It can be difficult to find companies that are both well run, thrives in an essential industry, generates high returns on capital while it also trades at low multiples. Especially in these days where more and more people tend to forget risk and instead chase rewards creating unfavorable risk/reward scenarios. Nonetheless, a company with these aforementioned mentioned characteristics seems to be what I have stumbled upon recently.
AGCO Corporation (AGCO) generated revenues of nearly $11 billion and had 22.100 employees in 2013. The company focuses on the development and manufacturing of farming machinery to the global agricultural industry. Typical products include tractors, combine harvesters, garden and park machines, material handling equipment as well as storage facilities. AGCO also sells spare parts and offers various after-sales services. The customer base extends from small farmers to larger industrial customers. The products are sold through its network of 3.150 independent dealerships in 140 countries. AGCO tries to expand its global reach while maintaining the local feeling for the customers, hence one of the company slogans: "reach further, stay closer". In 2013, 51% of the turnover was realized in the EMEA region (Europe, Middle East and Africa), 19% in South America, 25% in North America and finally 5% in Asia. The vast majority of sales in the EMEA region happens in Europe, and tractors make up 60% of the company's total revenue. AGCO focuses growth on emerging markets which in general fights with inefficient agricultural sectors and thus low crop yields compared to the industrialized countries. AGCO is an exciting company with high returns on capital, impressive growth, low debt, a positive outlook and last but not least a cheap valuation.
AGCO was founded in 1990 when the German company, KHD (Klöckner-Humboldt-Deutz), sold its North American subsidiary, Deutz-Allis Corporation, to a group of the subsidiary's own executives. KHD had five years earlier in 1985 purchased Deutz-Allis, which until then had served as the agricultural division of Allis-Chalmers Corporation - A highly regarded American manufacturer of agricultural machinery founded in 1901 especially known for its iconic orange tractors. Following the sale of Deutz-Allis, the management changed the company name to "AGCO" (Allis-Gleaner Corporation), and the ownership was once again American. The management is known to have made sound acquisitions over the years, and despite a number of acquisitions since 1990, only $1.1 billion goodwill has been generated. Even though the AGCO name is young, it possesses extremely strong and recognized quality brands which include Massey Ferguson who dates back to 1847.
AGCO is focused on providing high quality solutions to farmers by developing products that increase crop yields - a crucial issue in global agriculture as the global population increases while the middle class expands, which creates the need for ever-increasing amounts of nutritious food. AGCO's primary brands include Challenger, Massey Ferguson, Fendt, Valtra and GSI. The latter is an exciting new play focused on storage facilities for yield optimization and protein production. Better storage facilities minimizes post-harvest losses while the farmer can store the harvest for a longer period of time and thus "time" the market better regarding the prices of his crops. Here exists a huge growth potential in all regions - especially in the developing countries. The four other brands offer their own types of tractors, harvesters etc. Moreover, the company's know-how and products are state-of-the-art.
The management is keen on maintaining this position which is why R&D constituted more than 3% of the revenue in 2013 or a total of $353 million. This has resulted in a very strong pipeline. AGCO expects to introduce 16 new harvest products during 2014 and 24 in the period 2015-17. This includes product upgrades. AGCO is also in the process of rolling out its new innovation, "Fuse Technologies", which is technology that interconnects, coordinates and provides an overview of the farmer's activities. Machinery and equipment thus interact with software that makes the farmer capable of monitoring his farm activities on his computer, phone or tablet. This may also work as an incentive for farmers to use more products from AGCO. The long-term goal is to reach an EBIT-margin of 10% from the current level of 8% through product innovation, cost efficiency and demand growth.
In spite of great historical growth the company has encountered difficulties in 2014 for which reason the management expects total revenues of $10 to $10.3 billion (-6%). $5.1 billion was realized in the first half of 2014. Falling commodity prices have resulted in lower profits among farmers who therefore postpone the heavy investments. A good harvest and favorable weather conditions worldwide resulted in large harvests and therefore also a high supply, which has resulted in declining prices. As an example, the futures prices on corn, wheat and soybeans have fallen 55%, 39% and 37% from their 3-year highs, respectively. Management did, however, announce that their new products had been well received by the market in the first half of 2014.
