After a disappointing earnings report that saw the company lowering its full-year income and equipment sales expectations, Deere & Company's (NYSE:DE) management was obliged to outline how it would deal with weaker conditions. Current conditions are difficult in the farming machinery industry; but what is Deere doing about it? It's time to look at the five key takeaways from its third-quarter conference call.
Deere's end markets getting weaker
As Fools can read about here, Deere's latest earnings report produced a downgrade to sales expectations in its core agriculture and turf segment -- 81% of sales year to date. Essentially, the problem is that weak crop prices are lowering farmers' profits and encouraging them to hold back on purchasing farming equipment.
While lower crop prices are likely to impact farmers everywhere, the first takeaway relates to some specific commentary on China in both agriculture and construction. This is something that investors in Caterpillar (NYSE:CAT) should follow closely, too.
Economic growth is expected to slow in China in the second half of the year and the Ag economy there is slowing as well, due to lower grain prices... ...ongoing subsidies are supportive of agriculture, their pace of increase has slowed. In addition, the construction sector recession has deepened.
In other words, conditions are getting worse in China (construction included), and agricultural conditions are getting worse due to slowing of subsidies. It isn't just about crop prices.
Deere adjusts to weaker conditions
When end markets weaken, companies are usually forced to make adjustments, and Deere outlined some related initiatives, which make up the next two takeaways. First, management outlined that it would be "scaling back production" in line with lower end demand in agriculture. This is a realistic move that investors should welcome, as Deere also downgraded its expectations for U.S. Farm commodity prices for corn and wheat during the next two years.
The second adjustment, and the third key takeaway, is the introduction of a "John Deere certified pre-owned program," whereby products will be tested by certified technicians. This is a good move because it will enable its dealers to sell used equipment more easily. The benefit is that its dealers don't build up too much used inventory and, consequently, Deere can protect pricing on its new equipment.
What about margins?
While Deere is adjusting to the reality of negatively trending crop prices, the question of margin erosion is always likely to come up. In truth, management was noncommittal on the subject. Director of Investor Relations, Tony Huegel, outlined that margin guidance for 2015 would be discussed on the next conference call. This is something to look out for, and I will cover this issue in a future article.
On the one hand, Deere is clearly facing margin pressure from declining sales, and "many" of its small products are transitioning to Tier 4 -- a tighter emissions standard that requires investment. On the other, lower steel prices could reduce its material costs and, as outlined above, Deere is taking measures to scale back production.
Don't forget the weather
The final takeaway relates to the great known/unknown within the agricultural industry: the weather. Indeed, Huegel asked himself a question out loud on the subject: "Question is, what's going to happen with the crop that will get planted next year in terms of do you have yet a third year in a row of good growing conditions on a global basis, or do you have a year where those yields moderate a bit due to weather?"
This is a key point because predictions for crop prices have been reduced in expectation of bumper crops this year. For example, the United States Department of Agriculture, or USDA, recently predicted record U.S. corn and soybean production in 2014 -- something likely to put downward pressure on prices.
However, neither the USDA, Deere, nor anyone else, for that matter, can be completely confident of global weather conditions in 2015. In a sense, expectations are now so low for crop prices that any negative surprise from the weather, in any major crop-producing region of the world, could see sentiment toward the sector change rapidly.
The bottom line
All told, conditions are getting tougher. Deere's management is being proactive, and adjusting to it by scaling back production and helping its dealers to sell used equipment via its pre-owned program. On a more negative note, the information on China was slightly worrying, and the downtrend in crop prices was, too. However, the weather is likely to be an important factor and, if everyone is assuming some clement crop-growing weather in 2015, there could be some positive upside for Deere, given any poor weather.