Deere & Company: It Takes Oil to Make Ethanol

Investopedia Advisor submits: As the world’s largest manufacturer of agricultural equipment, what happens down on the farm is more than just a passing interest to the folks at Deere & Company (DE). Over the years, the company’s profits have been intimately tied to the boom/bust cycles that have tended to characterize the income fluctuations of their biggest customers – farmers.

Lately, the emergence of a global bio-fuel industry prompted by the high price of oil is being hailed as major long-term positive for the agriculture sector. Growing demand for crops such as corn and soybeans, which can now be economically converted into ethanol and bio-diesel, could eventually produce a permanent upward shift in global farm incomes. This would be a hugely positive development for farm equipment manufacturers like Deere, and its chief competitors CNH Global N.V. (CNH) and AGCO Corporation (AG).

Unfortunately, the short-run picture is marred by a rather unfortunate irony. The higher energy prices, which have raised the long-term prospects of the agriculture sector, are killing it in the short-run. Farmer’s fuel bills have soared over the last couple of years reaching a point where they are now having a seriously adverse effect on farm incomes. In the US alone, the total farm fuel bill is now expected to exceed US $30 billion this year – a 50% increase since 2003.

The combination of these higher fuel costs, higher interest rates and the lower crop yields due to this year’s summer heat wave has prompted the U.S. Department of Agriculture to predict a significant drop in U.S. farm income this year. From a level of US $73 billion in 2005, net farm profits are expected to slump to US $56.5 billion in 2006 and slide further to US $54 billion in 2007.

With 54% of its revenues derived from the sale of farm equipment, this isn’t good news for Deere. The company now expects agriculture-related equipment sales to be down 5% this year. With similar tough market conditions on deck for 2007, it’s a good bet that sales could be down again next year. The company’s other major market, construction and forestry equipment (making up 27% of sales), is also likely to take a hit as residential construction activity and lumber sales dip in response to the housing market slowdown.

Despite the gathering storm clouds, analysts continue to maintain a relatively constructive view on the stock. In response to the latest profit warning by the company, analysts only shaved 3-5% off their earnings per share ("EPS") estimates for this year and next. The consensus view still calls for EPS to rise by 11% in 2007, to reach US $6.87. Based on the current price of about US $75, the shares are now trading at a fairly modest forward multiple of only 10.9X – at the low end of the stock’s five year P/E multiple range.

With the shares now down roughly 17% from their earlier highs, and showing some recent signs of a recovery, the share price could now be fully discounted based on all the bad news. But, if you believe this you’d have to be onside with the analyst's view that Deere & Co. can still grow earnings at a double-digit rate next year, despite the growing body of evidence that agricultural and construction equipment sales are nose-diving. Personally, I see the analysts as being a bit behind the curve with their forecasts. Look for more serious downward earnings forecast revisions by analysts after the company reports its fourth quarter results sometime this November. My guess is the results won’t be pretty.

While there has been a modest share price recovery since mid-month, the move looks very much out of sync with the decidedly less exuberant share price performances put on by competitors AG and CNH over that same period. The story they appear to be telling is that difficult industry conditions may continue for quite a while longer.

DE 1-year chart:

By Eugene Bukoveczky, Contributor - Investopedia Advisor

At the time of release Eugene Bukoveczky did not own any shares in any of the companies mentioned in this article.