|Shares Out. (in M):||87||P/E||0||0|
|Market Cap (in M):||3,832||P/FCF||0||0|
|Net Debt (in M):||1,018||EBIT||0||0|
AGCO is in the midst of a multiyear industry downturn, which has created an opportunity for patient investors to buy a solid industrial company at a good price. AGCO is attractive because of its valuation, exposure to the more stable European market, internal margin initiatives, strong balance sheet, and the potential for value enhancing capital allocation and M&A decisions.
AGCO is a leading manufacturer and distributor of agricultural equipment. It sells a full range of equipment, including tractors (57% of 2014 sales), combines (6%), application equipment (5%), hay and forage equipment (9%), grain storage and protein production systems (9%), and replacement parts (14%). It has well known brand names like Challenger, Fendt, GSI, and Massey Ferguson. There are 3,100 dealers and distributors in more than 140 countries. AGCO also provides retail financing through a JV with Rabobank. For the year ended 2014, AGCO’s geographic breakdown was as follows: EAME 53% of sales (of which Western Europe is ~95%), North America 25%, South America 17%, and Asia/Pacific 5%.
At $44 with 87.1 million shares outstanding, AGCO has a market cap of $3.8 billion. It has $498.2 million of cash and $1.515 billion of debt for an enterprise value of $4.85 billion.
The opportunity in AGCO exists because the agricultural equipment sector is in a severe downturn. The industry experienced a very strong up cycle leading to a peak in 2013 that was driven by ethanol mandates that dramatically increased corn demand and tax stimulus following the financial crisis, among other factors in North America. Brazil benefitted from strong a macroeconomic and commodity environment in general, as well as increasing government subsidies. The tide has turned and those markets are now experiencing dramatic declines. As of 2Q15 North America tractor units are down 10% in 1H15, but higher margin high horsepower tractors and combines are down 25% and 37%, respectively. Europe tractor and combine units are down 8% and 15%, while in Brazil they are down 19% and 32%, respectively.
Inventories remain elevated in North America and pose a risk that the market has not found a true clearing price yet. AGCO usually has about 5-6 months of dealer inventory in the US and currently sees about 6 weeks of excess. AGCO expects its dealer inventory to be at normalized levels by the end of the year, but DE expects it to take through 2016 to get to more manageable levels, so despite managing through the downturn well, this will likely weigh on results. Europe inventories are actually at normal levels with about 3 months. AGCO is still playing catch up in Brazil because they lowered inventory to about three months, but then conditions deteriorated more than expected, so they have continued to draw them down and should be near normal levels by yearend.
Needless to say, sentiment on the stock is very negative. There is only one buy rating, while there are eleven holds and three sells. Additionally, about 16% of shares outstanding are short.
While not trying to call a bottom and at the risk of being early, AGCO has less exposure to some of the more problematic areas of the industry. Two years have also passed since the peak, so the challenges are well known and discounted to some degree. AGCO has some company specific initiatives that will also allow it to weather the storm better than some of its peers. Further, due to the oligopolistic structure of the industry pricing has remained strong during the downturn.
Over half of AGCO’s sales are in Europe, which is relatively stable compared to the rest of the world. EAME sales will decline around 20% this year, but European orders turned positive 2Q15, so there are some early indications that the region is stabilizing. German tractor sales are also slightly above their historical growth rate. Europe in general did not enjoy quite the boom that the rest of the world did leading up to the last peak, so it is experiencing less of a hangover now. Europe also has older fleets than North America and Brazil, so there will be more demand from a natural replacement cycle. Europe is also AGCO’s most profitable region with $134.6 million of operating income in 2Q15 compared to consolidated EBIT of $149.9 million, so other regions will continue to be a drag on AGCO earnings, but Europe should provide some much needed stability.
Brazil will certainly get worse before it gets better, but AGCO sales to South America will be down about 40% this year from the peak 2013, so much of the damage has already been done. South America will also probably only be about 15-16% of total sales in 2015, so its impact on the overall top line is becoming less important. Brazilian farms tend to operate all year round, whereas in North America and Europe there is one planting season, and in certain segments of the market, like sugarcane, farms operate 24/7, so there is much more wear and tear on equipment, which drives a shorter replacement cycle. The weaker BRL is also helping export crops like soybeans boosting farm incomes, although the downside is that it is much more expensive to buy imported equipment.
Ag equipment manufacturers will continue to feel the pain in North America, as well. The USDA expects farm cash receipts to fall 7.7% in 2015 and DE’s forecast for 2016 calls for another 1.4% decline, so next year will be another down year, but the trend appears to be moderating. There is anecdotal evidence that farmer balance sheets are better this cycle with lower debt levels than in previous cycles, and that land rents will reset lower next year, which should also bolster famer incomes.
Aside from being slightly more insulated from the vagaries of the cycle compared to peers, management has a number of internal initiatives that they believe will allow them to eventually earn 10% operating margins. There has been a headcount reduction of 10% and there are lean and six sigma programs in place that have generated $150 million of savings. Management is also focused on enhancing margins through better engineering, so there are initiatives to increase commonality of components across platforms and to globalize the procurement process. Material cost reductions with fairly strong pricing have already resulted in less decremental margins this cycle than in the past. Margins are also very volume dependent. The resilience of margins thus far in this downturn speaks to the operating leverage AGCO can achieve when unit volume recovers.
