Dividend growth investing is a popular, and largely successful approach to generating wealth over long periods of time. Investors typically do well focusing on companies with long streaks of dividend increases in part because of the positive qualities a business needs in order to be able to continually afford what is ultimately a cash layout to shareholders. However, many of the companies known as “dividend champions” – those with 25 consecutive years (or more) of dividend growth – are mature companies. By identifying strong companies earlier in their life cycle, we can benefit from strong total returns while these companies build their dividend growth reputation. We will be spotlighting numerous dividend up and comers to identify the best “dividend growth stocks of tomorrow.”
AGCO Corporation (AGCO) is a manufacturer and seller of agricultural equipment and parts. The company was founded in 1990, and today sells across the globe. The two main product categories AGCO builds are tractors and combines, though tractors represent a majority at just under 60% of total company revenues.
These tractors, combines, and parts are sold through a global distribution network. This network consists of more than 4,000 distributors and dealers. Europe represents AGCO’s largest market with approximately 57% of total sales. This is followed by North America with 23%, South America at 10%, and the remainder of the planet at 9%.
Source: AGCO Corporation
We can see that AGCO’s business has been a bit volatile over time. Revenues and EBITDA have both fluctuated. Why is this? The agriculture market is heavily dependent on the commodity prices of the crops that are sold. Similar to oil, low commodity prices choke businesses, which is a deterrent to investments into large and expensive machinery.
In other words, when crop prices are low, farmers won’t/can’t spend on expensive equipment such as tractors and combines. We can illustrate this impact on AGCO by charting the company’s revenues with the price of grain – a common crop:
Over the past 10 years, company revenues have grown at a CAGR of just 1.05%, and EPS has actually contracted at a slightly negative CAGR of -1.32%.
Due to this cyclical nature of crop prices and AGCO’s business, we take a long-term look at how the company’s operating metrics stand up through this volatility in the business.
We review operating margins to make sure the company is consistently profitable. We also want to invest in companies with strong cash flow streams, so we look at the conversion rate of revenue to free cash flow. Lastly, we want to see that management is effectively deploying the company’s financial resources, so we review the cash rate of return on invested capital (CROCI). We will do all of these using three benchmarks:
- Operating Margin – Consistent/expanding margins over time
- FCF Conversion – Convert at least 10% of sales into FCF
- CROCI – Generate at least 11-12% rate of return on invested capital
While we understand that the volatility of crop prices would impact AGCO’s business, it’s disappointing to see a sustained level of performance below our operating benchmarks. We were hoping for better levels of operating metrics during peak crop prices. It appears that the farming machinery industry is simply too price competitive to allow higher margins.
With this in mind, it’s important that AGCO maintains a very strong balance sheet. This is for a few reasons. First, a strong balance sheet provides “ammo” for management to drive growth through M&A. Secondly, a company with too much debt is unable to perform for investors at its full potential because interest payments are sucking cash from the business. Third, a strong balance sheet protects the business from negative events such as a dividend cut in the event that the business faces a downturn (which is likely when your business relies on commodity prices).
While the balance sheet certainly isn’t in “dire straits,” there are a couple of worrisome things to point out. The company’s total cash pile and debt load are moving in opposite directions. Cash on hand remains near decade-lows at $280 million, while total debt is near decade-highs at $1.84 billion. The resulting leverage ratio of 2.35X EBITDA is just below our cautionary threshold of 2.5X. Again, AGCO can operate with this balance sheet just fine. The problem we see is that it doesn’t leave much room for forgiveness should the operating environment worsen.
Dividend & Buybacks
AGCO Corporation has returned cash to shareholders through both dividends and buybacks over the years. Initiated in 2013, the dividend has been raised by management for each of the past seven years. The dividend today pays an annual sum of $0.64, and yields 0.87% on the current stock price. Income-focused investors will likely be turned off by this low yield.
The dividend being so young, has grown well since inception. Over the past five years, the dividend payout has grown at a CAGR of 8.4% which easily outruns inflation rates. Another big plus is the company’s low payout ratio. At just 14% of free cash flow, the dividend is small enough that should AGCO see a downturn in the business, only a significant drop in free cash flow would threaten its ability to afford the payout.
Conversely, AGCO has spent heavily in recent years on stock repurchases. More than $1.2 billion over the past six years has been spent to reduce the share count from about 100 million shares, to just 76 million today. The buybacks have helped soften the blow of volatile revenues over the past decade. Management has maintained an emphasis on dividend growth, so should cash flow drop – we see buybacks as a likely place where spending would be curbed.
Growth Opportunities & Risks
Even though the company faces volatility, there are some tailwinds that AGCO Corporation should benefit from over the coming years. The company should see a modest but steady tailwind from the gradual expansion of basic agricultural needs. As developing countries mature and the population grows, the overall need for more farmed crops will result in increased investment into crop production. Included in that would be farming equipment.
AGCO has also shown the ability to be forward-looking in its capital allocation. It spent an undisclosed sum to purchase farming technology called “Precision Planting” from Monsanto Company in 2017. This offers AGCO a high growth asset that should continue to grow as it spreads from mature markets (sales primarily in North America thus far) and into emerging markets over time.
Source: AGCO Corporation
Our hope is that as AGCO develops some of these emerging technology offerings, the company will command higher margins that boost AGCO’s overall profitability.
The risk that investors have to keep in mind is the occasional volatility caused by fluctuating crop prices. Like most cyclical businesses, it can be weathered by a strong company with competent management. We would want to see AGCO’s overall metrics improve over time, and AGCO’s management team will have to avoid putting the business in any tight financial spots, regardless of the operating climate.
At just over $73 per share, AGCO’s stock currently sits towards the high end of its 52-week range (between $49 and $80 per share).
Analyst estimates are currently estimating full-year EPS at $5.09 per share. This would place shares at an earnings multiple of 14.39X, a small 9% discount to the stock’s 10-year median P/E ratio of 15.05X.
We get a similar result if we chart the company’s FCF yield from the past 10 years. The current yield of 5.99% is an approximate midpoint. The FCF yield has ventured into the double-digits occasionally over the years.
Considering AGCO’s sub-benchmark operating metrics and the volatility it faces due to crop prices, we would pass on a long-term holding in AGCO Corporation. We would consider a short term based “trade” of AGCO should the valuation reach attractive levels. Something in the 10X PE range would give us an entry point of approximately $50 per share. This would provide some valuation-based upside which we would trade out of as the stock re-approaches historical norms.
Ultimately, AGCO Corporation is a solid company with some inherent flaws that we have trouble overlooking. The company’s volatility due to fluctuating crop market conditions is an issue, but the company’s inability to operate at benchmark levels during peak crop price conditions is more concerning. When you add in a balance sheet that is a little bloated for our liking, there just isn’t enough there to interest us as long-term investors. While AGCO may provide some volatility-driven upside at a deep discount on valuation, shares are not currently trading low enough to make that type of trade.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.