Deere in the Headlights

The farm-equipment giant gets punished by Wall Street after high raw material costs squeeze its profits. But by some measures the company's prospects couldn't be better

Rising commodity prices are a two-edged sword for Deere (DE), and on Aug. 13 the heavy machinery maker got sliced.

Shares of Deere at one point plummeted 12% after third-quarter results showed raw material costs eating into the company's profit margins.

Deere posted fiscal third-quarter earnings of $1.32 per share, up from $1.18 a year ago. Revenue rose 17%. Agricultural equipment sales rose 35%, while sales at Deere's other, smaller business units—commercial and consumer equipment, and construction and forestry—fell by single digits.

A 12% increase in profits is nothing to sneeze at. Wall Street, however, was expecting earnings of $1.36 per share.

One big reason for the shortfall was higher raw material costs. Freight and material costs for Deere rose $140 million from a year ago, and the firm expects those costs to jump $425 million to $475 million for the entire year.

But commodity cost increases aren't just hurting Deere—they're also helping.

Shopping for New Tractors
Farmers around the world are benefiting from higher crop prices, giving them more cash to buy up Deere's tractors and other agricultural equipment.

"Farm conditions remain quite strong throughout the world, driving our [agricultural] operations at an unprecedented level," Susan Karlix, Deere's manager of investor relations, told analysts on Aug. 13. "The big picture still looks good," she added.

While higher costs for steel and energy are hurting Deere, its customers love the higher prices their crops get at market.

Recently, the price of many commodities has fallen from record highs—including both crops and energy. But farmers are still doing well: Deere raised its 2008-09 forecasts for corn, wheat, soybeans, and cotton on Aug. 13. For example, corn is expected to be priced at $5.50 per bushel, up from $3.04 just two years before.

As a result, demand for agricultural equipment is booming. Deere raised those forecasts on Aug. 13 as well, with the industry's retail sales expected to rise 20 to 25% in the U.S. and Canada, and a 40% jump expected in South America.

Deere is investing heavily in places such as Brazil to meet the growing demand for its equipment.

Pricier Gear
Another benefit of growing demand and wealthier customers? Deere can raise prices to make up for its higher costs.

In fact, Karlix insisted that higher raw material costs were "a near-term issue." Deere plans to raise prices on its 2009 combines by 9% to 10.5%, she says. Higher prices should show up in earnings results in early 2009, she said.

Wachovia (WB) analyst Andrew Casey expects "most of the input cost issues to be behind" Deere beginning next year. "We would be buyers of the stock on weakness with a view toward [fiscal 2009] earnings growth re-acceleration," he wrote.

Despite this quarter's shortfall, "[agricultural] fundamentals and operating performance remain strong," wrote JPMorgan (JPM) analyst Ann Duignan.

Although Deere's earnings report rattled investors, by the end of trading on Aug. 13 shares had battled back. Deere shares closed above $67, down 3.3%.

That suggests at least some investors recognize that while higher costs are hurting Deere now, the company is poised to benefit from elevated commodity prices for years to come