This farm equipment manufacturer has a strong presence around the world and is therefore very well positioned to profit from growth in farming in the developing world. Increasing world population and a reduction in the number of farmworkers provides accelerating demand for efficient farming equipment. The company’s diversified revenue stream does also help to reduce weather related risks which play a major role in the farming industry. In addition, a wide range of products are helping the company to differentiate itself from its competitors. Apart from that, management makes substantial progress in improving profitability. On top of that, the company is currently in the process of repurchasing 10% of shares outstanding and seems to be focused on increasing shareholder value. Currently, the market seems to be afraid of a softer demand in the US and Brazil ignoring the progress in profitability and the long term growth potential for this company.
AGCO manufactures tractors (60% of revenue), hay tools and forage equipment (9%), grain storage systems and protein product equipment (7%), combines (6%), and application equipment (5%). In addition to sales of new equipment, the replacement parts business (13%) provides a less cyclical higher profitable revenue stream for the company. Since most of their products can be economically maintained with parts and service for a period of 10 to 20 years, each product that enters the marketplace provides them with a potential long-term revenue stream.
The company has established a distribution network of 3,100 independent dealers and distributors in more than 140 countries.
AGCO Finance provides retail financing (83% of total) and wholesale financing (17%) to Agco’s dealers. AGCO Finance is a joint ventures owned 49% by AGCO and 51% by Dutch Rabobank. The majority of the assets of the retail finance joint ventures represents finance receivables. The majority of the liabilities represents notes payable and accrued interest. Rabobank provides financing to the joint venture. So AGCO does not guarantee the debt obligations of the joint ventures (except from a small amount). The wholesale receivables are either sold directly to AGCO Finance without recourse from AGCO or AGCO Finance provides the financing directly to the dealers. The total finance portfolio in the joint venture was approx. USD 9.4 bn (88% of revenues) as of December 31, 2013. AGCO Finance’s assets are not consolidated on AGCO’s balance sheet and earnings of the retail finance joint venture are only included in “Equity in net earnings of affiliates” in the P&L. In 2013 the joint venture contributed USD 48.8 m to AGCO’s net income (8% of total net income).
The company generates 51% of revenues in the EMEA region (Europe, Middle East, Africa). Europe in general is a mature market dominated by replacement revenue where growth potential comes from new technologies. However, the management sees attractive growth opportunities in Eastern Europe due to underinvestment in the past and low productivity. The company has extended its dealer network to profit from a potential increase in investment activity in this region. Apart from that, the company is also planning to expand its operations in the African markets.
North America contributes 26% to revenues. An increase in farm income over the last couple of years has led to a strong market for farm equipment. In addition, given the low interest environment, farmers have been refreshing their fleet to lower the lease rate and renew warranties. For the coming years, the company forecasts a softer demand. This might be also due to an expiration of a tax break concerning the accelerated depreciation of equipment purchases. The company has a good position in the middle sized horse power segment. Nevertheless, going forward management wants to grab a higher share in the more profitable market for high horse power tractors. They have been working on improving and consolidating their dealership mainly due to a collaboration with the Caterpillar dealer network. In addition, they plan to import low horse power tractors from their plant in China to offer a low priced alternative to small farmers.
19% of revenues come from South America. AGCO has a very strong presence in Brazil with a market share of 40% in the tractor segment. AGCO lost market share to Deere over the last couple of years, as the world largest tractor manufacturer grabbed market share with a low price strategy. Over the long run, Brazil is expected to add 2% to 3% of new production capacity per annum. In addition, given AGCO’s large product range, the company also profits from a shift from standard products to special products. Farm income has been quite strong as Brazilian farmers profit from the weak currency and input costs in USD make up only 40% of total input costs. However, Brazil is currently suffering from a lack in financing due to a delay in the Government financing programmes and rising borrowing costs. This leads to softer demand in 2014. From January to May 2014 AGCO’ tractor sales declined by 16% year over year combined to 20% for the whole market. The decline has been lower for AGCO during the first two months of the second quarter while the market continued its weak performance (9% for AGCO vs. 18% for the market)
Currently, Asia plays a minor as the company generates only 4% of revenues in this region. In China, the company is still in the start-up phase. They have a new production site with a capacity of 30,000 tractors per annum located in Changzhou (close to Shanghai) exporting tractors mainly to the US and other developed markets. This is expected change as management wants to participate in the urbanization trend in China. As more and more farm workers move to the cities China needs higher efficiency production and agricultural machinery to develop their arable land. In India the, the largest market for low horse power tractors, the company participates through license payments from third party manufacturers.
Continuous extension of product range and product differentiation
AGCO is now focusing on internal product development and integration of existing brands. Historically, the company has grown through acquisitions. Acquisitions include Massey Ferguson in 1994, Fendt in 1997, Challenger in 2002, and Valtra in 2004. The recent acquisition of GSI in 2011 led to an attractive extension of the company’s product range as AGCO entered the market for grain storage and protein product equipment. In this segment, management sees ample room for growth for the following reasons:
GSI is a relatively high margin business and management is looking to shift revenues from GSI’s home market in the US to its European, South American and Asian markets. In terms of cross selling products, it also helps to differentiate its product range from larger competitors like Deere and CNH.
