AGCO Stock Is A Buy On Strong Growth Prospects (NYSE:AGCO)

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Investment thesis

AGCO Corporation (NYSE:AGCO), the third major player in the agriculture and machinery industry, is an interesting opportunity for long-term investors. The company is smaller than its competitors, with a market cap of only $9.4 billion compared to Deere’s (DE) $113 billion and CNH Industrial’s (CNHI) $19.85 billion. Though smaller and younger, it is well established in Europe and it has plenty of room to grow in North America. Ahead of the company is a more profitable future thanks to its strong precision agriculture line of products. In the meantime, the company is adopting a strategy that will enable it to face the current tight situations in the market.

This is the third and final episode I planned to start covering the agriculture and farming machinery industry, since it is becoming such a crucial sector in today’s world.

Favorable macro-trends

The agriculture and farming machinery industry is clearly linked to the level of net farm income. With soaring crop prices, farm income is due to be positively impacted. However, farmers are also facing the higher costs of fuel and fertilizers. The fertilizer scarcity may have an impact on net farm income that is still underestimated. Since farmers won’t be able to fertilize as they used to, they will probably harvest less than planned, with fields having a smaller yield. This will lead to lower income, but could be offset by the fact that crops will be sold at higher prices, given their scarcity. Furthermore, since farming equipment is usually quite expensive, farmers tend to look for financing to have the capital for these investments. Interest rates are still very low, but they are rising and this could have a negative impact on the financing requests from farmers.

Although we are in a contrasting situation, we have to recall that the industry is also witnessing three great macro-trends we should be aware of.

  1. World population is increasing and so is the need for food. As Eric Hansotia, AGCO Corporation Chairman, President and CEO, wrote in message opening the 2021 Annual Report: “Ten years ago, the World Wildlife Foundation estimated that farmers would need to produce more food in the next four decades than they had in the last 8,000 years of agriculture combined to feed our growing population”.
  2. As the urbanization process moves forward, land scarcity is becoming a problem that urges for new farming equipment that is able to increase production per acre.
  3. Labor force is hard to find and this pushes the industry towards automation and autonomous driving of tractors.

In this context, companies that will be able to manufacture highly technological products that will satisfy these needs are set to thrive and flourish.

The Company

AGCO Corporation has an interesting history that starts in 1990 thanks to the management buyout of Deutz-Allis from KHD. In 32 years, the company has grown to the point it is, as we have said, the third major player in the manufacture and distribution of agricultural equipment. Through many acquisitions the corporation managed to own many well-known brands such as Challenger, Fendt, GSI, Massey Ferguson and Valtra. AGCO is also committed to becoming a leader in the agriculture and has already a variety of innovations that spread out from hybrid combine harvesters to telemetry-based tracking systems, which include remote monitoring and diagnostics, that help farmers improve uptime, machine and yield optimization. Just a month ago, AGCO announced the acquisition of JCA Inc., a leader in the development of autonomous software for agricultural machines, implement controls and electronic system components.

True, by betting on precision agriculture, AGCO is clearly exposed to the semiconductor shortage we are still facing. But as business learn to cope with this crisis and new investments pour into semiconductor manufacturing the picture in the mid-term becomes interesting, since this business line has clearly greater margins. As Mr. Hansotia said during the last 1Q 2022 earnings report:

Our Precision Planting business was impacted by supply chain issues in the first quarter. However, we remain confident in the growth opportunities from our new product pipeline.

AGCO Business & Financials Compared to its Peers

In the past five years, AGCO has been steadily improving its performance, starting from a net sales increase that came along with a growing operating margin and EPS more than tripling, as shown in the graph below.

AGCO 2021 Annual Report Financial Highlights

AGCO 2021 Annual Report

However, if we look at a longer time period, we see that AGCO, as every other company of the industry, is somewhat exposed to market cycles. Agriculture machinery saw a peak around 2013 to then find a bottom in 2016 before a recovery that over the last year saw the market head up towards another peak. AGCO shows this cycle very well through this graph with net sales and EPS combined together. It shows that from one peak to another we need several years and that, during this last cycle, only when we moved towards the peak, we topped out the previous peak. This may lead some investors to wait for this current cycle to peak and then come down, with all the risks of trying to time market cycles. In my opinion, the cyclical nature of the industry should lead us investors to start a position if the business is sound and then dollar-cost-average during downturns.

AGCO EPS

AGCO EPS (AGCO 2021 Annual Report)

AGCO sells its products all around the world, with its major market being in EME (Europe & Middle East) well outnumbering both North and South America, as we can see from the results of the 2021 Annual Report.

AGCO sales by geography

AGCO sales by geography (AGCO 2021 Annual Report)

The geographical distribution of AGCO sales is a bit different from the one of its two main competitors. In fact, both John Deere & Co and CNH Industrial see North America as their major market, Deere’s 2021 North America revenue being $22.8 billion (57% of total) and CNH Industrial’s $7.8 billion (40% of total). AGCO, on the other side, sees a greater strength in Europe, where its net revenue seems higher than CNH Industrial’s revenue of $5.317 billion, even though we have to be careful because AGCO talks about EME region, while CNHI divides Europe from the other areas in Africa and Asia. In any case, we can consider the two companies’ net revenues quite similar. John Deere too is not very far ahead, as its 2021 net revenue in Europe was $8.9 billion.

