Friday, December 21, 2007

Time To Stop Nibbling on Monsanto Shares?

On-farm trials across the United States demonstrating a better seed corn product to farmers than leading competitors; rising global demand of corn for feed and fuel (ethanol); and, expectations that profitability will double over the next five years on U.S. sales of new, more profitable seeds and gains in sales outside the U.S.—is it no wonder that shares in biotech crop giant Monsanto Corp. (MON-$108.46) closed just below its 52-week high (of $109.85 a share) in trading Thursday, an increase of $5.42, or 5.4 percent, from the prior day.


Monsanto is now positioned as the leader in ag-biotech for growers and downstream customers, such as grain processors and consumers. With the exception of competitors in its vegetable and fruit seed business, too, most of the Company’s seed competitors are also licensees of its
germplasms or biotechnology traits.

In addition to the Seeds and Genomics segment, Monsanto is a leading provider of herbicides for residential lawn-and-gardens and animal agricultural feed products, with Roundup and other
glyphosate -based herbicides contributing approximately $854 million to gross profits in FY ’07 (ended August 31)—even though, glyphosate, the active ingredient in Roundup, lost key patent-protection back in 2000.

Driven by success in acceptance of its genetically modified row-crop seeds, which provide plant protection from herbicides and insects, investors rewarded the stock price with outsized (split-adjusted) five-year gains of more than 1,262 percent!

Can you, the investor, still find a buying opportunity here? Adding to the bulls argument: the World Agricultural Supply and Demand Estimates (WASDE) recently revealed lower corn and oilseed inventories by the end of the 2007/08, with prices for these respective commodities expected to rise.

Investment Considerations & Risks

Monsanto has been a bullish stock in a continuing
bullish commodity environment.

Nonetheless, at 45.2 times the company's FY 2008 consensus earnings estimate of $2.40 a share, the 10Q-Detective believes that—contrary to the majority of Wall Street analysts—Monsanto’s stated CAGR of 20 (+) percent over the coming five-years is already factored into the share price, and the stock is trading at a premium to its intrinsic valuation of $92 a share.

Monsanto’s steep P/E multiple leaves little wiggle-room, should adverse weather, exposure to global agricultural markets, and/or regulatory delays lead to special charges and lowered guidance.

In our view, investors have already discounted the expected future demand for corn by an expanding U.S. ethanol sector. While corn is currently the primary feedstock—and political favorite—for U.S. ethanol production, if/and when economically viable alternatives be developed, such as cellulosic biomass (wood fibers and crop residue), lower corn trait sales volumes might result.

Monsanto remains highly dependent on one commodity for its success—seed corn and traits, which accounted for about 32.8% and 57.1% of net sales and gross profits, respectively in FY ’07, up 57% and 69%, respectively, from last year.

Growth Outlook: Corn Seed

The company's national corn seed brand,
DEKALB, has realized six consecutive years of market share gains in the U.S. corn seed market, growing to 23 percent, doubling its presence in the market in the last five years, due in large part to yield and dry-down advantages.

Monsanto says corn seed will continue to be a key driver to the U.S. and international corn seed businesses. “Our success rests squarely on the shoulders of triple-stack penetra­tion," Monsanto Chief Executive Hugh Grant said on an Oct. 10 call with analysts.

Management is heralding advantages of its proprietary triple-stack combination, which offers three modifications (to protect against two types of insects and Roundup herbicide). For example, higher yields/acre are being reported for
continuous corn-corn growers (no crop rotation).

Triple-stack corn will account for at least half of Monsanto's U.S. corn-seed sales in 2008, up from 42 percent in FY ’07, according to management.

Backed by the aforementioned advantages that its seeds are delivering to farmers—with associated margin gains—management anticipates the DEKALB brand—including the next-generation YieldGard VT™ Triple technology—will be the significant catalyst of growth, gaining as much as 10 percentage points in the United States by 2012. In key international markets, the company expects to realize annual gains of 1-to-2 percentage points in most regions through 2012.

Adding a percentage point of corn-seed market share boosts Monsanto's profit by about $7 million in the European Union and $40 million in the U.S., where the market is bigger and gene modifications make the seeds more valuable, according to Monsanto.

Monsanto has high hopes, too, for the
SmartStax corn platform—a stacked-trait corn plant with eight different herbicide tolerance and insect-protection genes!

Management is aggressively talking up a FY 2010 rollout. In our view, given that the research is still only in
Phase One (Proof-of-Concept), a 2010 launch might be premature—inability to prove the original concept and/or runaway development costs/delays, two of a number of reasons why a new product concept may be abandoned.

[Ed. note. Monsanto bulls will counter that as every trait included in SmartStax is already either available commercially or in advanced stages of regulatory review, submission and subsequent approval could come quickly].

DEKALB represents Monsanto’s strategy of rolling-out "platform" technologies — genetic traits that Monsanto hopes will become as ubiquitous in soybeans and cotton as it is predicted to be in corn.

Soybean Seed

In our view, other current crop penetration data suggests that management might be too optimistic with sales volume guidance—even with predictions that the “bull-run” in commodities should continue unabated through the first half of 2008.

“Soybean business is on track for a one million to two million acre controlled commercial release of Roundup RReady2Yield technology in 2009, with a full-scale launch of five million to six million acres in 2010. The introduction of Roundup RReady2Yield soybeans will serve as the platform for up to five new stacked trait offerings in soybeans by 2012.”

Does it matter that
Asgrow brand ’08 Elites yielded on average 3.4 bushels more per acre than competitors’ brands (Pioneer and NK brands)? Demand for soybean seed and traits net sales fell 6 percent, or $59 million, in 2007, driven by a decrease in sales volumes of U.S. soybean seed and traits because fewer soybean acres were planted. This-despite average (Jan – Nov) 2007 soybean and soybean oil price increases of $103/metric ton and $258/ metric ton (year-over-year), respectively.

