Will Agriculture Companies Get Burned By Scorching Weather?

(By Jeffrey Stafford) With extremely hot and dry conditions in the U.S. Corn Belt so far this growing season, the prospects for bumper corn and soybean crops are withering. Farmers in the United States stepped up planting this year to take advantage of high crop prices and to return stocks/use ratios to a more normal level after a couple of seasons of tough weather. However, Mother Nature has reminded everyone that weather has the final say on crop production year to year.

We see the scorching conditions and rising crop prices as a potential boon for some agriculture companies. However, our enthusiasm comes with caveats. While a little bit of bad weather can be a major plus for farmer economics, an all-out crop disaster has sent farmer cash receipts reeling in the past. Our take: The offsetting effects of higher crop prices and lower yields ultimately will determine the final impact on farmers' wallets, and thus the amount of money growers have to spend on seeds, chemicals, fertilizers, and equipment for the 2013 season.

Unfortunately, with Mother Nature holding all the cards, the near-term outcome becomes difficult to predict. In the long run, we still think weather will normalize and crop stocks eventually will be replenished. Thus, the current conditions have little impact on our fair value estimates for agriculture companies.

Crop Rapport: Lower Yields and Cash Receipts

Damaged by sweltering heat and insufficient rain, corn crop conditions are deteriorating by the day across the Midwest. In its latest Crop Progress report from July 30, the portion of the corn crop that the USDA rated as "good" or "excellent" dropped to 24%, compared with 62% in the previous year. Since June 11, the proportion of the crop rated good/excellent has dropped a massive 42 percentage points from 66%. For soybeans, 29% of the crop is rated good/excellent, a drop from 60% on June 11.

Corn and soybean prices have responded by rebounding, providing a natural hedge for farmers likely to suffer from lower yields that dent the volumes U.S. growers bring to market in the fall. However, the final effect on cash receipts is still unsettled. Since 1980, gains in corn prices have only fully offset significant year-over-year yield declines about half of the time. For example, in 1988, the yield per planted acre declined 32% compared to the prior year, while average corn prices at the farm level increased 31%. With differences in planted acres between the two years, the net impact on total corn cash receipts was a 10% year-over-year decline. Further, in 1983, yields declined 31% year over year, while corn prices only advanced 26%. On the other hand, in 2010, when yields dipped 7%, corn prices increased 46% and cash receipts advanced 37%. In our opinion, a yield disaster in 2012 probably would look somewhat like 1983 and 1988, when corn cash receipts declined 36% and 10% year over year, respectively.

With a small data set and inconclusive results in down yield years, it's hard to predict what will happen to farmer cash receipts. The outcome for farmers this season will also depend on what higher corn and soybean prices do to demand. A further price spike likely would lead to feed rationing and harm margins for ethanol producers. Significant demand destruction could pull prices back down later in the year.

Beating Around the Bushel
Our calculations show that at corn prices of $7 per bushel, yields would have to decline to about 120 bushels per harvested acre for cash corn receipts to shrink compared with last year's record levels. If we assume $6 corn (which is more in line with the most recent USDA estimate for average farm price for the current marketing year), then yields would only have to drop to about 140 bushels per acre for a year-over-year decline in corn cash receipts. Yields were 147 bushels per acre last year, and the USDA's current estimate (as of July 11) calls for 146 bushels per acre this year. The 1995 season marks the last time corn yields fell below 125 bushes per harvested acre. For soybeans (at prices of $15 per bushel), yield would have to decline to about 35 bushels per acre (compared with 41.5 in 2011 and the USDA's current 2012 estimate of 40.5) to see a year-over-year decline in soybean cash receipts. For reference, last year was a very good year for farmer cash receipts, and even flat receipts this year would mean an excellent year for farmer economics. According to the USDA, crop cash receipts totaled $197 billion in the U.S. last year, compared with an average of $172 billion from 2008-10.

While our analysis shows that farmers' wallets are still looking quite healthy, a number of caveats should be noted. First, with recent weather forecasts lacking meaningful rainfall in the U.S. Corn Belt, yield estimates could deteriorate further in the coming months.

