Thursday, September 27, 2012

Monsanto: Execution Needs To Merge With Opportunity

A good story will only take a company so far, and the last few years have brought that lesson home to Monsanto (NYSE: MON) the hard way. After years of aggressive pricing on their seed traits and tactics towards farmers that skirted (if not crossed) the line of bullying, Monsanto found to its dismay that rivals like DuPont (NYSE: DD) and Syngenta (NYSE: SYT) had closed the performance gap and customers were more than happy to give them a try. While Monsanto has what looks to be the most exciting pipeline in agribiotech and ample growth opportunities; management must be careful not to repeat the errors of the past if investors are to reap all the rewards they should.

Monsanto Fixing Itself Faster Than Some Expected

After years of riding high on the success off its genetically-engineered seed traits, Monsanto has had a rough couple of years recently. The company basically overpriced its seeds relative to their yield production (particularly SmartStax and Roundup Ready 2) and farmers began switching over to alternatives from DuPont and Syngenta. This transition was aided in no small part by a bad reputation that Monsanto had built with its customers after years of arrogance and aggressive tactics designed ostensibly at protecting its franchise.

Luckily for Monsanto holders, the company has come back from this faster than many analysts thought likely. Monsanto quickly adjusted its prices and offers a more compelling value trade-off than in the recent past. It also helped that a lot of the rumors about Monsanto's yield shortfalls proved over-heated; DuPont and Syngenta have closed the gap, but Monsanto's actual results were not so bad as feared and the company continues to show solid yield improvements in corn and soybeans.

Are Chemicals A Lost Cause?

One of the major factors in the investment reset on Monsanto was the virtual collapse of the company's Roundup herbicide business. Due in large part to glycophosphate overcapacity, Monsanto had little choice but to cut prices and take a hit to margins.

At this point, it doesn't look like Monsanto has any particular interest in expanding this business. Simply put, the company is just not committing much in the way of R&D to this business and it looks to be an ever-shrinking part of the profit picture. While there are some deals that the company could contemplate – say the acquisition of American Vanguard (NYSE: AVD) or the ag chemical business of a company like FMC (NYSE: FMC) – it seems unlikely that management will go that way.

R&D Holds Real Value

Monsanto's value as an investment has always revolved around its R&D capabilities and its pipeline, and that doesn't look to change soon. Monsanto seems to be in position to be first-to-market with long-awaited drought-resistant corn and that would be a major competitive advance on DuPont and Syngenta. Likewise, SmartStax Refuge In the Bag should drive greater sales with its convenience advantage for farmers, while the Intacta soybean product could be a multi-hundred-million dollar opportunity.

Longer term, the company has some promising R&D efforts underway in oilseeds and wheat – major crop categories where the company hardly competes today. Add in some advanced cotton and vegetable traits under development (including more nutritious vegetables), and rice is really the only major area where Monsanto is lacking.

Most Things Breaking Monsanto's Way … For Now

As seen in publicly-traded farm companies like Cresud (Nasdaq: CRESY) and Adecoagro (Nasdaq: AGRO), crop plantings in Argentina and Brazil are strong and getting stronger. With leadership in most markets already and relatively better perception, this certainly helps Monsanto. It's also worth noting that Europe seems to be softening a bit towards genetically-engineered crops – it's hardly a welcoming market now, but there are some signs that conditions are improving.

Still, plenty could yet go wrong. Sudden resistance (like corn rootworm) is always a risk and public policy worries about modified seeds is not going to disappear anytime soon. It's also worth noting that there are DOJ and SEC investigations underway, as is litigation with DuPont. Last and not least, while engineered seeds is largely a three-horse race in most markets, companies like Dow (NYSE: DOW), BASF (BASFY.PK), and Bayer (BAYRY.PK) could emerge as bigger threats down the road.

The Bottom Line

With strong land and crop prices, farmers are in better shape today to adopt engineered seeds than in years past. Moreover, Monsanto has a rich pipeline that could deliver several blockbusters over the next five to ten years.

Unfortunately, much of that is in the price today. Even allowing for solid revenue growth and ongoing margin improvements, it takes some work to build a cash flow model that shows Monsanto undervalued by much more than 10% or so. For a company with solid returns on capital and market leadership in growing markets, that's not terrible, but it does suggest that investors can find better bargains elsewhere.

Disclosure: I am long MON.

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