It is estimated that the positive effect from cost reductions and productivity improvements will offset the declining revenue, why the EBIT margin is likely to remain above 8 percent. However, AGCO's large inventory of $2.4 billion may indicate that the industry is encountering a partial demand peak. The global agricultural investment cycle indicates a slowdown, and thus 2014 and 2015 are likely to be years of lower activity. The management has announced that the inventory will be significantly reduced towards the end of the year - especially with regard to increase the cash inflow which is needed to reach the cash flow goals for the year. This is the current situation, but there is a broad consensus that the long-term megatrends will result in strong commodity prices. I will elaborate on these subjects later in the article.
The company uses these challenging times to streamline the business, thereby streamlining its production and cost structure. It maintains its strong focus on product development, and the management has repeatedly stated its preference for stable and moderate growth as opposed to acquisitions in the fight for market share. AGCO focuses on creating a strong foundation in the company with the intention to increase ROIC prospectively. This should be achieved by streamlining the operations to achieve the aforementioned EBIT margin of 10%.
AGCO is conservatively financed with a debt of $1.1 billion equivalent to 26% of its equity - A debt covered plenty by the net working capital of $1.7 billion and strong operating cash flows which have averaged around $473 million annually the last decade. This strong financial position resulted in an interest coverage ratio of 17x in H1 2014. I believe that AGCO can realize an EBIT of approximately $860 million in 2014 given a corporate tax rate of 35%, $50 million in other expenses and $60 million in interest expenses for the year given the managements' expectations about a net income of approximately $490 million (EPS: $5).
The EPS forecast regarding 2014 was downgraded in Q1 from $6 to $5, which has been one of the main reasons for the recent fall in the share price together with the announcement of an investment slowdown among farmers due to lower commodity prices. An EPS of $5 should, all else being equal, result in a return on equity of 12% this year.
The management stated in the webcast for Q2 2014 that AGCO has a target of generating $250 million in free cash flow for the year. This will probably be a challenge, since H1 2014 was characterized by a negative operating cash flow of 250 million due to increased receivables and inventories. AGCO thus needs to generate a net operating cash flow of $900 million in H2 2014 in order to achieve this goal given the expected CAPEX outflow of $400 million.
A total of 2.1 million shares has been acquired by employees the last 12 months equaling to approximately 2% of the company. This shows great confidence in the company by its own employees. Moreover, the successful female entrepreneur, Mallika Srinivasan, who has been a board member of AGCO since 2011, has been a huge inside buyer recently. Srinivasan is the director of Indian TAFE Ltd. (Tractors and Farm Equipment) of which AGCO owns 24%. TAFE produces, among other things, Massey Ferguson to the Indian market. Srinivasan has bought around 5 million shares in AGCO since 2012 through her company. TAFE also experiences strong growth in India, and one may wonder why she has been such a heavy inside buyer of AGCO. Maybe she has bigger plans, or maybe she just views AGCO as a bargain at current levels? So far she owns approximately 5.6 million shares constituting 6% of AGCO. Finally it is worth mentioning the acknowledged and highly successful value investor from Third Avenue Value Fund, Martin Whitman, who has bought 253.000 shares in AGCO recently.
AGCO is also repurchasing shares at a rapid rate. So far 4.2 million shares has been repurchased through two share repurchase programs totaling $550 million. One represents $50 million and runs indefinitely while the other of $500 million expires in June 2015. $240 million has yet to be deployed for repurchases and the management strongly hints to a new share buy back program maybe even in 2015. The total number of outstanding shares is likely to be reduced by 10% up to June 2015. Going forward, this will have a positive effect on both EPS and book value per share.
AGCO paid dividends for the first time in 2013 of $0.4 per share. The quarterly dividend has already been raised by 10% since its initiation to $0.44 annually constituting a current dividend yield of nearly 1%. The management plans to increase the dividend continuously going forward. This is certainly no problem since the dividend of $0.4 in 2013 formed a payout-ratio of just 7%. In total AGCO has paid $311 million back to its shareholders in 2014.
