Description

We recommend shorting shares of AGCO (AG); for background, please see our initial posting on this company dated 1/13/03.

AG is a low margin business. This characteristic has led management to rely on debt financing to produce returns in excess of its capital costs. As a result, AG is vulnerable to higher interest costs, which have the toxic combination of increasing the company’s cost of capital while depressing sales. We will show that AG’s performance is beginning to suffer, probably from rising interest costs and fertilizer prices, and conclude that the company’s shares are overpriced at 6.7x trailing EBITDA and 11x trailing EBITDA if one accounts for its off-balances sheet debt.

Catalysts
1) Rising interest rates.
2) High energy (fertilizer) prices.


AG’s current market capitalization is $1.6 billion and its enterprise value, net of cash, is $2.6 billion. At this a valuation, AG is trading for 10x trailing earnings and 6.7x trailing EBITDA. AG’s off-balance sheet debt is comprised of $473 million of accounts receivable securitizations and $2 billion of debt used to supported tractor loans to farmers. Including off-balance sheet debt, AG’s enterprise value comes to $5 billion, which implies a valuation of 11x trailing adjusted EBITDA (adding back $78 million of interest for the companies seven off balance sheet JVs and $21 million for the A/R securitization). Whether or not one includes AG’s off-balance sheet financing, it is reasonable to conclude that debt is a prominent feature of AG’s capital structure ($1B - $3.5 B). Below, the implications of the company’s highly leveraged capital structure are discussed.



Cyclicality
AG makes tractors and related farming equipment which it is sells to farmers through dealers. Founded in 1990, AG grew through acquisition and is now the third largest farm equipment manufacturer in the world behind Deere and CNH.

Farming, by nature, is a cyclical business. A review of AG’s income statements for the last several years indicates that the tractor business is also cyclical; for instance, over the last eleven years, AG’s earnings have ranged from a loss of $84 million to as high as $169 million. Yet, AG’s capital structure features a great deal of debt ($1B - $3.5B, depending on how one counts the debt), which leads to the question: if selling tractors is a cyclical business, why would AG management use debt, much of it short term, to finance the company? The most likely answer may be found in the observation that debt is less expensive than equity, and short-term off-balance sheet debt is less expensive than on-balance sheet debt. One can only conclude that either AG’s management is reckless, or AG generates such low returns that management has no choice but to use short-term debt to finance the business. While debt financing may work in a benign business environment, it is not a prudent way to finance a cycle business.

Pretax Return on Capital: 2.5 - 7.7%
We first became interested in AG when we noticed that its gross margins ranged between 15% and 23%, and have remained below 18.5% since 1997. This is low for an equipment manufacturing business, which has ongoing engineering and sales costs as well as meaningful capital expenditures. Further analysis indicated that AG’s business is quite capital intensive and generates very low returns. For example, AG’s EBIT return on assets has rangedged from a low of 3% during the twelve months ending 12/31/02 to a high of 7.7% for the twelve months ending 6/30/05. While these returns are low, e.g., long-term tax free municipal bonds are currently yielding 4.5%, what is surprising is that AG has been able to secure financing below these rates.
With leverage, the company has managed to boost after tax return on equity above 10%.

Debt and Rising Interest Rates
Given such low returns, inexpensive capital is a requirement to remain in business. Optimists will point out that while these returns are low, they are improving; in fact, the optimists are probably wrong. While it is true that AG is able to borrow a great deal of money ($3.5 billion) at a very low rate (4.47%), eighty-six percent of the $3.5 billion of debt is variable rate i.e., linked to LIBOR. In the last eighteen months LIBOR has risen from 1.3% to 4.3%. Rising short-term interest rates eventually increase AG’s cost of capital and a flattening of the yield curve will reduce the spread they earn on tractor loans. (AG undoubtedly swaps its off-balance sheet floating-rate debt for fixed, but rising rates cannot be staved off indefinitely). As a result, the spread between LIBOR and AG’s return on capital is shrinking, this does not bode well for a highly-leveraged business operating in a cyclical industry. Optimists will note that AG generated record earnings during 2004 and that the results for the first half of 2005 were respectable. Yes, but since AG is currently priced at 6.7x trailing EBITDA (11x trailing EBITDA if one takes into account the off-balance sheet debt), it is hard to consider AG a bargain.