The picture is double sided. AGCO strength in Europe is important and could be an advantage over Deere, in particular. Let’s remember that, as Mr. Hansotia said in the last earnings call, “Europe is typically not as cyclical as the rest of the other markets”. This makes us understand the importance of this market for a company. However, a smaller presence in North America can be a problem, since this is both the most rewarding market from a marginality point of view and a huge market highly in need of precision agriculture equipment. AGCO will have to penetrate North America more if it wants to keep up with its two competitors.

This situation is reflected when we look at AGCO’s marginality compared to Deere’s and CNH Industrial’s. I already covered both companies and discussed both Deere’s problem of reduced marginality in 1Q 2022 and CNH Industrial’s efforts to increase it.

AGCO 1Q 2022 Earnings Presentation

AGCO Financial Summary 1Q 2022 (AGCO 1Q 2022 Earnings Presentation)

As we can see from the financial summary AGCO reported, the operating margin is 7.6% (adj. 9.0%). Deere came in above as it declared an 8.8% margin that is, in any case, well below its usual marginality of 16-20%. CNH Industrial did better reaching a 10.3% operating margin, which, however, factors in the low margin construction division. If we look only at CNH Industrial’s agriculture division, margins come in higher at 12.6%.

AGCO, like its competitors, will raise pricing in the range of 9-10%, as its CEO declared in the last earnings call. This may offset inflationary pressures, but may be not have the power to increase marginality. True, at the moment, as CNH Industrial’s CEO Scott Wine stated, the industry sales are driven only by one them: availability. This gives manufacturers the power to increase prices and continue selling their products. This situation, however, will not last forever. In my opinion, AGCO needs to use this to penetrate North America more and become and established precision agriculture leader in order to keep increasing its marginality as market conditions will change.

During the last earnings call, Mr. Hansotia addressed this issue when he mentioned that AGCO suffered in North America as…

…operating income for the first three months of 2022 decreased approximately $20 million compared to the same period in 2021. A weaker sales mix, primarily caused by chip-related supply constraints related to the Precision Planting business, as well as the impact of higher production costs resulted in lower first quarter operating results. [But] we absolutely want to continue to focus on operating margin improvement. […]The key drivers for margin improvement are additional operating leverage through growth, and we also want to grow our high-margin businesses. So that means, growing our Precision Ag businesses, which carry high margins, growing our premium product brands like the Fendt brand.

There is really no other way for the company to grow, but to bet heavily on its precision business. But to play an important role in today’s market, Mr. Hansotia explained the short-term strategy the company is undertaking:

Additional working capital requirements caused by higher inventory levels resulted in lower free cash flow for the first quarter of 2022 versus the same period in 2021. For the full year 2022, we expect our raw material and work in process inventory to remain elevated, to help us manage through the difficult supply chain environment.

I really think that the only way to compete in the manufacturing industries now is to have inventories. True, this implies a large use of cash, but it benefits the companies that manage to have their products available with quick lead time, advantage that leads to a renewed pricing power.

AGCO has a capital structure that enables it to pursue this strategy as its cash compared to its total debt is in a stronger position. AGCO’s cash is $655.7 million in front of a total debt of $2.12 billion, equaling to a 30% debt coverage, while CNH Industrial’s debt coverage is 13% and Deere’s 7.9%. This gives room to AGCO to use all the cash it needs to fund its high inventory strategy, knowing the strong demand of the market. If AGCO will be able to have machines available with quicker lead time than its competitors, we should see the results in a few quarters and even the lower marginality should come up a bit.

Valuation

AGCO’s stock saw its price soar 3x from the COVID market crash since its EPS kept on crushing expectations quarter after quarter.

Chart
Data by YCharts

This may lead many people to consider the stock overvalued. However, if we look at the current metrics, we see that the stock is not at all expensive, since the fundamentals did really drive this huge price surge. With the aid of Seeking Alpha’s Quant Ratings we see a very interesting picture.

AGCO Quant Ratings

AGCO Valuation Metrics (Seeking Alpha)

Both TTM and FWD PEs are way below the sector average and are even way below to AGCO’s 5y average. This means that the Company has been able to become way more profitable compared to what investors are pricing in at the moment. It is quite curious that this is happening through a strong agriculture cycle as the one we are in.

I used also a discounted cash flow model to check if this undervaluation can be confirmed. I assumed that AGCO’s 2022 net margins will be around 7.5% and that they will increase to 9-10% in the next 5 years. I then used an 8% discount rate, which I also used in my valuation for Deere, starting from the consideration that the risk free rate is now at 3% and that AGCO’s average cost of capital is around 9.14%. The equity risk premium I used 5.5%, which is quite common for U.S. based companies. I assumed that AGCO would grow its revenue to $14 billion in 2027 (CAGR of 4.7%) and then down to a perpetual growth rate of 2%. With these parameters I reach a $160 share price, which makes me consider AGCO as a good buy at the moment, with a potential 26% upside. I have been conservative in assuming slow growth and low marginality and I know there are good reasons to expect even better results.

Conclusion

With this article I end my initial coverage of the three major players in the agriculture equipment industry. I think AGCO, though smaller that its peers, has been steadily gaining a status in the industry which will keep on growing thanks to its highly technological experience in the field of precision agriculture. With plenty of room to grow in North America and a path to close the gap with the market leaders’ marginality, the company could be a very interesting play to invest in for the next five years. This is why I rate it a buy, considering it with a 26-30% upside from today’s prices. Investors may take advantage of the current bear market to pick up some shares to initiate a position or to increase an already existing one.

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