Headwinds Won't Last for Monsanto

Although there was a lot to digest in

We continue to think that Monsanto's shares are trading at attractive levels and that some of the near-term headwinds the company is facing today will eventually subside, allowing the market to appreciate the solid long-term value and growth prospects of Monsanto's industry-leading seeds and genomics business. In the near term, the company is facing headwinds from currency, elevated costs, and lower glyphosate pricing. Although these factors are likely to hold back growth in 2016, we don't think they damage Monsanto's long-term growth prospects. Notably, management is sticking to its long-term target to more than double earnings per share from 2014 to 2019. We think this speaks to the competitive positioning of Monsanto's products and the opportunities for seed technology growth, given necessary yield improvements globally.

Monsanto guided to 2016 EPS considerably below our previous forecast. The company expects EPS of $5.10-$5.60, which would represent a more than 6% decline from 2015 ongoing EPS of $5.73. Several headwinds that should dissipate over the long run are holding back near-term results. First, currency has moved against Monsanto globally, particularly in Brazil. Second, the glyphosate market has suffered recently from pricing declines, but management expects pricing to stabilize going forward. We've adjusted our near-term and long-term forecast for glyphosate profits accordingly. With a large chunk of Chinese producers currently selling below costs, we think glyphosate prices will find a near-term bottom soon. Third, elevated corn costs and Xtend soybean launch costs will lead to a higher-than-normal cost of goods sold in 2016. Management estimates that these items together represent an EPS headwind of $1.05-$1.55. We think these near-term headwinds have already been priced into the stock.

Management held firm on its target to double EPS from 2014 to 2019. This is now an even taller task given that 2016 EPS is expected to be similar to 2014 EPS. Although we think it is an achievable target if things break Monsanto's way, we ultimately think the company will fall roughly 15% short of this target even if we include $7 billion of share buybacks from 2016 to 2019. Given the discrepancy between our fair value estimate and the trading price, we think the market is expecting a much bigger miss. This market expectation does not line up with the growth prospects we see for Monsanto. In addition to the dissipating near-term headwinds, we expect solid profit growth from annual price lifts in corn, the expansion of Intacta acres in South America, the introduction of Roundup Ready Xtend soybeans, and material contribution from Climate Corp. toward the end of the decade. All of this will happen against a backdrop of growing emerging-market diets, which will place pressure on yields.

The company announced a restructuring and cost-saving plan that will cost about $900 million, but is expected to strip out $300 million in annual costs by 2018. The plan includes 2,600 job cuts. We were already expecting Monsanto would take costs out of the business in the face of tougher agriculture markets and lower farmer net incomes, so we haven't made sweeping adjustments to our forecast. That said, the incremental cost savings we did add to our forecast helped offset the lower expected profits from glyphosate.

We recently wrote that we were leery of a potential strategic shift by Monsanto to farm data. First, we don't think Monsanto has nearly the competitive advantage in data as it has in seeds. Second, we were somewhat worried that a big strategic shift could portend weakness in seeds. These concerns were somewhat quelled during the fourth-quarter earnings call. Management reiterated its expectation to double EPS by 2019 and spent much of the call outlining growth drivers in seeds and genomics.

R&D Keeps Monsanto a Step Ahead 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 and Dow Chemical 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.

Patent Portfolio Is Foundation of Wide Moat 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, the company 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 SYT 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.

Despite all of the recent negative headlines, we think the company will continue generating returns on capital for shareholders at a rate similar to historical averages. While the company may not be able to extract large share gains from competitors DuPont DD and Syngenta, we think its massive R&D budget and important collaboration projects will keep Monsanto at or above industry growth rates in the GM seed market. We think the company will continue to plow about 10% of sales back into R&D in an effort to maintain its market lead. Monsanto's long-term seed profitability will depend on the company's ability to drive farmers toward new products with younger patents in order to fend off inevitable generic competition. We think the company will be relatively successful in this regard and don't expect a dramatic drop-off in seed margins over time.

Tough Competition Remains a Risk 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.

The company maintains good liquidity, with more than $2 billion in cash as of December 2014 and $2 billion availability under its unsecured credit facility. Furthermore, the company's debt maturities are well laddered, with the next scheduled maturity of $700 million coming due in 2016. We think the company will continue to meet its debt maturity requirements through a combination of strong cash flow and continued access to public debt markets.