It's a simple equation.
When farmers' income is up and debt generally low, farmers invest in new equipment.
And right now, farmers in the U.S. and around much of the world are enjoying boom times. This should turn into continuing gains for major farm equipment makers Deere (DE), Agco (AGCO) and CNH Global (CNH), who stand to profit from a mix of factors now aiding farmers.
As people in China, India and other developing nations achieve a higher standard of living, they tend to eat more protein. Domestic sources of protein like cattle and chickens are fattened on grain. The global demand for more grain, along with some adverse weather conditions and the relative weakness of the dollar, has sent prices of wheat, soybeans and corn soaring.
The result could be a record year for farmer income.
High Income, Low Debt
For next year, Deere forecasts an all-time record high of nearly $347 billion in U.S. farm cash receipts — almost 5% above the previous high set in 2008.
Meanwhile, farmer debt is "as low as it's been in a generation," said Jefferies analyst Steven Volkmann. "When farmers make money, they invest in capital equipment."
Investment in farm equipment like tractors and combines may be especially appealing. If farmers want to produce more to take advantage of high prices, they can either expand acreage or improve crop yields. But in the U.S., at least, acreage expansion is often not a viable option. "This country doesn't have a lot of space to expand farmland," Volkmann said.
Meanwhile, bad weather has produced disappointing yields for corn, soybeans and wheat, the USDA recently reported. This has helped lift grain prices higher. And it's convinced analysts that farmers will turn to new equipment to boost output and fully enjoy the benefits of high prices.
"We see a strong cycle for the agricultural equipment producers based on the strong commodity cycle and the need for expanded production and replacement of existing machinery," said Lawrence De Maria, an analyst at Sterne Agee. "We see an extended replacement cycle in the U.S. and the beginning of a new replacement cycle in Europe."
Deere is the industry leader and is coming off a strong fiscal fourth quarter in which it topped analyst forecasts. Earnings of $457 million were Deere's highest ever for its final fiscal quarter of the year.
Deere is not a pure agriculture play, as it also sells construction equipment. Ag equipment accounts for nearly 80% of sales, DeMaria says.
The company expects its agricultural unit's sales to grow by 7% to 9% next year. But analysts say Deere tends to offer conservative guidance and may be understating its prospects. Deere guidance suggests roughly $4.90 in 2011 earnings. Sterne Agee's De Maria, for example, thinks earnings could be $5.85.
Just under 80% of sales of CNH, whose equipment bears the familiar farm logos of Case and New Holland, are in ag equipment. Duluth, Ga.-based Agco, on the other hand, is a pure play for aggie believers.
Agco also seems to be in the right markets at the right time. It has a solid presence in Brazil, a strong growth area. And it's also a major player in Europe, where growth has been slow.
But Volkmann notes that there is significant "pent-up replacement demand" in Europe. Since Europe represents roughly 60% of Agco sales, it has much to gain from revived spending there.
"They have a solid position in Europe, where business is starting to get better," DeMaria said.
In the growing equipment markets of South America, machinery to harvest sugar and cotton are doing especially well. "Supply and demand for cotton and sugar cane have been out of whack," DeMaria said. Both Deere and CNH have sugar cane harvesters that have been selling well, he adds.
Beginning next year, equipment manufacturers will have to meet tougher new emissions standards. The pollution-fighting regulations will be phased in over a number of years. Analysts expect manufacturers to raise prices in hopes of passing on the added costs. This could be contributing to some advance buying to beat the higher prices in coming years on the lower-emissions machines.
Eli Lustgarten, an analyst at Longbow Research, sees "a cumulative 12% to 14% impact over multiple years" as the tighter standards are phased in. But he believes farmers will not back off buying pricier equipment.
"That's a head wind you'll have to deal with, but the farmers will be able to afford it," he said.
Healthy Crop Prices
Lustgarten is also confident that the good times in farmland will not swiftly reverse. For one thing, he says, crop prices should stay high even if growing conditions improve. The bad weather may have temporarily tightened supply, but heightened demand is the chief factor in strong prices.
Good weather will be needed next growing season just to "maintain stability" in prices, Lustgarten says.
"We're looking at materially higher prices for crops going forward," he said.
This should continue to bring in strong profits for farmers around the world. "We're looking at multiple years of strengthening farm income — and not just in North America," Lustgarten said.