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Morningstar | Strong Competition Limits Agco's Margin Expansion. See Updated Analyst Note from 20 Dec 2018

After taking a fresh look at Agco, we are reducing our fair value estimate to $70 from $78 per share while keeping our no-moat rating. The valuation change is largely based on our midcycle operating margin estimate for 2022, which we have reduced to 7.9% from 8.2%. While we believe there will be operating margin expansion from 5.0% in 2017, we feel the market for tractors will remain highly competitive, thereby limiting management’s ability to reach its target operating margin of 10%.

Despite its strategy of expanding the scope of its operations through astute acquisitions of differentiated agricultural equipment offerings, the company struggles to earn an operating margin comparable to either Deere's agricultural segment (12.4% in 2017) or CNH's agricultural segment (8.9% in 2017). Managing four tractor brands continues to weigh on the firm’s development costs and marketing expenditures. The lack of a single global brand also appears to limit Agco's ability to attract customers of the dominant players in the industry.

Our recent conversations with farmers revealed that brand loyalty is a major driver of buying decisions. In addition, farmers indicated that they maintain personal relationships with dealers over generations. Although Agco’s brands do have recognition in their respective markets, none of our research indicated that they enjoy the level of widespread loyalty or long-term dealer relationships experienced by Deere or CNH.

The product development costs associated with managing four separate tractor brands also continue to inhibit Agco's profitability, and management has suggested that they are cognizant of this disadvantage. Its latest premium, high-horsepower tractors--the Fendt Vario 1000 and the Challenger 1000--share 98% of their components. In developing its new Ideal combine platform, Agco hopes to consolidate seven combine platforms into one global platform. We believe such initiatives will contribute to operating margin expansion.

Increasing sophistication of agricultural equipment is driving greater investments in research and development. Since 2007, research and development expenditures have increased from 2.3% of revenue to 3.9% in 2017. We forecast research and development costs to further increase to 4.3% of revenue by 2022. These costs must be spread across four tractor brands, which will diminish the impact of these investments. As bargain tractor manufacturers, such as Mahindra and Kubota, gain market share, Agco will need to make larger investments in developing differentiated tractors to prevent customers from gravitating toward cheaper models.

Mahindra, which now manufactures tractors in the United States, sold 22,636 tractors nationwide during fiscal year 2018, representing 8.4% annual unit sales growth. Mahindra is also making inroads into the European market. In 2016, it acquired a 35% stake in Finnish combine manufacturer Sampo. In 2017, it acquired the second-largest tractor manufacturer in Turkey--Erkunt Traktor Sanayii. These acquisitions will provide a springboard for Mahindra to increase its presence in Agco's core market, Europe, which represents approximately 54% of Agco’s revenue.

In the long run, we view Agco's acquisitions of a diverse set of agricultural equipment manufacturers as a compelling strategy that will help mitigate competitive challenges. Tighter integration across digitalized systems will provide farmers a holistic view of their entire enterprises. We believe that farmers will desire further integration of their self-propelled equipment with other stationary agricultural systems, which Agco manufactures, unlike Deere or CNH Industrial.