When temporary bad news hits a well-run leader in an industry with outstanding long-term prospects, compelling buying opportunities can occur. Such is the case with the agricultural equipment business and John Deere.
U.S. farm income is expected to decline 38% this year to $55.9 billion, the lowest level in more than a decade. Blame it on the weather—it remains nearly perfect. But ideal growing conditions aren’t always ideal for farmers. Until last year, the farm industry had been minting money. Crop prices soared for much of the past decade, driven by drought and rising demand for corn from ethanol processors and foreign importers, which in turn fueled a large jump in farm income. Accompanying a massive rally in crop prices, agricultural land prices began rising sharply in 2004, posting double-digit percentage gains in eight of the succeeding nine years. Then, almost overnight, the cycle turned.
Prices for corn, the biggest U.S. crop by value, have tumbled more than 50% since the summer of 2012. In 2014, U.S. farmland posted its first price drop since 1986. Farming related expenditures have also been impacted. Capital equipment purchases, usually the first farm input to be delayed or eliminated during a downturn, have experienced a precipitous decline. The decline in demand for farm equipment has been most pronounced in the sale of high-horsepower models. The large agriculture equipment industry in the United States and Canada – defined as tractors and combines greater than 220 horsepower—is now down more than 50% from 2013 levels.
While profits in agriculture are inherently cyclical, a once irrelevant factor helped contribute to the record farm income and increased equipment spend of two years ago—the demand for ethanol. Corn has long been the largest cash crop in the United States. Farmers used to grow corn for food. This started to change in the early 1990s, when U.S. began to enact legislation that encouraged biofuel and ethanol production in an effort to reduce the country’s dependence on foreign energy imports. Ethanol blend mandates, requiring annual increases in the amount of biofuel that must be mixed with gasoline sold in the United States, fueled an exponential growth in ethanol production. This near ten-fold rise in production left more than 30 percent of the annual US corn crop consumed in the creation of biofuels (4.2 billion bushels annually) and helped corn prices reach record highs in 2013. Coming off a record high year for corn prices, renewed fervor about renewable fuel mandates contributing to less food security and rising input costs for refiners helped compel the EPA to retreat on its aggressive renewables requirements. The EPA’s amended quotas for ethanol blended gasoline reduced corn-ethanol levels to 13.4 billion gallons this year, down from the prior requirement of 15 billion gallons, weakening a driving force behind the strength in corn prices.
Agriculture equipment spending was also buoyed by two depreciation-based provisions in the U.S. Tax Code that benefited farmers: bonus depreciation and Section 179 expensing. Bonus depreciation allows farmers to depreciate 50% of the value of new machinery in the year it is placed in service. Section 179 allows tax deductions on the purchase of new or used machinery. As part of the financial stimulus bill in 2012, Congress increased the Section 179 deduction limit from $125,000 to $500,000 on capital purchases through 2014. Farmers were particularly keen on taking advantage of the high depreciation limit, leading to some front-loaded capital spending in the years leading up to 2014. While the House has passed a bill to make Section 179 permanent, the Senate has not yet voted, leaving uncertainty amongst the farming community and delaying large equipment purchases, as the deduction will fall to $25,000 if not renewed.
Not surprisingly, the cyclical trends in U.S. agricultural spending have also depressed the share prices of stocks related to the industry. John Deere, the 800lb gorilla of the agricultural equipment industry, now expects further sales declines in 2016, as farmers clamp down on expenditures to preserve cash flow. While some U.S. farmers are expected to defer purchases of capital equipment over the next several quarters, we continue to view the prospects of Deere and certain other agriculture companies as favorable beyond the next year. While the timing is uncertain, both history and demographics suggest crop sales will eventually rebound. Lower crop receipts for 2016 would mark the third consecutive yearly drop in sales and would leave farm incomes well below long-term averages. Since 1965, there has only been one period that produced three sequential years of lower crop sales, after which receipts rebounded substantially. Increased receipts combined with more clarity around depreciation deductions should help remove some of the headwinds facing equipment manufacturers.
What shows no signs of abating are the secular trends of increasing global food scarcity and rising protein consumption. The Organization of Economic Cooperation and Development (OECD) forecasts that worldwide agricultural production needs to grow by 60% over the next forty years to meet increased demand. This demand growth is a result of an increasing population, urban migration, and a rapidly expanding middle class across many emerging markets. As living standards rise, people tend to consume more meat in their diets. Meat-based diets increase the demand for grain; it takes roughly seven pounds of grain to produce one pound of beef. Consequently, increased meat consumption can have a logarithmic impact on the demand for grain. The OECD also predicts global ethanol production will increase by nearly 4% per year and reach 158 billion liters by 2023, which will provide an additional driver of demand. These trends will continue to propel the need for an increasing amount of industrialized farm equipment.
Like most companies in the agricultural sector, Deere’s business is cyclical. Farmers typically upgrade and expand their equipment when crop prices are high and farmer sentiment is strong. High prices lead farmers to plant more, resulting in larger harvests the next season and more supply. A larger supply leads to lower prices, leading to smaller harvests and lower capital investment, and the cycle repeats. While the market often focuses on the short-term, cyclical trends in U.S. agricultural spending, Deere has demonstrated that its business quickly recovers after temporary disruptions in crop receipts. It is highly likely that Deere will look similar in ten years and that the many farmers that have purchased Deere equipment for multiple generations will likely continue to do so. Deere should continue to hold and likely increase its dominate market share in manufacturing agricultural equipment.
Today’s depressed agriculture sentiment is, in our opinion, more of a buying opportunity than a reason to avoid the stock.
We occasionally mention specific stocks or other investments in Intellectual Capital. If so, the comments specific to those investments represent our opinion as of the date of the post. We might (or might not) change our opinion the next day, week or year. Accordingly, nothing in this blog should be considered a specific investment recommendation. Nor does this blog include all investments in which we have an opinion or ownership stake, either previous or current.