Second, the impact on the individual farmer should not be ignored. For example, Farmer A in Iowa fights through tough weather to harvest a crop marginally below trend-line yields and benefits greatly from the natural hedge of rising corn prices; Farmer B in Illinois has to totally abandon his crop and rely on insurance payments, seeing a significant decline in revenues and having less money to spend the next season on crop inputs and machinery. With the ability of Farmer A to increase his acreage next year limited by the land he already owns, the impact of total cash receipt growth on crop input purchasing in 2013 could be limited by Farmer B's depleted wallet. We have heard anecdotal evidence that some farmers in Illinois are indeed contemplating cutting current crops for silage.

Third, farmers abandoning corn crops could drag down the ratio of harvested acres to planted acres. In the drought year of 1988, 86% of planted acres were harvested compared with an average since then of about 91%. If we assume only 86% of corn acres are harvested in 2012 (the current USDA estimate is 92%), then the corn yield per harvested acre would need to drop to 130 bushels per acre for total corn cash receipts to decline compared with last year, assuming $7 per bushel of corn. At $6 corn and 86% of planted acres harvested, yields would have to beat the current USDA estimate of 146 bushels per acre for total cash receipts to stay flat compared with last year.

Certain Firms Will Weather the Lack of Storms
The recent crop conditions have not changed our long-term outlook for agriculture companies with economic moats, such as  Monsanto (MON),  Potash Corporation of Saskatchewan (POT), and  Deere (DE). We think these firms are best equipped to handle the ups and downs that weather brings to the agriculture market. From a valuation standpoint, wide-moat PotashCorp looks the most attractive with a 4-star rating.

In the near term, bad weather and higher crop prices have provided a boost to seed, chemical, fertilizer, and equipment companies. We expect the gains to hold if demand is not destroyed by higher crop prices. With higher crop prices and cash in their pockets, farmers likely would plant another large crop in the U.S. next year, setting the stage for another strong volume year for crop inputs. For example, in both of the last two seasons, corn yields have declined year over year, but the decline has been more than offset by much higher corn prices, leading to higher revenues for farmers. Even if crops were to deteriorate further and cash receipts for the current crop were to fall compared with last year, it's not a foregone conclusion that 2013 purchases of seed, pesticides, and fertilizers would decline. In fact, according to USDA data, the drought years of 1983 and 1988 were followed by year-over-year growth in expenditures for seeds, pesticides, and fertilizers in 1984 and 1989. In 1989, dollars spent on seeds climbed 8% compared with the prior year, while pesticide purchases advanced 21% and fertilizer spending grew 6%. However, it's worth noting that during the drought years of 1983 and 1988, sales of pesticides declined (10% year over year in 1983 and 8% year over year in 1988). We theorize that farmers giving up and plowing crops for silage early in the season reduced the amount of pesticides sales later in these years. As such, companies in the crop chemical market could see some pressure if the percentage of acres harvested to acres planted slumps further. Of the companies in our coverage universe, we think    Syngenta (SYT) is the most exposed to potential weakness.

For equipment, the potential outcomes look a little different based on historical results. Although the recent weather headwinds likely will lead to increased prices and higher cash receipts for farmers, we caution that circumstances of increased receipts driven by reduced domestic yields have led to lower demand in the past, as the psychological effect on farmers of a "bad" harvest year can cause reluctance to purchase. Most recently, for instance, the difficult weather conditions last year led to a massive increase in cash receipts (nearly 30%), but just a single-digit year-over-year climb in high-horsepower tractors. As another example, rapidly declining conditions in 2002 led to poor harvested corn acres as a percentage of planting area, driving down production levels and yields; we saw a similar situation in 2006, with both cases showing positive year-over-year cash receipt growth but declining high-horsepower tractor sales.

As a result, we wouldn't be surprised to see sales of farm equipment show slow growth over the immediate future, particularly for combine harvesters due to their reduced necessary usage in a low-yield environment. That said, we think tractor sales during next year's planting season could benefit from another round of record acreage, potentially boosting volume for market-leader Deere.

Jeffrey Stafford, CFA, is an equity analyst for Morningstar, covering agriculture and chemical companies.