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Can Ag Equipment Firms Harvest Bountiful Returns?

A look at the farming sector and the prospects for agriculture equipment companies.

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There were few more-attractive sectors to be positioned the last several years than those tied to the farming industry. The world's major agriculture equipment producers, such as  Deere & Company  (DE),  CNH Global (CNH), and  AGCO (AG), were no exception, as each experienced a three- to four-fold share price appreciation in the three years leading up to the summer of 2008. However, the market contraction over the past several months has driven these firms' share prices down 60% to 85% from peak levels, erasing the impressive gains recorded the past few years. With a reeling global economy and tight credit markets, is there reason to believe agriculture equipment companies can regain their traction? We think this space still offers attractive prospects for several reasons.

Despite a contraction in crop prices, the farm sector remains relatively healthy.
While grain and soybean prices are down 50% or more from the highs reached in 2008, crop prices are still well above historic averages and should continue to allow farmers to generate attractive returns. The U.S. Department of Agriculture estimates that farm incomes in 2009 will be down 20% from the record levels of the past couple of years, but incomes will still be roughly 10% higher than the average level recorded over the prior 10-year period. Farmer balance sheets also remain impressively robust with farm debt-to-equity levels at 40-year lows. The strong financial position of most farmers should allow the agriculture sector to weather the credit downturn better than many other industries, in our opinion.

The financial entities that provide the bulk of agriculture financing are in much better shape than their banking industry cohorts.
While the solid financial position of the farming sector is certainly a positive, it's of little consequence for the equipment manufacturers if farmers can't access capital to finance input costs and big-ticket purchases. The bulk of farmer financing is derived from small, community banks that did not drown themselves in risky investments like their Wall Street brethren. According to the University of Illinois Department of Agriculture and Economics, 93% of the banks loaning to the farming sector are less than $10 billion in asset size and only 18% are publicly traded or owned by a publicly traded bank holding company. The captive finance arms of the major agriculture equipment companies are also in good shape and remain a solid source for lending. Correspondingly, we believe farmers may have greater access to credit relative to other industries, which will allow them to continue purchasing agriculture equipment (albeit at a slower pace than the past several years).

Improving diets, global population growth, and increased biofuel production will continue to drive increased crop demand and support high crop prices.
As the standard of living in developing countries continues to rise, the inhabitants of these regions are increasingly moving toward more protein-rich diets. This has a multiplying effect on the demand for grains. For instance, it takes approximately 7-8 pounds of grain to produce one pound of feedlot beef. But people's diets are changing, and there are increasingly more people to feed in the world. A growing global population not only raises the demand for grains, but also reduces the amount of arable land per person to supply that demand. While higher-protein diets and an expanding population base will be the primary sources of incremental grain demand, increased biofuel (such as corn-based ethanol) production will also put a strain on global crop supplies. Grain crop stocks-to-use ratios--that is, supply relative to demand--are currently at decade lows, and we expect these factors to contribute to low stock-to-use ratios for some time to come. This should benefit agriculture equipment manufacturers in a couple of different ways. First, the lower supply of crops relative to demand should create a backdrop for higher sustainable crop prices going forward. This in turn will translate into higher incomes, a portion of which will be used to continue to invest in new equipment. More importantly, however, is the fact that higher demand, coupled with declining land availability, will require farmers to increase land productivity, or yields per acre). This is particularly the case in international markets where yields per acre are much lower than in the United States. While chemical and seed technologies will play a large part in improving productivity, advances in agriculture equipment technologies will also play an important role. This offers an attractive opportunity for the major agricultural equipment manufacturers to seize over the coming years.

But the outlook for farm equipment manufacturers isn't without its risks.
While our discussion above largely concentrated on the health of the U.S. farming sector, the near-term outlook for international farmers is more complicated and varies by country. Droughts are ravaging large swaths of farmland in places like South America and credit availability in many international markets is virtually nonexistent. With international markets comprising close to 50% of revenues for Deere and CNH Global (and even more for AGCO), these are hardly trivial matters, and they are certainly weighing on the stock performance of the agriculture equipment group. We, too, expect weak international markets to have a significant drag on revenues across the industry this year. For example, we are forecasting agriculture equipment sales to be down as much as 30% in South America during 2009, and we anticipate sizable volume declines in Eastern Europe and Russia as well. Even the relatively healthy North American market is likely to see modest volume declines from 2008's banner-year levels. That said, we believe the market is overly focused on the industry's short-term uncertainties while failing to account for the promising medium- to long-term opportunities that were previously (and justifiably) priced into the agriculture equipment suppliers' stocks. Once the current economic clouds start to clear, we believe the agriculture equipment companies will harvest healthy returns for investors.

Editor's Note: Information about how many pounds of grain are required to produce one pound of feedlot beef was updated on Feb. 26. Click the date to learn more.

John Kearney does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.