Forget Caterpillar, this Stock Could Surge 40%

Few stocks are better indicators of economic growth than Caterpillar Inc. (NYSE: CAT). With strong international diversification and sensitivity to economic cycles, the company is closely watched by fund managers and analysts alike for clues about the trajectory of the country’s gross domestic product and corporate earnings in general. In other words, Caterpillar’s performance is a pretty accurate predictor of how the economy is doing.

#-ad_banner-#So when Caterpillar posted weak third-quarter results that fell short of expectations, it was a clear signal that the global economy and industrial demand is slowing.

But in spite of these macro headwinds, it doesn’t mean it’s time to abandon the industrial stocks altogether. In fact, one of Caterpillar’s industrial equipment cohorts is bucking the bearish trend, looking much less susceptible to a slowdown in the global economy as share price and estimates continue to rise. 

Take a look at the chart below and see how my favorite industrial-equipment stock has sharply outperformed Caterpillar in 2012.

The company in question is AGCO Corp. (Nasdaq: AGCO), a farming-equipment specialist with a market cap of just $4.8 billion. In spite of a relatively weak global economy, AGCO has had a great year. The company has beat expectations in each of the past four quarters, completed a major acquisition to expand its product line and seen estimates steadily rise. These strong fundamentals have lifted AGCO’s share price to a 10% gain this year, handily outperforming industrial-bellwether Caterpillar as investors take note of the up-and-coming mid-cap.

But looking forward, this burst of short-term strength in a weak economy is merely a reflection of a bigger story. With the bullish trend in agriculture well in play, AGCO is making some very strategic moves to capitalize on this big opportunity.

AGCO’s core business is in mid- and small-size tractors. This is a little bit different than a company like Deere & Co. (NYSE: DE), for instance, which operates across a wider spectrum of the tractor market with an emphasis in large machines and combines. But late last year, AGCO completed a $934 million acquisition of GSI, a global leader in grain storage and protein production systems. With sales of $700  million in 2011, GSI significantly increased AGCO’s sales and market cap. It also provided AGCO with access to new markets, customers and opportunities to cash in on growing agriculture demand.

But in spite of this emphasis on product diversification, AGCO remains focused on growing its core business in tractors. In September, the company celebrated the completion and opening of a new $350 million manufacturing plant in Germany, and launched a new line of mid-size tractors under its high-end subsidiary Fendt. Both initiatives are intended to support additional sales and production in Western Europe, an important international grain hub.

AGCO is also focused on tapping into lucrative emerging markets. The company is scheduled to begin construction on a new manufacturing plant in China next year, called Centurion Project, investing more than $200 million in a strategy to streamline global procurement. This could also help AGCO advance its goal to increase in-house engine production. As it stands, AGCO builds about 50% of its own engines with the other 50% insourced from Caterpillar. But longer term, the company wants to source 80% of its engines in house to drive margins and profitability.

South America is also a key part of AGCO’s long-term strategy. In the short run, Brazilian farmers have been scrambling to increase production and become stronger competitors after the worst drought in 100 years crushed production in the U.S. Midwest. Higher production will drive local earnings and support capital spending. Longer term, Brazil’s planted acreage is expected to continue growing as demand for food resources increases with the global population. And AGCO will likely cash in on this long-term trend.

But simply adding additional production capacity and growing revenue isn’t always a formula for higher profits or profitability. Adding products and tapping into new markets presents operational challenges to even the best companies. That’s why AGCO launched a campaign last year to expand its operating margins to 10%. As it stands, AGCO has lower margins than industry competitors like Deere & Co. and CNH Global NV (NYSE: CNH), but by streamlining global procurement, lowering production costs and improving productivity, the company has a clear path to accomplishing its stated goal.

Risks to Consider: All equipment makers are fairly cyclical, leaving AGCO vulnerable to industry fluctuations. Higher input costs due to rising metals prices is also a threat to margins and profitability.

Action to Take –>  While leading equipment maker Caterpillar is struggling in a weak global economy, AGCO is quietly posting strong results and charging higher on the chart. But in spite of that bullish movement and all the good news, shares are still trading with a historically low valuation. If AGCO forward price to earnings (P/E) ratio of 8.3 simply carried the same valuation as the industry average of 11.6, then shares would jump to $67, a 40% increase from current levels.