Cyclical industries have this way of making investors look stupid, as the "it's different this time" crowd goes hand-to-hand with the "doom is just around the corner" contingent. Luckily for CNH Global (CNH) investors, the company is so well-diversified around the globe that a slowdown in one area can be offset by stronger conditions in another.
Like Deere (DE), CNH management has been a little conservative/cautious of late, and sell-side analysts seem to be getting a little more nervous about the health of the North American farm equipment market and the global construction equipment market. That said, CNH's overseas position is intriguing, particularly if management can start to execute better.
Markets May Be Moving In CNH's Favor
CNH had a somewhat disappointing fourth quarter, particularly from a margin standpoint. Production cuts targeted at maintaining better inventory control led to some factory under-utilization, and other factors like higher R&D and engine stockpiling took their toll.
Recent data from the AEM suggests some encouraging some encouraging trends. Tractor demand was pretty strong in Europe and Latin America in January. While rival AGCO may see a little more benefit from its greater leverage to smaller tractors, CNH isn't exactly a non-factor here either. Sales performance has been a little more sluggish in North America, with more weakness in larger equipment categories.
Going Global A Good Long-Term Strategy
CNH is the world's second-largest farm equipment manufacturer and is well-diversified from a geographical basis. While over 40% of sales to go to North America, CNH gets almost one-third of its sales from Europe, and it has leading share in Europe in tractors (ahead of AGCO and Deere), with particular strength in Eastern Europe.
Latin America is increasingly important to the company. This area accounts for close to 20% of overall sales (and, somewhat surprisingly, more than one-third of construction equipment sales), and in addition to the #1 spot in combines, CNH is aggressively targeting AGCO's dominant share of tractors with more mid-power offerings.
Although sales in the Asia-Pacific region are relatively light, CNH's overall emerging market exposure is about a third of its sales. What I find interesting is that CNH has been pretty flexible with regard to pursuing numerous joint ventures in emerging markets in Eastern Europe and Asia. You may remember that this is the strategy that Cummins (CMI) employed years ago and has resulted in significant share in many of these markets.
While sales to countries like China, India, Turkey, and Pakistan may not be large today, there could be solid growth potential here. I do wonder, though, if CNH needs to build up its offerings in smaller equipment (tractors, especially) to better penetrate these markets. Like as not, this would be easier to achieve through a few targeted tuck-in acquisitions.
Operational Factors A Reason For Some Concern
Looking at some of the fundamental ratios at CNH, it seems fair to say that the company needs to do better. The company's margins aren't that bad compared to Caterpillar (CAT) or Deere, but the returns on capital have been pretty poor. Some of this may be do to the joint ventures and building ahead of growth, but the recent trends for asset turnover relative to CAT and Deere bother me.
The corporate structure is also a reason for pause. Fiat owns nearly 90% of the company, but nobody seems entirely sure what its long-term plans may be. While CNH may perhaps enjoy some efficiencies in scale or R&D from being part of Fiat, there is nevertheless at least some overhang from the "what will Fiat do?" questions.
Construction Needs To Offer More
The need for management to raise its game is definitely clear in the construction equipment business. Relative to Caterpillar, Deere and Komatsu (OTCQB:KMTUY), CNH's margins are poor and have been poor for some time. Some of this may well be due to the fact that CNH is more skewed towards lower-margin light equipment, and some may also be due to the sub-optimal production levels created by dealer inventory levels.
Whatever the reason(s) may be, the performance has to improve. CNH actually has a solid construction business in many respects - it is a #3 construction equipment company in Brazil and is a #1/#2 player in certain North American markets like skid-steer and backhoes. The company also has JVs in Asia that could pay off down the line.
Maybe all CNH needs is for demand to return and for production levels to climb back to a point where they can clear the fixed costs. Whatever the case, these margins have to improve if CNH is going to work as a stock.
The Bottom Line
With all of the ups and downs in sentiment for industrial companies, the stocks have sorted themselves out such that the expected returns relative to fair value are pretty similar. On the basis of 6-7% compound growth in free cash flow, I think CNH could be worth about $44 a share. That's a somewhat robust growth target for a cyclical industry, but the overseas growth potential in markets like Russia supports it. At the same time, valuation is hampered both by a hefty debt load and an above-peer discount rate tied to its poor returns on capital compared to Caterpillar, Deere and AGCO.
At these prices, then, I'd be more interested in Deere among the direct comparables. I would also suggest investors check out names like Titan International (TWI) or Sauer-Danfoss (SHS), which serve the off-highway equipment markets as part and component suppliers.