Agco: A Growing Population Still Has To Eat

Farm Equipment manufacturer Deere & Co. (DE) rose as high as 7% on Wednesday after CNBC pundit Jim Cramer touted agriculture as the next sector that could “break out” during his Tuesday night Mad Money show. In promoting “agriculture” as a possible break out play, Cramer cited an optimistic crop forecast from the U.S. Department of Agriculture and said that an agriculture rally would lift companies like Deere.

We agree with Cramer that agriculture could break out, but then again we see agriculture as a demographically supported sector that will always be in demand and should generally experience healthy long-term growth. Growing populations spur an increased need for for food, and mechanized machinery offers a good means for increasing production while offsetting costs. And, while Deere will certainly continue to benefit from increased worldwide agricultural production, we believe that Agco Corp. (AGCO) offers more room for upside returns.

Agco is the world’s third-largest maker of farm machinery, offering a full line of tractors, combines, hay tools, sprayers and forage and tillage equipment sold through four core brands – Massey Ferguson, Challenger, Fendt and Valtra – in more than 140 countries. The company was established in 1990 with the management buyout of Deutz Allis Corp. from the German-based Kloeckner-Humboldt-Deutz AG. The company, which went public in 1992 at an offering price of $14 per share, quickly became a global leader through market growth, development of “cutting edge agricultural solutions” and extensive acquisition efforts, including the 1994 takeover of the Canadian-based, world-wide tractor sales leader, Massey Ferguson Ltd. Agco derives 58% of its sales from Europe, Africa and the Middle East (EAME); 21% from North America; 18% from South America; and 3% from Asia Pacific.

The year 2008 proved to be a watershed for the company, as it posted record sales of $8.4 billion, a 23% increase over 2007, and earnings per share of $4.09, more than 60% higher than in 2007. The company attributed its strong performance to robust sales and high operating margins in the EAME region, a “return to profitability in the North American market, and record tractor sales–both for the company and within the industry as a whole–in South America.

Agco’s record breaking year ended with the global financial meltdown and a worldwide recession, which helped bring the company’s sales and earnings back down to earth in 2009. On Oct. 27, the company reported a third quarter profit of $10 million, or 12 cents per share, down from $99 million, or $1.01 per share, reported in third quarter 2008. For the full fiscal year 2009, the company expects net sales to decline 23% to 25% from 2008, and expects to see adjusted earnings per share in the range of $1.30 to $1.50. Company executives attributed the reduced sales and earnings to softened market conditions that led to reduced demand, higher inventories and lowered margins. The EAME region saw the weakest demand, followed by North America and then South America.

While Agco is not expecting any improvements in fourth quarter 2009, owing to continued “dampened worldwide industry demand for farm equipment,” the company remains quite optimistic about the long-term future. In particular, the company points to world population growth and the associated increased demand for agricultural products as primary drivers for future growth. In the EAME region the company sees long-term growth opportunities in Eastern Europe, primarily Russia, Ukraine and Kazakhstan, which are increasingly turning to Western-style agricultural practices using modern equipment. These countries have immense amounts of farmland, and Agco sees significant demand for agricultural technology, a demand that can be met when credit markets recover.

In Asia Pacific, the company expects to see continued market share growth in Australia and New Zealand, and is working to develop joint-venture opportunities in China that would give access to distribution and production capabilities for both the local market and sourcing to other regions. China is currently the world’s largest market for small, low-technology agricultural tractors, but Agco believes that farm consolidation in China will lead to the need for larger, high-horsepower tractors, which are the company’s core product.

And in South America, Agco has a strong market position in Argentina and Brazil, with the latter holding significant potential for farming expansion driven by its expanding role as a world leading exporter of soybeans, sugar cane and coffee.

On a demographic basis, Agco executives are probably right in thinking that world population growth will drive increased demand for agricultural products, and thus for Agco’s farm machinery.

However, population growth is not going to be a major factor in either Eastern Europe or China, as the countries of Russia and the Ukraine are experiencing negative population growth, while China and Kazakhstan are hardly growing at all. The labor forces of Russia and the Ukraine are already in decline, while those of China and Kazakhstan have peaked and are expected to go into imminent decline. So, even though population growth may not be a driver of increased sales in these countries, declining labor forces generally lead to higher labor costs, which should spur the demand for cost-saving mechanized solutions as offered by Agco products.

While Agco competitors, like Deere & Co. in particular, will also benefit from demographic influences, we feel that Agco‘s share price has the best potential for upside growth. The company is significantly less leveraged than Deere, with a long-term debt to equity ratio of 0.13, compared to Deere’s at 1.78. The company's shares, currently at about $29.65, trade at a Dec. 2009 P/E of 14.30, falling to 12.80 for Dec. 2010. This compares to Deere, currently trading at about $50.40, which trades at an Oct. 2009 P/E of 19.30, falling to 18.80 in Oct. 2010. Agco has a trailing 12-month P/S of 0.41, compared to Deere’s P/S of 0.86