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Morningstar | Agco Continues Margin Expansion, but Our Long-Term View Remains Unchanged; Maintaining FVE

No-moat Agco was able to increase its operating margin in the fourth quarter to 6.1% from 5.7% in the same quarter last year. Agco’s fourth-quarter revenue of $2.59 billion beat consensus by $15 million, while GAAP EPS of $1.26 beat consensus by $0.05. Management provided an upbeat outlook on 2019, suggesting 3% revenue growth and 28% EPS growth. Despite this optimism and Agco’s ongoing margin expansion, we remain skeptical of management’s stated goal of reaching 10% operating margin and are maintaining our fair value estimate of $70.

Overall sales in the fourth quarter were up approximately 3% year over year, which was in line with our expectations. The Europe/Middle East segment--Agco’s largest market--experienced 10% year-over-year growth in the quarter, excluding currency impacts. Operating margin increased to 12.2% from 11.3% in the same period last year. Agco expects flat sales in Western Europe for 2019.

South America was mixed bag for Agco in the fourth quarter with growth in Brazil offset by lower sales in Argentina. Revenue increased 1% year over year excluding currency impacts. Operating margin improved to 3.8% in the quarter after averaging negative 3% in the prior three quarters as Agco worked through a technology transition to Tier 3 engines. While sales in South America are expected to improve in 2019, Argentina is likely to be an ongoing drag on Agco’s performance.

Sales growth in North America was up 1% year over year on constant-currency basis. Operating margin in North America declined in the quarter to 1.2% from 2.4% in fourth-quarter 2017. Materials costs and product mix were cited as contributing factors. We feel strong competition from Deere and CNH likely hurt Agco’s profit in the region.

In the Asia/Pacific/Africa region sales increased approximately 16% on a constant-currency basis year over year in the quarter. Operating margin declined to 8.3% from 10.4% in the fourth quarter of 2017 due primarily to an unfavorable sales mix.

We believe Agco’s strategy of providing a full suite of agricultural products including grain storage, protein production equipment, and precision planting tools will continue to enhance its margins, much like it did in the fourth quarter. Yet it will be negatively impacted by strong competition at the high end of the market from Deere and CNH while lower-priced offerings from Kubota and Mahindra gain market share. Hence, we think management’s often repeated goal of reaching a 10% operating margin seems overly optimistic. During the fourth-quarter earnings call, management suggests its engineering costs (typically classified as research and development by other manufacturers) will decline as a percentage of revenue post 2019. We think this is unrealistic as farmers will demand greater equipment productivity, which will increase product sophistication and product development costs. Therefore, we believe it is unlikely that Agco will be able to reach its lofty margin goals without ceding market share.