrigation and agriculture and it's this trend that will support Deere's growth.
A similar story is unfolding in China. Home to the highest number of people on the planet, China derives over 10% of its GDP from agriculture. According to estimates made by Research and Markets, China's agricultural machinery market could grow at a CAGR of 10.38% between 2013 and 2018. These trends could infuse life into Deere's ag machinery sales before long.
C&F sales to get support from improving fundamentals
Sales improved by 2% in the construction and forestry, or C&F, equipment business in the second quarter, and helped offset the 12% sales decline in ag equipment sales. The segment operating income climbed 63% driven by higher shipment volumes and lower production costs and this helped to offset the negative impact of the 22% fall in ag business operating income.
Though the sales improvement is at best modest compared to the 20% surge in construction equipment sales reported by Caterpillar (CAT +2.01%) in its first-quarter results, it couldn't have been better timed. During the quarter, 75% of Deere's C&F segment sales were driven by the favorable investment climate in the U.S. and Canada, while the remainder was through international sales.
The gradual ramp-up in the housing sector and improved real estate prices boosted segment sales. Caterpillar has made huge benefit from this trend -- its sales lift was influenced by dealers increasing their stock at the beginning of the year to take advantage of the recovery seen in the U.S. non-residential construction market. Deere's sales could also pick momentum in the coming quarters.
During the second-quarter earnings call, manager of investor communications Susan Karlix said that "although the fundamentals are all lower than three months ago, the economy is slowly moving forward and there are positive signs in the market. Unemployment is falling and construction hiring is increasing." Karlix's statement clearly hints at the upside potential that management sees in the market. For the full year C&F sales are expected to be up 10%.
John Deere Excavator, Source: Deere.
Foolish bottom line
It's true that Deere's core agricultural machinery business is going through a bad patch, and it's tough to see the broader picture. However, once the U.S. market enters its seasonal up-cycle things could improve, and sales would be supported by growing demand in the developing countries. Management is also determined to make the most from the construction business. With improving fundamentals, the C&F business could prove to be a good avenue for growth. Deere clearly has enough long-term prospects to keep investors interested.
