Description

AGCO (AG $21.74) remains grossly overvalued. The company’s market capitalization comes to $1.876 billion which is 90x trailing twelve month earnings. The company recently announced its 20th acquisition (11/7/02) and is in the process of rolling-out the Challenger tractor line recently purchased from Caterpillar. We remain skeptical about this company; in addition to the outsized valuation, there are four reasons why this stock is likely to fall in value.

1. High Debt Burden
The company’s capital structure is highly leveraged. Debt consists of:

• long-term debt ($684 million)
• accounts receivable securitization ($419 million)
• seven off-balance sheet finance joint ventures operating in eight countries ($1.195 billion)

The finance JVs lose money and the funding of the finance companies is subject to redemption on 30 days notice. Is it extreme to include the debt of the finance JV’s on AG’s balance sheet? Consider this fact: AG may be forced to pay $1.195 billion on 30 days notice if its JV partner, Rabobank, in its sole discretion, decides to put the debt back to AG. To meet such a put, AG has $7.9 million of cash and $178 million of unused capacity on its revolving credit facility. The debt burden is large in comparison to AG’s adjusted tangible book value of $535 million and is appalling when one considers that in the three years and nine months ending 9/30/02, AG’s combined GAAP earnings total $12.2 million.

2. Deteriorating Working Capital
Inventory turns have deteriorated from a poor 3.8 turns per year during the 12 months ending 12/31/01 to 3.2 turns per year during the 12 months ending 9/30/02. Net working capital required has grown by $100 million since 12/31/01.

The traditional distinctions between inventory, accounts receivable and tractors sold to end users are blurred with AG. This is the result of the company’s policy of financing inventory to its dealers (up to 18 months interest free) and then financing the sale of tractors, through its financing JV’s, to end users. For instance, the company is currently in the process of introducing the Challenger line of tractors. The company boasts that CAT dealers are enthusiastic about the product line, and why not: their agreements with AG do not require minimum stocking levels of parts and the CAT dealers have six months to pay for tractors shipped to them. Traditional AG dealers enjoy even better terms: they have nine to 18 months to pay for tractors. Sales to end users may be financed through one of the company’s financing JV’s, so while the tractors move off of AG’s balance sheet, AG retains exposure long after the tractor is “sold.”

Given these policies, one way to estimate AG’s financial condition is to sum inventories, accounts receivable, securitized accounts receivable and receivables of the financing JV’s. The result shows that the company’s total inventory plus aggregate receivables are growing, reaching $2.94 billion on 9/30/02.

During the nine months ending 9/30/02, AG’s inventory plus total receivables increased by $193 million (7%). For perspective, consider that during the same period, the company reported a loss, on a GAAP basis, of $2.4 million.



3. Under-funded Post Retirement Obligations
Like many companies, AG’s retirement plans have suffered during the recent stock market downturn. AG has two post retirement problems:

• During 2001, the funding status of AG’s post retirement obligations fell to 86.5% (see exhibit, falling below 90% triggers a mandatory funding call). According to an analysis published by MorganStanley, AG’s funding status will fall to 76%, during 2002, triggering a $10 million contribution to the company’s defined benefit plans during 2003. In the context of AG’s earnings record, $10 million is a sizable sum.

• More worrisome is a dispute regarding the recently announced closure of AG’s Coventry, UK plant. At issue is whether or not AG will have to pay full pensions to employees terminated from the facility before retirement age. According to AG’s most recent 10 Q, “in the event of an adverse ruling, the estimated impact on the pension plan would be an increase in plan liabilities of between $50 million and $60 million.”

4. Weak Corporate Governance
AGCO’s governance is abysmal. As mentioned above, cumulative GAAP earnings for the three years and nine months ending 9/30/02 were $12.2 million; cumulative free cash flow for the same 3 ¾ year period totals $86.9 million. For this dismal performance, management awarded themselves restricted stock valued at $42.6 million plus cash bonuses of $17 million (to pay tax on the restricted stock) during 2002 alone. These payments are in fact the tail end of a long term incentive plan established several years ago; management has every reason to let the stock falter a bit while they establish a new long term incentive plan.

Going Forward
AG management is sanguine about the future. They cite the introduction of the Challenger tractor line, further cost cutting initiatives and the farm bill as reasons that their business will improve. We are less optimistic given Caterpillar’s experience with Challenger, AG’s manufacturing strategy and the relatively small exposure the company has to US farmers.

Challenger
The Challenger strategy has two elements: 1) the acquisition of the large, track based tractor product line developed and sold by Caterpillar since 1987; and 2) the addition of several CAT dealerships which will sell the traditional Challenger line as well as traditional AGCO products which have been re-branded as Challenger products.

We spoke with several CAT dealers about this and they are generally enthusiastic about the added products; this was especially true of large dealers in the Midwest who have historically sold a number of Challenger tractors. Having said this, Caterpillar’s experience with Challenger was dismal: in 1999 they lost $47 million on net sales of $106 million of Challenger tractors. In addition, while CAT dealers may see an opportunity to sell smaller tractors, there is a high chance that they will simply be cannibalizing sales from other AGCO dealers. One CAT dealer we spoke with recounted a recent experience with a farmer who noticed a new Challenger tractor in the dealer’s parking lot. According to the dealer, the farmer remarked: “It looks just like a Massey Ferguson” (an AGCO brand) and didn’t bother to walk over to see the tractor. Needless to say, AGCO dealers we spoke with were less enthusiastic about the Challenger initiative.

So what is the bottom line? AG needs to figure out how to do something that Caterpillar couldn’t: how to make money selling the Challenger tractors. Since Caterpillar is the primary supplier of Challenger parts to AG, and the Challenger line is being sold exclusively through CAT dealers, it seems a long shot that the product line will have an immediate positive impact on AG’s earnings.

Further cost cutting and the Farm Bill
As discussed in our note dated 5/14/02, AG’s strategy has been to outsource the majority of its manufacturing. Given this approach, it is a bit of a stretch to believe the company will be able to squeeze significant savings from its manufacturing. The farm bill has also been cited by AG management and Wall Street analysts as a profit driver for the company; the affect of the farm bill will likely be small because AG derives less than 27% of its revenue from the US.

Based on AG’s past acquisition integration performance, investors should expect further “one time” charges resulting from the Challenger acquisition (5/5/02) and the Sunflower Manufacturing acquisition (11/7/02). In fact, management recently disclosed that Challenger is starting to depress operating margins. As Yogi Berra said, “it’s déjà vu all over again.”

Disclosure: We are short AG.

Catalyst

Post retirement benefit issues, Challenger tractor integration costs, continued weakness in the agricultural equipment