Deere Ready to Grow in a Corn-Crazed World

Ethanol fever and developing markets put the farm-machine maker in a sweet spot.
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The best investments in 2007 were in energy and agriculture, as prescient investors profited from emerging countries' need to supply their fast-growing economies.

And so far this year, the trend continues. Seed, fertilizer, pesticide and farming-equipment companies have been among the few to avoid ruin in the first two weeks of 2008.

I spoke with veteran speculator Jim Rogers about this phenomenon late last month, and Rogers, a trading partner with George Soros, said ag was essentially the only sector he likes. Rogers is talking his own book, to be sure; he has created indices and exchange-traded funds that make the purchase of grains and other soft commodities easier for nonprofessionals. But that shouldn't prevent us from listening.

"The number of acres devoted to wheat farming is at a 30-year low while inventories of food worldwide are at their lowest since 1972," Rogers says. "With so much corn going into our tanks as ethanol, a growing middle class worldwide eating more corn-fed meat and wearing more cotton than ever, agriculture has a great future, if you ask me, and that's why I'm buying."

How to Play the Cornfields

One of my favorite plays in the space is farm-equipment maker


(DE) - Get Report

. It's been on a tear lately, so it's buyable only on dips, but you really need to make sure it's on your list of names to pick up on big down weeks.

While you may not think that an agricultural company like Deere should be grouped with energy companies like



, which I

wrote about earlier in the week, in truth, agriculture and energy are becoming synonymous.

Just look at the number of cornfields sprouting up to meet ethanol demands in the Midwest. As fuel prices continue to soar, fermented corn takes up an ever-growing portion of your fuel tank. Mandated ethanol production is lousy policy, popular in corn-growing states with undue influence on presidential elections. Nevertheless, the government has cynically decided that ethanol will continue to play a role in new energy until other, more environmentally friendly alternatives make economic sense.

As a result of this recent increase in ethanol production, food prices are also on the rise. And these prices are being pushed up even farther because of supply constraints stemming from crop failures, droughts in Australia and demand surges in emerging markets.

This is bad news for U.S. consumers who, on top of paying higher prices at the pump, are now shelling out more for groceries. On the other hand, it's a good time to be a farmer -- or an equipment vendor selling into this cash-rich sector.

Growing Season

In sum, it's party time at Deere, the world's largest maker of farm tractors, combines, seeding equipment and the like. With all their newfound wealth, farmers across the world are upgrading old equipment with state-of-the-art machines. The expert on the matter, the U.S. Department of Agriculture, reports that farm incomes grew a whopping 26% in 2007 to a record $87 billion on the back of higher corn, wheat and soybean prices.

If this sounds strange to those of you who remember Farm Aid concerts in the mid-1980s, you're on to something. Pricey food is definitely a recent phenomenon. Accounting for inflation, world food prices fell significantly between 1974 and 2005, but things have since quickly reversed; prices of all major crops are at or near all-time peaks.

The Economist's

food price index, which has been tracking food prices since 1845, is at all-time highs after rising 30% over the past year.

Despite a crippling drought in the important Murray-Darling river basin of Australia, price increases came during a record-setting season for crops. According to the International Grains Council in London, more than 1.83 billion tons of cereals were harvested in 2007, representing an increase of nearly 100 million tons over the previous year. If the greatest growing season in history could not slow rising food prices, you know that something epic is at hand.

The global community is now drawing down food stores at a frightening pace. According to the U.S. Department of Agriculture, the ratio of global food stocks to the amount used each year is falling for all major crops. In fact, stocks-to-use ratios are now at 36-year lows for wheat (less than 18%) and corn (14.5%).

In the Tank

It's no wonder, given the outsized impact that energy production and developing countries have on the supply-demand balance. Take the wild inefficiency of ethanol: Each time someone fills up an SUV with a tank of ethanol, enough corn to feed one person for an entire year is lost. More than a third of America's corn harvest will be going to the production of biofuels this year. In 2000, the U.S. converted 16.5 million tons of corn into ethanol. Now, it's more like 100 million tons.

Rising incomes in places such as China and India, where the swelling middle class wants to eat more chicken and beef than tofu and rice, are also affecting food prices. According to

The Economist

, world meat consumption has historically grown in line with economic growth, and things are no different this time, as the world economy enters its fifth straight year of growth. Meat production is also a relatively inefficient use of grain; it takes nearly 18 pounds of grain to produce a single pound of beef.

Looking forward, I don't see the need for harvested goods softening anytime soon -- ethanol is catching on as an alternative energy source because of a government mandate, and development in emerging countries will keep grain harvests in strong demand. Farmers will have to adjust their work capabilities and schedules to match these demands. We have already seen farmers plant more cornfields and search for ways to boost output to capitalize on the ethanol craze.

This is where Deere fits into the story, since the only way to boost farm results is to plant new land or boost harvest yields. Both require more equipment. This expansion takes time. In addition, most of the virgin arable land around the world is located in Sudan, Kazakhstan and Brazil, the first two of which are vulnerable to climate changes and political unrest. Global warming is expected to reduce total farm output by one-sixth over the next 12 years as droughts and desertification become more commonplace.

For these reasons, I expect both food prices and farmer incomes to remain elevated. I'm not alone in this outlook, as both the United Nations and the International Food Policy Research Institute expect prices to rise by about 20% through 2015.

Deere is rapidly preparing itself for this new reality. New Deere tractor factories have sprung up in Brazil, India and China. And Deere's new glass-encased technology research center is now operating in India. These expansions will boost production capacity and allow the company to turn out tractors and combines that boast higher speeds, reduced harvesting losses and greater fuel efficiency.

More than 50% of Deere's $24 billion in sales come from farm equipment, so I'm looking for overall revenue growth in the double digits through 2010. Although the company has some exposure to the housing downturn through its consumer equipment segment, this should be more than offset by farming strength.

Earnings per share should come in well above consensus this year. I'm projecting $5.74 in 2008 and $7.20 in 2009. If you put a reasonable 18 multiple on the 2009 estimate (the P/E is currently 22), you get a target of $130, which is 45% higher than the current quote. Now that the big picture behind this idea is clear, I'll explore Deere's operations in more detail in a few weeks.

P.S.: If you want to learn more about how I got onto the agriculture theme last year and how you can do the same with the next big investment phenomenon, check out my new book,

The New Day Trader's Advantage


At the time of publication, Markman was long Deere, although positions may change at any time.

Jon D. Markman is editor of the independent investment newsletter

Strategic Advantage. He also writes a regular column for

MSN Money. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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