With regard to grain storage a relatively large share of grain harvest is wasted due to insufficient storage capacity in the emerging world. With increasing demand for food, this problem can be solved with improved food storage equipment. In addition, farmers are incentivized to invest more in food storage due to the increasing volatility of crop prices. Having the opportunity to store the harvest, enables them to wait for the right time to sell their crops to the market.
In general, an increasing demand for animal protein products in the emerging world is good for GSI. In addition, this segment is somehow countercyclical as lower grain prices increase profit margins for stock farmers which should lead to increased demand for protein product equipment stabilizing the overall business.
Operating Performance and margin enhancement
Over the last couple of years AGCO has been able to enhance profitability. Management targets a 10% operating margin within the next two to three years (2013: 8.4%). The progress in margin improvement is due to the following reasons:
Material costs make up a large portion of total costs. The company is in the process of converting from a regional purchasing organization to a globalized organization. As a result, better buying power is a key driver to reduce input costs and improve profitability.
In addition, management has been heavily investing in existing plants to achieve productivity gains. AGCO is a multi-brand company comparable to Volkswagen or GM in the automotive industry. To become more profitable, they are currently working on a platform solution (as Volkswagen did some years ago) to streamline production. Capital expenditures should reach its peak in 2014. This should translate into higher free cash flow margins starting from 2015.
On top of that, management focuses on the sale of higher horse power equipment to professional farmers in the developed markets to achieve margin enhancement.
Risks and Red Flags
In terms of working capital management, the company experienced a spike in its inventory levels in Q1 2014. The below table shows, that days sales in inventory jumped 25 days both quarter over quarter and year over year:
During the Q1 2014 conference call, management stated that they are “dissatisfied” with the current situation. They target an inventory level for the end of the year 2014 which is below the Q4 2013 level (DSI of 98). At least, comparing finished goods and replacement parts with raw materials and work in process there is no negative component divergence, as the increase in days sales in finished goods/replacement parts is in line with the combined increase in days sales in raw materials/work in process. This means that finished goods do not pile up in excess of raw materials and work in process which would be an indicator for future inventory write downs. Nevertheless, the run up in inventory is a concern and I will monitor this closely over the next quarters.
Apart from that and a potential economic downturn in AGCO’s markets, I see the following risks:
AGCO’s business model heavily depends on the availability of affordable financing and the credit quality of the finance portfolio. An increase in interest rates and/or a lack of financing provided by the company’s joint venture partner Rabobank could harm AGCO’s business. In addition, given the size of the portfolio relative to the joint ventures’ level of equity, a significant adverse change in the joint ventures’ performance would have a material impact on the company’s operating results.
Though the company is highly cash generative a significant portion of the operations are held through foreign holding companies. As a result, it is difficult from a tax perspective (as for most other US multinational companies) to repatriate cash back to the US. This hinders the potential of the company to return capital to shareholders.
In addition, in many markets demand for the company’s product depend on Government schemes and subsidies. Moreover, the company is currently profiting from low steel prices, which could change when excess capacity in the steel industry is reduced.
Valuation and competition
AGCO competes primarily with Deere and CNH. Deere is also involved in the forestry and construction businesses, while CNH derives part of its sales from construction and transportation. AGCO is the only major pure play on agriculture equipment. Below you can find a comparison of the three companies:
It is important to note that Deere and CNH consolidate their financing division in the financials, whereas AGCO does not. To compare the three companies, I excluded the financial division’s obligations to receive adjusted numbers for total debt (incl. pension liabilities and operating leases) and enterprise value. In addition, I adjusted EBIT and EBITDA for finance income and interest payments relating to the finance division. As a result, income from the finance division is only included on the net income level (P/E, ROE) as it is the case in AGCO’s P&L.
Deere seems to be more efficient than AGCO from an operational perspective. However, it becomes also clear that Deere’s high return on equity depends to a large extend on the company’s finance division. The same applies to a lesser extend to CNH. On the other hand, AGCO’s finance division seems to have a much smaller impact on net income.
Overall, Deere might have a better market position and advantages in terms of scale and distribution. However, I regard AGCO as less risky with regard to their balance sheet. AGCO will be affected by a deterioration of the finance portfolio, but the company is not liable for the portfolio. In addition, they carry less debt than Deere or CNH on their balance sheet. Compared to the two larger competitors, I view AGCO’s valuation as attractive given that further margin improvement might get AGCO closer to Deere’s level of profitability (ignoring income from the finance division).
Free cash flow approach: If we assume that AGCO is currently able to generate roughly USD 800 m of operating cash and that capex will go down to USD 300 m, then the company is currently trading with a price to free cash flow multiple of approx. 12x. From my perspective, this is an attractive multiple given the current market environment and the existing growth opportunities for the company.
AGCO’s sales depend on agricultural spending which is mostly driven by farm income. Farm income in the U.S. and Brazil has grown strongly over the last years. A slowdown of investment activity in these regions over the medium term is likely. However, AGCO has a strong global presence and should be able to profit from recovering demand in Europe and growth in other developing countries. In addition, margin improvement should help to compensate for lower top line growth. A solid balance sheet combined with strong cash flow generation, an attractive valuation and management’s commitment to return excess capital to shareholders completes the investment case.
Over the long run, an increase in protein diet per capita, a larger world population, less affordable labour available for farming and the need to increase crop yields due to a limited amount of arable land should provide for rising demand of AGCO’s products. From my perspective, AGCO is very well positioned to benefit from this scenario.
For the portfolio I purchase a 4% portfolio position at today’s VWAP.
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