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Heavy Equipment Firms Look to Plow Out of the Recession

Is it time to load up on heavy machinery firms?

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The stomach-churning ride heavy equipment manufacturers have been on during the last couple of years would prompt even the most ardent thrill seeker to slam on the breaks. Construction equipment firms saw their sales and profitability skyrocket during the housing and commodity booms as customers purchased new construction and mining equipment with a seemingly insatiable appetite. Those sales figures then came crashing down after construction activity halted and commodity prices were slashed. Similarly, agriculture equipment manufactures witnessed unprecedented demand for new tractors and combines as crop prices soared and farmers' wallets became laden with cash. Yet these firms also now find themselves in the midst of a global demand drought. So with the recent signs of improvement in the economy's leading economic indicators, are we likely to see a swift snapback in heavy machinery sales? In our view this appears unlikely, at least over the near term.

Catalysts for Equipment Will Take Time
U.S. residential housing starts continue to hover around their paltry historic lows despite reaching an apparent bottom in early 2009. We expect modest recovery in residential building activity from here, but it could take at least a couple of years before we get back to more normalized build rates. Meanwhile, nonresidential construction activity in the U.S. continues to contract, and the international construction boom has been derailed because of substantial credit constraints. This is weighing heavily on new equipment demand. Nonresidential construction could remain depressed for several more quarters because this sector tends to lag economic recoveries.

As the economy slowly nurses itself back to health, construction activity in both the residential and nonresidential sectors will eventually improve and demand for heavy machinery will pick back up. However, considering the feverish pace that manufactures such as  Caterpillar (CAT) and  Terex (TEX) churned out equipment before the recession, the pickup in machinery sales may be muted initially as the industry works through what we believe could be an oversupply of new and used equipment already in the market (a sizable portion of which is likely idle at the moment). But like the housing market, we expect the construction equipment industry to slowly work through its inventory overhang before resuming its upward growth trajectory by late 2010 or early 2011.

Farm Income Declines Halt Demand
The farming sector was able to stave off the full brunt of the current recession longer than most. This was because of the strength of farmer balance sheets heading into the downturn and the robust farming sector fundamentals that had been driving equipment sales up into the early stages of the recession. Crop prices have since plummeted from 2008 levels, however, because of lower crop demand and bumper crop production reports. Lower crop prices typically translate into lower farm incomes. The Department of Agriculture now expects 2009 net farm incomes to be down 38% from 2008's record levels and 15% below the average farm income earned during the last decade. This will likely lead to a modest decline in North American agriculture equipment sales during 2009 and perhaps a more sizable decline in 2010, given the strong correlation between farm incomes and tractor sales.

The near-term outlook for international equipment sales is much worse, however, as a decline in farm incomes and much tighter credit conditions will lead to sales declines of 30%-40% in key developing markets like South America and Eastern Europe during 2009. Among the prominent players in the market, we believe  AGCO (AGCO) to be the most susceptible to this drop in international demand over the near term given its heavy reliance on international markets.  Deere (DE) certainly won't escape this recession unscathed, but its solid balance sheet gives the company an opportunity to potentially pick up share from its less well-heeled competitors, just as it has done in past downturns. As the global economy recovers, we expect the world to regain its voracious hunger for higher-protein diets. This should generate a strong secular tail wind across the entire farming sector which will once again fill the sails of all major agriculture equipment manufacturers.

Down, but Not Out
Just as we've seen in past recessions, the most recent economic downturn hit the highly cyclical heavy equipment industry with an abrupt and punishing blow. Although we don't think the sector will spring back to its feet immediately, it's certainly not down for the count either. After traversing through some muddy terrain over the near term, the construction and agriculture equipment market will regain its long-term traction.

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