Accounts Receivable Losses
After several years of declining losses, losses from AG’s securitized accounts receivable began to increase in 2004 and have continued to rise during 2005. Non-performing loans are devastating. In AG’s case, the company’s cash balance fluctuated between $47 million and $68 million over the last twelve months. As of June 30, AG had $2.5 billion of securitized, off-balance sheet debt supported by tractor loans and accounts receivable. Small increases in the non-performance of these loans can quickly burn through AG’s cash, i.e., $68 million is 2.7% of $2.5 billion. AG management is quick to make the point that technically, AG’s exposure to this debt is limited to its equity in the finance JV’s (total equity in the JVs was about $270 million as of 6/30/05, of which AG owns 49%). The fact is, if loan performance deteriorates, AG will be called upon to support the JVs or the JVs will be closed, cutting-off this source of funding to AG’s business. Without the JVs, AG would cease to exist.

Regarding the likely future direction of interest rates, LIBOR tracks (at a small premium) the federal funds rate which is controlled by the Open Market Committee of the U.S. Federal Reserve Board. According to a recent survey on the world economy published in The Economist, from Q4 2001 to Q2 2004, the U.S. economy enjoyed the biggest fiscal and monetary stimulus since World War II. The result has been a surge in real estate values, commodity prices and dollar depreciation. The inference we make from this is that there has been significant dollar inflation. To the extent this is the case, one would expect short-term interest rates to continue to rise, putting pressure on AG’s finances. Given AG’s low returns on capital, there is little management can do to maintain profitability in the face of higher interest rates.

Market Outlook: 2005 down from 2004
AG’s 1H ‘05 performance is lagging 2004 and losses from its accounts receivable securitization have increased. A look at AG’s markets indicates that conditions are deteriorating. AG generated 49% of its 2005 operating earnings from Europe, 33% from South America and 9% from North America. Eurpeaon tractor demand during 2005 (through August) is up 4% year-over year, South America is down 33% year over year and North America is up 6%. Using these numbers, to the extent the first eight months of 2005 are indicative of the balance of the year, one would expect AG’s 2005 earnings to be abut 8% lower than its 2004 earnings. This conclusion is corroborated by AG’s financial performance during the first six months of 2005.

Higher Fertilizer Prices and Lower Tractor Sales
Fertilizer prices have been on a tear since 2002. Farmers, when faced with a decision of buying a new tractor or buying fertilizer typically opt for fertilizer (yields are directly tied to fertilizer consumption, the correlation between yields and tractor age is less well established!). One of the key factors driving fertilizer prices higher is rising natural gas prices, natural gas is the primary feedstock used to produce nitrogen-based fertilizers. Gas is constrained in North America and will remain constrained. European gas prices are set by the price of bunker oil, which is likely to remain expensive for the foreseeable future. We conclude that fertilizer will remain expensive, which does not bode well for AG.

Conclusion: Short the Stock
We have endeavored to establish the following:

1. AG is highly leveraged and operates in a cyclical industry.
2. AG earns low returns on capital i.e., less than 8% pre-tax.
3. The spread between AG’s cost of capital and its return on capital has begun to shrink and losses on its accounts receivable have begun to rise.
4. Higher fertilizer prices are likely to persist and are contributing to the company’s 2005 revenue shortfall.

If we are correct, the fate of AG depends on future interest rates and fertilizer prices; obviously, there is nothing that AG management (or anyone else) can do about either.

Given that AG’s enterprise value is 6.7x trailing EBITDA (11x trailing EBITDA if one takes into account the off-balance sheet debt) and that 2005 earnings are likely to be less that 2004 earnings, AG’s shares are more likely to fall than rise.

Catalyst

1) Rising interest rates.
2) High energy (fertilizer) prices.