Agricultural analysts suspect that high demand for corn for ethanol production and distiller’s grains (a high-protein animal feed) has driven many farmers to plant two years of corn for every year of soybeans.

Cotton Seed

“Cotton business remains focused on converting the Delta and Pine Land portfolio to its double stack of second-generation technologies. By 2012, pending regulatory approvals, the company believes this business will be selling stacked, second-generation offerings in both its India and U.S. cotton business, effectively doubling the gross profit contribution of this business.”

In our view, in FY ’08, any revenue gains to be had from the $1.5 billion Delta and Pine Land acquisition in August 2006 will likely be somewhat offset by the divestiture of the Stoneville and NexGen businesses. [Ed. note. Monsanto's Stoneville and Delta & Pine Land together would have accounted for more than 57% of the total US cotton market. In June 2007, to receive the required regulatory approvals, including the Department of Justice, Monsanto completed the sale of the aforementioned cottonseed subsidiaries]

Beyond 2008, however, the purchase of DPL should enable Monsanto to accelerate its penetration of second-generation cotton traits. Of interest, how quickly Monsanto can execute on the competitive advantage [i.e. speed in getting a new product to market], given existing DLP distribution channels dealt by the Delta & Pine Land acquisition.

D&PL comes onboard with subsidiaries in 13 countries - including major markets such as China, India, Brazil, Mexico, Turkey and Pakistan.

We agree with Wall Street analysts who suggest that the takeover means that Monsanto will command a dominant position in some of the world's most important agricultural trade commodities and that millions of cotton farmers will be under increased pressure to accept genetically modified cottonseed.

In India, management believes its cotton trait product has the potential to be planted on 15 to 20 million acres by 2010.

Worldwide demand for cotton is projected to grow by about 20 million bales or 16 percent in the coming decade, according to an analysis published by Texas Tech University's Cotton Economics Research Institute in May 2007.

China will remain on top in production, and the United States will fall to number three. India will rise to the second spot on the heels of recent technological breakthroughs in seed and production practices, according to the forecast.

However, in 2007, seed cotton and traits net sales decreased 15 percent, or $57 million, driven by lower cotton trait sales volumes in Australia resulting from a decline in cotton acres. Planted cotton acres declined 54 percent there in the 12-month comparison because of a severe drought in certain parts of Australia in first quarter 2007. In addition, there was a decline in net sales of seed cotton and traits related to the decline in cotton acres in the United States.

Uncertain is
how will biofuel demand affect changes in U.S. farmers’ output (in terms of field usage). Albeit, the USDA, projects that actual U.S. planted area will drop by 28% in 2007.

Patent and Intellectual Property Issues

Patent positioning is strong. Herbicide tolerant products (Roundup Ready traits in soybean, corn, canola and cotton seeds) are protected by U.S. patents that extend at least until 2014; and, second-generation trait for cotton, Roundup Ready Flex, is protected by U.S. patents through 2025.

Net sale gains of corn seed in Europe, Argentina and Brazil— related to stronger customer demand—did not seem to translate to other commodity seed revenue gains, especially in Argentina and Brazil. Historically, Monsanto has had problems with
protecting its intellectual property rights in South America (e.g. Growers in Brazil have pirated Roundup Ready soy seeds, which can withstand applications of glyphosate herbicide, from neighboring countries, planting them illegally to reap higher yields and lower herbicide costs).

Credit Issues

Another unanticipated problem—should economic instability return to Argentina and Brazil, business could be adversely impacted—and Monsanto could decide to return to a cash payment system, rather than its current credit program.

Monsanto has agreements with banks that provide financing to its customers in Argentina and Brazil through credit programs that are subsidized by the respective governments. The amount of loans outstanding was $66 million and $47 million as of August 31, 2007, and August 31, 2006, respectively. For most programs, Monsanto provides a full guarantee of the loans in the event of customer default.

Brazilian farmers currently plant around 50 percent of acres with Monsanto’s Roundup Ready soybean variety, according to Monsanto’s vice president of global commercial business, Brett Begemann. In our view, stepping towards its targeted 95 percent penetration levels will not be accomplished without looser customer financing terms—credit risks in tandem.

Valuation Analysis

As our DCF model, which assumes an 8.3% weighted average cost of capital, a 22 percent growth rate, and 15 percent operating margins, calculates intrinsic value of $92 a share.

As any ‘act of God’—weather conditions and natural disasters—will affect the IF in the timing of planting and the IF in acreage planted, as well as the IF in yields and the IF in commodity prices.

Conversation about the weather is the last refuge of the unimaginative. ~ Novelist Oscar Wilde (1854 – 1900)

Lest we be accused of being tiresome beings, suffice it to say, technical momentum will probably carry Monsanto shares to new trading highs; we prefer not to nibble on this IFFY corn stock.

Editor David J. Phillips does not hold a financial interest in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

1 comment:

Glen W Peterson said...

The author's comments are a classic case of not seeing the forest from the trees.

China GDP and India GDP are moving at above 8% rates.

Argentina and Brazil have the arable land to feed them.

Diets are historically, inelastic related to demand. Meaning once they improve, they don't usually get worse. This will continue to stimulate demand for feed grain imports.

The same can be said of demand for clothes and cotton.

Fuel is also becoming fuel a la the Brazilian model. Mandates for bio-fuels are cropping up everywhere faster than spring wheat. Brazil just increased bio-diesel mandates and the U.S. energy bill made dramatic committments to raising all bio-fuel usage.

The focus should be on the increases in demand and the dominant position of MON, along with the sustainability of the growth story.