A New Industry Mammoth?
The merger between CNH and Fiat Industrial, to form CNH Industrial, has been the latest and most important news to come out of the heavy machinery industry. The transaction was expected since Fiat Industrial owed a great stake on CNH, and production benefits are expected to derive. However positive the news may be for management and expectations, the market has not reacted in kind. And stock price tumbled 2.47% to reach a new 52-week low of $11.44, amid strong farm equipment performance and renewed gains in the European truck industry.
In the short term, CNH Industrial expects a revenue decline in the fourth quarter because inventory has been replenished. This in turn will benefit cash flow and affect return on capital as inventory is draw down. A good note is the continued margins improvement in the back of a recovering construction European market, costs controls on the Iveco truck, and South American growth, amid a slowdown of the farm machinery market in North America. However the firm’s great international exposure and margin improvements, no economic moat has been achieved.
CNH Industrial’s greatest rivals in the farm segment are Deere Co. and AGCO. Given the industry’s future growth prospects, driven mainly by a higher demand for technology at developing countries, the firm should have no trouble benefiting from market synergies. In the construction segment, the company has carved a niche in the compact-equipment category. Although competition for the segment is considerably smaller, underutilized factories and new product initiatives have placed margins under increasing pressure. Hence, the main growth driver is expected to come from the farm segment.
Financially, CNH Industrial has shown an overall slowdown related to restructuring costs. However, costs continue to decline, indicating efficiency improvements. Currently trading at 10.47 its forward earnings, the stock is carrying a 21% discount to the industry average. Mason Hawkins has been the only guru with a registered transaction, and holds an excess of 30 million shares. I share his optimism due to the introduction of 18 Case brand tractor models, three additional tractor models under the New Holland brand, Naveco´s new mid-size cab Yuejin “Chaoyue,” and launch of recently developed Euro VI version of the NEF engine.
AGCO is the closest competitor to CNH Industrial’s farm segment. Three times smaller when measured by market cap, AGCO’s brands Challenger, Fendt, Massey Fergusson and Valtra compete directly with CNH Industrial´s Case and New Holland. Although AGCO does not have a truck segment, they both have an important powertrain segment, and their product offering is very similar. And future prospects have recently been fed by the insider purchase made by Mallika Srinivasan, director at AGCO.
International expansion continues to be the most important policy to AGCO. The company aims at a greater presence in the Commonwealth of Independent States (CIS), China and Africa. Like its rival, growth opportunities have been identified at developing countries, where technology has not been fully incorporated to production techniques. In North and South America growth is expected as production intensifies and planted area increases. However, management expects the growth to be offset by sale drops in Western Europe. Hence, the CIS, China, and Africa are all the more important.
Like its competitor, AGCO has been unable to dig an economic moat. On the upside, the company holds50% percent of the Brazilian tractor market, and is second in Europe. Looking ahead, this is an important characteristic as competition with Deere Co. and CNH Industrial in the North American market where the firm holds a small share can be avoided. On another note, and opposite to CNH Industrial, AGCO continues with a growth strategy based on acquisitions. The results have proven to be very successful as operating margins remain above the 10% mark.
The balance sheet for AGCO is strong because net income continues to improve amid a decline in margins due to inefficiencies related to recent acquisitions. Trading at 9.67 its forward earnings, the stock carries a 27% discount to the industry average. Jim Chanos and Jim Simons, the two largest gurus with a stake in the company, have increased their holding through 2013. I share their optimism because an interesting stock price drop has opened a window for a discounted entrance.
It Is a Matter of Size… and Efficiency
Size can sometimes be an obstacle to efficiency and growth. I believe Case and New Holland never solved this issue, and this is a great argument for the latest merger with Fiat Industrial. Hence, I prefer the smaller but more tightly structured AGCO, because the firm holds dominant positions in markets set to grow in the upcoming years. Additionally, international expansion continues to be one of the key policies for growth.
Disclosure: Vanina Egea holds no position in any of the mentioned stocks.