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Plowing Into The 21st Century

Italy may be one of Europe's struggling economies, fighting to avoid being dragged into bankruptcy and out of the Eurozone by its looming sovereign debt. But that didn't keep Turin-based Fiat Industrial from nailing down a $1.5 billion deal to buy Illinois-based tractor maker CNH Global (CNH) in November.

The deal gives Fiat the 12% of CNH it didn't already own, as well as control of CNH's $5 billion cash war chest. Fiat, which owns Iveco trucks, plans to streamline CNH and merge the two companies into a new entity.

At about the same time, farm equipment maker Deere (DE) announced mixed fiscal fourth-quarter results, with sales above and earnings below analyst estimates. It guided 2013 sales expectations to 5% growth, less than half of this year's 13% gain and only slightly less flat than a Kansas corn field.

In the quarterly conference call, financial officer Raj Kalathur told analysts the looming "fiscal cliff" in the U.S. and slowing growth in China would likely have no "lasting impact on the powerful tail winds" the company sees driving "demand for agriculture and construction equipment well into the future.

Those tails winds are generated by global population growth expected to rise 16% to 8 billion by 2025, according to the U.N, Department of Economic and Social Affairs. A growing portion of that population is learning to love higher protein, better quality diets.

Another tail wind for farmers and equipment makers has been price pressure created by ethanol demand. A combination of tax credits and renewable fuel mandates helped boost corn used for fuel production more than 600%, to 4.5 billion bushels between 2000 and 2012, according the U.S. Department of Agriculture.

That made the farming sector one of the most successful segments of the U.S. economy, increasing farm incomes to record levels even as the rest of the country suffered through a recession. U.S. equipment sales shored up Deere and other equipment makers as global sales slipped.

IBD's Machinery-Farm equipment industry group gained ground in the fourth quarter, reaching a No. 43 ranking Friday, up from No. 147 at the start of September. CNH has posted the biggest gain so far for the quarter among the group's seven stocks, up 24%. It is up 34% so far for the year. That is just behind irrigation equipment maker Lindsay Corp's (LNN) 41% year-to-date gain and ahead of the 29% advance by Japan-based tractor maker, Kubota (KUB).

But analyst Charles Neivert at Dahlman Rose says the group faces challenges ahead, as U.S. farmers shift spending priorities for their businesses.

"Equipment isn't high on the list because of turnover rates on the equipment. Farmers already went through a phase of buying equipment, so unless someone invents something really new, growth will be harder," he said.

1. Business The United States remains the largest producer and exporter of corn and soybeans in the world. In 2012, it has exported nearly twice the amount of corn as its nearest competitor, Argentina, and more than 20 times the corn exported by the third largest exporter, China.

The U.S. is also the world's largest wheat exporter, but now ranks third in wheat production, overtaken by rapid growth in China, India and Russia. Global wheat production increased 179% between 1960 and 2012. The number of acres used to produce that wheat increased over the same period by only 7%.

Innovations in seed types, fertilizers and insecticides all contribute to that increase in efficiency. But so does expanding use of mechanical farming, with more farmers in more countries turning to more advanced tractors, combines and other equipment.

Deere's green and yellow leaping deer logo is an international symbol of successful farming. So is the triangle Cat logo of construction and agriculture equipment giant Caterpillar (CAT). Caterpillar is listed in IBD's Machinery-Construction/Mining group.

Lindsay is among the group's smaller players, providing crop-scale irrigation systems, as well as specialized construction barriers for road builders. AGCO Corp. (AGCO) owns a long list of international equipment names, including the Fendt and Massey Ferguson brands.

2. Market Farmers in developed economies might be forced to make changes to their equipment as the European Union and the U.S. pass rules reducing engine emission allowances. Rising farm employment in some developing economies could help boost farm equipment makers' international opportunities, but equipment needs in China and other developing nations are smaller than in the U.S.

Deere and Lindsay will continue to dominate the market in the foreseeable future.

"Market share doesn't change quickly in this business; changes are glacial," said Stephen Volkmann, an analyst at Jefferies. "What drives businesses is overall farmer sentiment, age of the fleet and the need for people to replace more equipment.

3. Climate More than any other industry, the weather affects the economic climate of the agriculture industry. The 2012 drought in the U.S. destroyed much of what was supposed to be the largest crop planted since World War II. The drought knocked down this year's corn yield by 17%, but the price rose 25%, Kalathur said in a phone interview with IBD. That kept most farmers on track to post a healthy year.

"Farmers' financial pictures are (doing) well. Those who didn't produce a crop had insurance so they weren't at a total loss, so they have money to spend," Neivert said.

How farmers will choose to spend their cash remains to be seen.

Overseas, the Ukraine also suffered a drought this year. The weather was more forgiving in other countries, providing opportunities for equipment makers.

"The Europeans and South Americans had a good year last year and produced a lot of crop," Volkmann said. "Deere made an effort to grow more overseas. Because they have a strong position in the U.S. they are looking to balance out the U.S. cycle with the non-U.S. cycle.

4. Technology Farmers have always been at the forefront of technological development. Deere was founded by a 19th century blacksmith who innovated a steel edge for horse-drawn plows. CNH, formed in the combination of the Case and New Holland companies in 1999, is descended from Jerome Case who manufactured the country's first successful threshing machines.

Today, Deere offers unmanned tractors, able to operate without a driver, freeing up a worker for other jobs. GPS mapping helps farmers get the biggest yield out of the sprawling farms that blanket the Midwest. Deere's new model 7760 cotton picker not only harvests the cotton, but also rolls it into bales, then wraps the bale.

Other companies, including electronics maker Trimble Navigation (TRMB), provide laser and satellite guidance equipment. These allow farmers to grade fields perfectly level, which helps to retain water applied by irrigation equipment. It also enables farmers to grade fields to a prescribed tilt, so that chemical runoff can be directed into catchments.

The key, Kalathur says, is spending to develop precisely what farmers need most.

"We don't provide technology just for the sake of technology," Kalathur said. "We do it to understand the need of the customer.

5. Outlook Volkmann sees flat growth in North America for the industry in 2013. Brazil, on the other hand, will see double-digit growth while European sales will rise slightly.

"Longer term, I think we are near peak in North America," he said. "But that should continue at these high levels for several years absent some kind of external event. In Europe and Brazil, and in other emerging markets, I think there will be a need for agriculture infrastructure growth for the next several years.

Upside: As severe as the drought was, it might actually be good news for farm equipment makers.

"After drought years we have seen an increase in equipment sales," Kalathur said, citing 1988 and the mid-'90s as booms in equipment sales.

Deere gave flat guidance for 2013, but it is hoping that growth will kick in from developing markets in the long run as the markets mature. Deere's long-term goal is to have 50% of its sales originate outside the U.S as developing markets mature.

Downside: Farm equipment sales have been growing for the past 10 years, the typical length of an industry growth cycle, according to Volkmann. Farms may use the extra cash from high crop prices to buy seeds or goods other than equipment.