Deals

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

Deere & Co.'s big bet on construction equipment is magnifying a weakness at a $15 billion rival.

Deere last week announced it's acquiring closely held Wirtgen Group, a producer of road pavers and rock crushers, for about $5.2 billion. The deal for the German company will boost the amount of revenue Moline, Illinois-based Deere gets from construction equipment by more than 50 percent, giving it the heft to be a meaningful competitor in a business that's at times been an afterthought next to its comparatively gargantuan agricultural operations. It also will make the construction business at CNH Industrial NV look even tinier and more ill-suited to the truck and tractor maker than it already is.

Small and Getting Smaller
CNH Industrial's construction unit has been handicapped by its small size
Source: Bloomberg
Note: Komatsu's fiscal 2016 ended March 31, while Deere's ended Oct. 31. The other companies operate on a calendar year. Wirtgen had revenue of 2.6 billion euros for the year ended Dec. 31, 2016. That total has been converted to USD for graphing purposes based on the exchange rates for the final day of that fiscal year.

CNH was formed via a 2013 buyout of CNH Global by its parent company, Fiat Industrial, the maker of Iveco delivery trucks. The deal, done partly to counteract the side effects of the European debt crisis, did little to prop up CNH Industrial's lagging market share in construction. Sales of excavators, backhoe loaders and other construction equipment have never accounted for more than 15 percent of the combined company's sales, putting it meaningfully behind Caterpillar Inc., Komatsu Ltd. and even the pre-Wirtgen Deere.

Executives have known this wasn't an ideal situation. In 2011, Sergio Marchionne, then chairman of Fiat Industrial, acknowledged "it's possible that somebody could view our positioning in construction as something which will potentially benefit from an association." The next year he called the business an "industry laggard." In 2015, CNH Industrial CEO Richard Tobin said the company is more of a follower in the construction equipment market and as such could face challenges should pricing become very competitive. Well, that's exactly what happened and it hasn't been pretty.

It's tough to go toe-to-toe with significantly larger peers and command whatever price you want, says Bloomberg Intelligence analyst Christopher Ciolino. CNH Industrial's construction unit earned a mere $2 million (yes, with an M) of operating profit on more than $2 billion of sales last year. In 2015, the unit's most profitable year since its merger with Fiat Industrial, the implied margin was about 3.5 percent. Caterpillar has been feeling the price squeeze as well amid excess capacity, but its construction-industries segment managed to earn $1.65 billion on $15.6 billion of sales in 2016. 

Struggle is Real
Revenue at CNH Industrial's construction business has shrunk, while profit remains under pressure
Source: Bloomberg

Deere's move to get even bigger in construction should make investors more aware of the size and struggles of CNH Industrial's business. It's been cutting costs and has said pricing pressures should mitigate as the year goes on, but it's still a small, sub-scale competitor and that's not the type of thing that's going to magically fix itself. Getting bigger in construction via a takeover could hamper the company's efforts to achieve an investment-grade rating, depending on how it was financed. Spinning it out wouldn't solve the size problem, so that leaves a joint venture with another middle-of-the-pack construction equipment maker or a divestiture as perhaps the best options. 

Follower, Not a Leader
CNH Industrial shares have lagged behind larger machinery makers
Source: Bloomberg

The unit's performance has been far from spectacular, but it gets about half its revenue from North America and its established distribution presence there could appeal to a foreign buyer looking for a U.S. foothold, says Larry de Maria, an analyst at William Blair & Co.

As for how much the business could command in a sale, Deere is paying about 1.8 times Wirtgen's 2016 sales. While CNH Industrial's profit-challenged construction unit may struggle to command something quite that high, this week is supposed to bring a big infrastructure push from President Donald Trump (if he can ever get off Twitter) and optimism for an eventual spending boom is running high. Who knows if it will actually happen in the U.S.; there's little sign so far that all the rhetoric is translating into action. But Deere, at least, felt strongly enough about the long-term prospects for infrastructure spending both at home and abroad to break out its wallet for the biggest deal in its 180-year history.

Should other potential buyers be like-minded, CNH Industrial should be ready to listen. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net