Despite the severity of the downturn in North America and Brazil, AGCO is managing its business well. Due to the cost reduction programs its margins are holding up better this cycle than in the past as discussed above. Even though sales are falling, AGCO is realizing price increases of 1-2% this year, which is partially due to rational behavior in the industry, and partially due to execution. AGCO is also taking various actions to increase the usage of internally sourced spare parts. It also acquired GSI in 2012, which addresses the grain storage and protein production markets, which are performing better than much of agriculture and should be less cyclical over time.
AGCO holds a 23.75% interest in the #2 tractor manufacturer in India, Tractor & Farm Equipment Ltd (TAFE). TAFE is a private Indian company, so it is not easily valued, nor will it be readily monetized, but it is valuable nonetheless. TAFE’s revenues are approximately $1.7 billion and it is attractively positioned in a good growth market. Valued at 1x sales, similar to the industry leader Mahindra & Mahindra, AGCO’s interest would be worth $400m. TAFE also owns 12.2 million shares of AGCO, which is just under its limit according to an agreement from 2014. TAFE’s CEO, Mallika Srinivasan, joined AGCO’s board of directors in 2011. TAFE most recently purchased 547,000 shares in September near current levels. There is potential for this relationship to be expanded both operationally and through M&A.
Beyond the current efficiency programs, AGCO needs to rationalize its geographic footprint. AGCO has a strong market position in Europe and Brazil. However, Asia/Pacific has always struggled with unprofitability. And while AGCO at times earns good margins in North America, it is a subscale #3 in the region with 6% market share. Its revenue/dealer is $1.8 million, almost a quarter of DE’s productivity. Given this lack of scale, management should be considering all options including M&A. Antitrust concerns in North America and Europe would probably prevent DE or CNHI from acquiring AGCO, but there has been some speculation of some sort of tie up with TAFE. Kubota in Japan has also been expanding its product portfolio and geographically into areas that have historically been among AGCO’s strengths, so this would be a natural fit.
There is a $500 million share repurchase authorization in place through 2016, of which about $125 million was bought back through 2Q15. Management has said they would like to remain investment grade, but they have room to expand the buyback meaningfully given the strength of the balance sheet. Another $500-750 million repurchase would not be a stretch, which could mean another 15% or shares outstanding on top of the 13% they bought back over the past couple of years. Blue Harbour recently increased its position and filed a 13D, likely focusing on capital allocation decisions, among other facets of the business.
Margins are holding up better through this downturn due to the reasons discussed above, so even though revenue will be down 20% (11% from currency translation) this year margins are only compressing 140bps to 5.7%. AGCO should earn about $3/share in 2015. 2016 revenues could be down mid single digit, so EPS could fall into the $2.85 range. From there the top line will recover in the 2017-2018 timeframe to ~$8 billion. With some operating leverage, but without all of the benefit of its current margin initiates, it could earn 8% operating margins, which would equate to about $870 million of EBITDA and $4.50 EPS, so in this scenario the stock could rise 50%. Giving AGCO credit for its $400 million TAFE stake would lower the EV/EBITDA multiple by about half a turn.
Longer term in the 2018-2019 timeframe, AGCO unit volumes will recover with good operating leverage. If it were to hit $10 billion in sales (compared to $10.8 billion in 2013) and achieve operating margins of 10%, it would generate $1.3 billion of EBITDA and $7.25/share, so it is trading at 3.75x and 6.1x respectively, which also gives the company no credit for further share buybacks, which will undoubtedly happen. If this scenario were to come to fruition I could see the stock nearly doubling over the next three years.
In the event that spending on agricultural equipment falls further than expected in 2016, EPS could fall to $2.50, so there could be downside to $38 based on 15x trough earnings, which I would view more as cyclicality than a permanent impairment of capital.
Time, which admittedly isnt that exciting.
|Entry||10/20/2015 11:18 AM|
Thanks for the write-up. Do you know where in AGCO's financial statement TAFE earnings would flow thru (i.e. looks like affiliate income and Investments in Affiliates are mainly the financing JV)? Overall their's not much disclosure in the 10K about it. thx
|Entry||10/21/2015 06:56 PM|
Drew, it’s an interesting question. Unfortunately, the disclosure is pretty lacking here, so the opacity and illiquidity of the position have led me to not include in the valuation, but it is worth keeping in mind as a call option. I also figured it should be accounted for under the equity method, but mgmt told me that they use the modified cost method since they do not have significant influence. They do receive a small amount of dividends that are recorded as miscellaneous income. Being a private, Indian company TAFE does not have any reporting requirements. The info on the dividends is in the related party section. Per the 2014 10K:
During 2014, 2013 and 2012, we purchased approximately $149.0 million, $90.7 million and $104.5 million, respectively, of tractors and components from TAFE. During 2014, 2013 and 2012, we sold approximately $2.1 million, $0.8 million and $0.3 million, respectively, of parts to TAFE. We received dividends from TAFE of approximately $1.8 million, $1.6 million and $1.3 million during 2014, 2013 and 2012, respectively.
Hope this helps.