I truly understand why people with knowledge about AGCO has bullish views of the company from an investment perspective. The enterprise value of $5.8 billion results in an EV/EBIT of just 6,7x and it also trades at a pretax P/E of 6x for 2014. Also the P/B ratio is only 1.1x compared to the industry average of 2.7x according to Morningstar. AGCO may not be as profitable as for instance Deere & Co. (DE), but one must also remember that Deere & Co. has generated much of its returns through leverage, why their debt to equity ratio is 3.4x compared to AGCO's ratio of only 0.3x. This has resulted in an EV/EBIT of 12x for Deere & Co. The picture is the same for CNH Industrial (CNHI) who trades at an EV/EBIT of 11x and has a debt to equity ratio of 4x. Furthermore, AGCO trades at this low valuation even though they are well in position to realize a return on equity and return on invested capital of approximately 12% even in this challenging year. To calculate ROIC I have used the expected profit before interest but after tax divided by the sum of total equity and long-term debt. It is obvious that significant pessimism is discounted into the current share price and definitely not much growth - if any. This is despite of AGCO's great opportunities to increase its sales globally, where there is an increasing focus on enhancing crop yields while exploiting the farm areas as much as possible. Even in these dull times AGCO manages to generate sufficient returns on its capital, hence my wondering why it trades at these levels.
The future looks bright for AGCO who enjoys the advantages of several megatrends including global population growth and therefore an increasing demand for food, an onrushing global middle class who wants healthier and more protein-rich nutrition, a growing interest and incentive to increase the crop yields globally as well as the rising focus on sustainable fuel solutions such as biomass from corn. These factors are likely to increase the prices of crops in the long term. AGCO is in a strong position to capitalize on these opportunities with their global presence and quality products in various price ranges, which also appeals to budgets of developing countries.
As many already know, large parts of the harvests is lost in the developing countries. An example is Brazil where agriculture accounts for 20% of GDP and yet farmers only have the capacity to store 75% of the harvest - Something AGCO'S GSI segment can solve thanks to its capabilities in storage facilities that can ensure crop yields and help farmers improve their margins. This will result in higher prices for farmers together with more investment in agricultural machinery and equipment.
Another example is Russia who only have 3 tractors for every thousand hectare of farming land. This is nothing compared to the US who has 25. An average of 14% of the harvest is lost outside the industrialized countries due to inadequate handling, storage and transportation methods. This is why governments in these regions are becoming more and more interested in optimizing crop yields. Only 4% of the harvest is lost in the US. The low capacity levels in Brazil are one of the reasons why the Brazilian government recently initiated a $12 billion multi-year program to promote increased investment in grain storage. This will also benefit AGCO who is the market leader in Brazil and has a more global profile than for example Deere & Co. who focuses more on the North American market. AGCO's products are well suited to diminish this efficiency gap. Asia, Africa, South America and Russia offers a tremendous potential for AGCO. However, the challenge is particular difficult in Africa, because expansion plans requires that AGCO educate farmers in mechanical farming while building a dealership network. Moreover, they must provide the African farmers with sufficient after-sales services. This will be a big challenge on this continent especially due to its poor infrastructure. For the time being this market will probably not be as exciting as for example Asia, the Middle East and South America.
The short and medium-term outlook is bleak with a slowdown in the global agricultural industry. Farmers do not earn as much on their crops as they used to which results in lower earnings. Thus they postpone investments for better times and this hits AGCO's sales. However, as stated above, the long-term trend indicates strong commodity prices and AGCO's CEO states that the demand will far exceed the supply, thus resulting in strong commodity prices. GSI possesses a particularly high potential in storage facilities together with protein production and appeals to all regions. The current period of lower crop prices will probably not last forever.
I believe that AGCO has everything a good investment needs: great historic growth, a competent management, a strong balance sheet, solid returns on capital, great cash flows, a positive outlook and a low valuation. In other words: This is a great business at a cheap price.
Disclosure: The author is long AGCO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.