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Thursday, April 15, 2010

Deere's Harvest


At Deere & Co., It hasn't been so easy being green lately. 
Since the Great Recession began in December 2007, Deere, the world's largest maker of farm equipment and a major builder of John Deere construction equipment, has watched earnings plummet by half. Construction sales worldwide fell by 45% last year alone, and agricultural sales sank more than 15%.

It is no small feat, then, that Deere earned $873 million in 2009 on sales of $23 billion. That's because the iconic manufacturer today is more focused on making profits than on just making tractors. Indeed, over the past decade, the firm's production capabilities have become leaner, smarter and faster as it has eliminated waste, pushed innovation and expanded its global footprint. "Deere's competitive advantage has always been a superior product and tremendous brand loyalty," says Morgan Joseph & Co. analyst Charles Rentschler. "But it performed better this down cycle than ever before because of the tight cost controls and excellent execution it already had in place."

Deere, of course, operates in two of the most cyclic industries around. The $87 billion agribusiness sector, dependent on commodity prices, is about as predictable as the weather. Still, Deere can count on the fact that people need to eat. Growing populations and incomes in places like China and India mean food output must increase. Indeed, it could double by 2050; globally, farmers have planted more corn, soybeans, rice and wheat for two straight years.

Construction remains troubled. Volumes shrank as much as 80% during the downturn's lowest point, about as much as in the Great Depression. Still, housing starts showed some signs of life in January, and after such a protracted drop, the $30 billion construction-machinery business can "expect a bounce as people simply need to replace equipment again," says Morgan Stanley analyst Robert Wertheimer. "So we do think there is a recovery at hand, though it could be in 2011, not 2010."

John Deere is a brand about as American as apple pie. It's headquartered in Moline, Ill., not far from where it started in 1837 as a one-man blacksmith shop making steel plows for sod-busting pioneers. Under John's son Charles, who served as CEO for 49 years, the modern Deere emerged, a network of factories and dealers supplying tractors, wagons and combines to farms nationwide. It expanded to Mexico and Europe in the 1950s, complete with construction products and then credit operations.

Yet Deere's strong performance in the most recent downturn is hitched to CEO Bob Lane, who stepped down in June. Lane diligently cut costs, pared unprofitable businesses and inventories. He also added a novel profit driver: a capital charge of about 1% a month that managers must "pay" before they can report any gain internally — in other words, 12% annual profit before break-even. During Lane's tenure, Deere saw record earnings, soaring free cash flow and a quintupling of its stock price.

When the housing bubble burst, a streamlined Deere was ready. Despite collapsing sales, it was able, for instance, to avoid major staff reductions — most of the 1,500 workers Deere laid off or furloughed are already back on the job — while maintaining enviable margins of nearly 10%. "Deere was ahead of the curve when it came to cost controls and data collection, so as soon as demand started to drop, it could shut down production and keep inventories low," says Alex Blanton, an analyst at Ingalls & Snyder. "That also means there will be little lag time in its recovery."

That recovery will be driven by the John Deere farm equipment unit, which still comprises 90% of its sales. Even here, Deere's gotten tough, canceling franchise contracts with smaller dealers — who, like the farmers, are deeply brand-loyal — encouraging them to partner with higher-volume dealership chains. "Our customers now have to drive more than an hour to get parts," says Roy Dufault, whose family-run franchise in Fosston, Minn., closed in October after 80 years of selling John Deere clothing, toys and other products. "At harvest time, if a tractor breaks down, an hour means a lot of money lost."

In reality, Deere is following its customers. For decades, smaller U.S. farms have been replaced by industrial, or factory, operations. It's not the storybook farm, but it's more efficient. "The amount of money a dealer has to invest to train its technicians or buy diagnostic tools continues to grow," says Deere CEO Samuel Allen, a company lifer. "So to be a great dealer requires making more money and that's gotten harder for smaller operations."

Another factor in Deere's shrinking U.S. presence is that its biggest opportunities will be overseas: 60% of its current business is in North America, 40% in the rest of the world. Allen knows that ratio will change drastically. "Emerging markets hold the most potential," Buckingham Research Group analyst Joel Tiss says. "It makes no sense to open a new dealership in Dubuque, Iowa, anymore when they could put it in Santiago, Chile, where they can do 10 times the volume." Sales in South America are expected to rise as much as 15% in 2010.

Likewise, Russia and Eastern Europe offer potential. Russia has arable land and is in need of a new fleet of farm equipment, and the government has put a priority on being self-sufficient in food and agriculture. The recession has made financing hard to come by in the region, but "Deere is planting the seeds for when the markets normalize," says Lawrence De Maria, an analyst at the New York brokerage firm Sterne Agee. Still, De Maria adds, "it's sticking with assembly factories for now so that if they had to pick up and leave, it wouldn't kill the shareholders."

Asia is a tougher row to hoe. The company opened a factory in Pune, India, in 2001 and has several operations and joint ventures in China. But the Indian tractor maker Mahindra & Mahindra has also begun selling its wares — less sophisticated but cheaper — in the U.S. "If Deere is making the Lexus or Mercedes of farm equipment, Mahindra is making Hyundai quality," Tiss says.

There are other challenges too. Deere has had to pump billions of dollars into engine technology to meet changing U.S. emission standards coming in 2011 and again in 2014 — costs it will pass on to customers through higher prices. "The 2011 product will go up several thousand dollars in price," Longbow Research analyst Eli Lustgarten says. "So when prices go up again just three years later, even the most price-inelastic customers will feel it."

Questions also persist about whether Deere should remain in the low-margin lawn-mower business and whether it should shed its construction unit. Allen downplays such concerns. "All of our divisions must meet a sustainable level of business," he says. "We're happy where construction is now."

Farmers today are even happier, since they now ride the most sophisticated John Deere ag equipment ever made. "Onboard GPS, leather seats, CD players — farmers fall in love when they walk into a Deere showroom," Rentschler says. "It's hard to resist buying the green."