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Stock Strategist

Monsanto Still Underappreciated by Market

The company's not getting credit for its long-term innovation-driven growth prospects.

 Monsanto's fiscal second-quarter results held few surprises. As expected, the company continues to battle several headwinds, including compressed grower margins caused by languishing crop prices, competitor discounting, Argentine currency devaluation, and lower glyphosate pricing. Taken together, these factors are likely to push Monsanto's fiscal 2016 earnings per share below the fiscal 2015 level, an unfamiliar situation for a company that has experienced steady profit growth over the past five years. With management leaving its 2016 EPS guidance intact and no change to our long-term outlook, we are holding our $120 fair value estimate and wide moat rating steady.

Past fiscal 2016, we think Monsanto's growth is set to reaccelerate, as we see this year as only a hiccup for a wide-moat company and clear leader in crop biotechnology. Our long-term outlook assumes crop prices, relevant currencies, and glyphosate pricing will stabilize near current levels, with incremental growth for Monsanto driven not by improvement in these outside (and uncontrollable) factors, but rather by the continued monetization of the company's innovative product lineup and pipeline.

Monsanto should see growth from multiple products, including the continued rollout of its Intacta soybeans in South America, the commercialization of Roundup Ready 2 Xtend soybeans, and incremental price lifts for its best-in-class corn hybrids. Longer term, we expect contributions from the digital agriculture platform Climate and Monsanto's microbials partnership with Novozymes. We think the market has focused too much on near-term headwinds at the expense of Monsanto's solid long-term outlook.

Our Monsanto thesis is not without its risks. In particular, we continue to monitor competitive pricing actions from DuPont , which cut seed prices this year in an attempt to gain market share. Monsanto responded in kind, cutting its own prices to maintain share. With Monsanto's management publicly committed to protecting share, we think DuPont will restrain from further cuts, as a share-steady price war would reduce profits for both major players.

Further, negative consumer sentiment toward genetically modified organisms could threaten Monsanto's current business and its ability to expand into new emerging markets down the road. Our stance has always been that GMO penetration will increase, not decrease, over time as the need to increase crop yields globally outweighs negative developed-market consumer sentiment concerning GMO safety. In addition, we expect the view of the public to eventually match the widely held view of the scientific community that GMOs are safe.

Biotechnology Efforts Hugely Successful
Monsanto's complementary business lines include crop chemicals and seeds. The company first commercialized Roundup weed killer in 1976; 20 years later, it began selling genetically modified seeds that were unaffected by Roundup. Roundup Ready crops allow farmers to spray their entire fields with the potent herbicide without harming crops. Additionally, Monsanto has developed biotech traits that make crops resistant to damaging insects. Monsanto's efforts in biotechnology have been hugely successful. Farmers value the reduced pesticide use, time savings, and yield protection provided by Monsanto's traits. About 90% of the soybeans and 80% of the corn grown in the U.S. contain a Monsanto trait. The firm has saturated the market by snapping up seed companies and also through its extensive licensing program. Monsanto made the decision early to broadly license its traits to competitors, leading to rapid adoption. This decision has created a GM seed industry with multiple licensing deals, collaboration efforts, and frequent lawsuits among the main players.

While the firm's main competitors have worked to close the gap in seed and trait share, we still view Monsanto's research and development pipeline as a step ahead. We think the company will continue plowing about 10% of sales into research and believe its collaborations with the likes of BASF will make those dollars even more meaningful. Monsanto offers partners access to its world-class distribution and conventional seed-breeding capabilities, without the need to purchase their own seed platforms.

We think Monsanto will remain the industry leader, but the firm is not without its problems. In our opinion, profits from the Roundup business have been permanently damaged by generic competition. Further, the development of superweeds and bugs threaten the company's current line of GM seeds. Also, the company is always in some kind of legal battle, and anti-GMO consumer sentiment may limit Monsanto's potential markets. That said, we think the need to improve crop yields globally will lead to eventual GMO growth in emerging markets.

R&D Keeps Monsanto a Step Ahead
Having created the agricultural biotechnology market where it now competes, Monsanto has a wide economic moat, in our opinion. The company's portfolio of patented traits forms the basis of its moat, much in the same way patent-protected drugs form the moat foundation for a pharmaceutical firm like Pfizer. Monsanto's proprietary seed companies use the traits it develops, but the firm also licenses traits for use by others. This strategy has led to dominant market share, and Monsanto enjoys premium pricing for its patented traits. Monsanto uses the cash flows generated from its current product lineup to invest in research and development for next-generation offerings. The company consistently pours 10% of sales into R&D each year.

Monsanto is an attractive partner for agricultural biotech companies without their own extensive seed platforms. Further, Monsanto owns an industry-leading germplasm (a seed bank for conventional and molecular hybrid breeding) and global breeding operation that is difficult to replicate. Signs of Monsanto's dominance in GM seeds are readily apparent, including rivals' accusations of controlling an unfair monopoly and the fact that some competitors choose to license the firm's technology instead of going head-to-head with Monsanto. For example, Syngenta has chosen to license Roundup Ready 2 Yield for its second-generation soybean offering instead of investing the dollars to develop its own platform. We think Monsanto will earn returns on invested capital above its cost of capital for quite some time.

Competition and Consumer Sentiment Are Risks
Despite its position as an industry leader, Monsanto faces stiff competition in both seeds and crop chemicals. There is no guarantee its investments in researching and developing the next generation of biotech traits will bear fruit, and Monsanto could be passed by its rivals, eventually losing share in the lucrative corn and soybean seed markets. Further, once GM seed patents expire, Monsanto will need to compete with generic manufacturers and could see margins erode, similar to the dynamics that currently plague the firm's glyphosate business. Also, weeds and bugs could develop resistance to the firm's traits, rendering Monsanto's technology useless.

Additionally, consumer sentiment could turn against bioengineered crops in the United States and South America, similar to conditions prevailing in Europe. The firm also faces government scrutiny. The U.S. Department of Justice has investigated Monsanto's competitive practices, and the company's products are subject to extensive regulation. Finally, demand for Monsanto's seeds and crop chemicals is tied to highly unpredictable factors, including weather and commodity grain prices.

Monsanto sports a healthy balance sheet, even after its recent recapitalization program. The firm is a strong cash flow generator, and we don't think it will have any trouble meeting its additional debt obligations. Even with internal needs for R&D, Monsanto has generated enough cash to return money to shareholders in the form of dividends.