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Deere in the Spotlight

Turbulent weather, market present a long-term opportunity to buy into farm OEMs.

Adam Fleck, associate director of research, 08/17/2011

It's no secret that many weather forecasters have terrible reputations. From predicting sunshine during a rained-out ball game to issuing a dire warning for what turns out to be a beautiful day, many meteorologists simply get it wrong from time to time. Stock-picking can sometimes be a similarly challenging endeavor, as investors must weigh myriad probabilities of uncertain future events. Combining these two uncertain projections--weather forecasting and stock-picking--seems like a match made for the foolish, yet that's what many try to do when predicting short-term movements in the share prices of farm equipment manufacturers such as AGCO AGCO, CNH Global CNH, and Deere DE.

Last year, terrible global weather conditions led to reduced U.S. corn yields, challenged Russian wheat production, and limited South American soybean growth. Although demand increased only in the low- to mid-single-digit range for these commodities, prices climbed dramatically on the back of limited supply. U.S. farmers benefited immensely, with cash receipts from crops (about 55% of all receipts) climbing 4.4% after declining 7.4% in the year prior.

Historically, when farmers have money, they spend it to improve their operations by buying new equipment such as tractors, sprayers, and combine harvesters. It shouldn't be a surprise, then, that North American customers purchased 5% more tractors in 2010 versus the prior year, when sales declined 21%. We expect the industry to see short-term, quarter-to-quarter movements due to changes in bonus depreciation rules, borrowing costs, and EPA-driven engine upgrades, but farmers' cash receipts will drive agricultural equipment purchases over the long run.

Of course, we don't know whether the world will see droughts or floods in the next quarter, or good or bad conditions for crop plantings this year even. The USDA currently foresees an even more massive 14% increase in cash receipts from crops for 2011, but we think it's unlikely that the worldwide supply limitations of the last year will continue in the long run. Chinese demand for soybeans and U.S. corn-based ethanol production will elevate crop values above pre-2008 levels, but rebounding supply and limited demand growth will eventually lead to softer pricing and farm income. As a result, we recommend investing in only the farm machinery manufacturers that possess a suitable margin of safety.

The Year in Farming: Better, but Still Challenged
The 2011 U.S. planting season got off to a rocky start, as poor weather conditions led to late plantings for the three major crops: corn, wheat, and soybeans. Texas drought conditions, southern flooding, and Midwestern heat have further challenged crops, but according to USDA estimates, conditions have remained relatively decent since.

The agency recently reduced its yield outlook for corn, but still believes increased U.S. plantings and rebounding yields will help prevent a decline in ending stocks as sharp as last year's. Similarly, improved Russian wheat production looks to prevent the global issues seen last year. Only soybeans are forecast to be in a worse position for 2011-12 than last year.

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