Market Too Focused on Corteva's Near Term

Since seed and crop chemical company Corteva CTVA was spun out of DowDuPont in June, we think the market has focused on near-term uncertainties like the effects of flooded U.S. fields and the dry start to the Brazilian planting season. However, we continue to expect a full rebound in U.S. agricultural input demand in 2020. Because the planting season has just begun in Brazil, we think it is too early to determine any impact on crop plantings this season. If plantings pick up in October, the effect could be that sales simply shift from Corteva’s third quarter to the fourth, similar to the delayed U.S. plantings in 2018. Regardless, we remain optimistic on Corteva’s long-term outlook and view the shares as undervalued.

Corteva is a leader in the development of new seeds and crop chemicals. Its product portfolio skews toward seeds, which generated 56% of revenue in 2018. The company develops its pipeline by investing nearly 11% of sales in research and development, which outpaces all competitors. This should allow Corteva’s sales and profits to continue to grow even as patents expire and generic products come to market.

Corteva’s seed portfolio is skewed toward corn, which generated 65% of 2018 seed sales, and soybeans, which generated 20%. Although Corteva’s market share in seeds is second to Bayer (Monsanto) BAYRY, the company has worked to close the gap through the development of its proprietary genetically modified organism seed platforms, Enlist and Conkesta. GMO seeds makes crops resistant to damaging insects. Over the next decade, Corteva plans to launch 10 new corn and soybean seed products. While anti-GMO consumer sentiments may limit Corteva’s growth in developed markets such as Europe, the need to improve crop yields globally should lead to eventual GMO adoption in emerging markets.

Corteva’s crop chemical portfolio, which generated the remaining 44% of sales in 2018, skews toward herbicides, which complement GMO seeds and should see increased demand. Conversely, we see insecticide demand falling over the long term due to an increase in GMO seeds. However, Corteva’s new insecticides will use new modes of action to target resistant bugs. Corteva plans to launch four herbicides, eight insecticides, and nine fungicides over the next decade. These new products should help farmers fight resistant pests, which are increasingly rendering older crop chemicals ineffective, creating the need for new crop chemicals.

Wide Moat From Patented Products We award Corteva a wide economic moat rating on the basis of its portfolio of patented biotech seeds and crop chemicals. The company's patented products command pricing power as they protect farmer yields and reduce other expenses such as insecticides. Corteva's intangible assets stem from the R&D spending required for the continual development of proprietary seed and crop chemical formulations. As patents expire and bugs develop resistance to current products, seeds with new traits and new chemical formulations must be developed. As a result, moaty businesses in this space must continue to invest in R&D. Corteva's R&D as a percentage of sales tops all major competitors, with the company investing nearly 11% of sales in new product development each year. This investment tops Bayer (Monsanto historically averaged around 10%), Syngenta (9%), and FMC FMC (7%), which gives us confidence that Corteva is investing enough to continue to successfully develop new products.

Before the merger between Dow and DuPont, DuPont’s agriculture business was second to wide-moat Bayer in biotech seeds and had built a solid position in the market, controlling a strong germplasm, or seed bank, and a capable distribution and marketing operation. DuPont had even bested Bayer in recent years on the marketing front with its more regional strategy.

Additionally, Corteva’s Enlist platform, which stems from Dow, sets the company up for long-term success as GMO seeds are adopted in emerging markets. Enlist seeds have also had two key product wins over Bayer in the last couple of years. In 2018, Enlist corn seeds were the first GMO corn approved for import into China. In 2019, Enlist soybean seeds were approved for import before a Bayer soybean received the same approval. We think import approval is the first step toward eventual GMO adoption. Although Corteva has yet to leapfrog Bayer on the technology front, it is beginning to close the gap and maintains a portfolio of patented traits that are difficult to replicate. As a result, Corteva should maintain its position as a clear number two and formidable competitor to Bayer.

Further, Corteva has begun to successfully license its Enlist platform technology to other seed companies, which sets up the seed business for a steady stream of profitable licensing royalties. In addition to the royalties, Corteva’s licensing strategy will reduce competition. As potential competitors license a Corteva technology instead of developing their own, they are more likely to spend R&D toward enhancing the base technology rather than invest in products that could take market share from Corteva’s seeds.

Competition, Regulation, Litigation All Risks Corteva faces stiff competition in both seeds and crop chemicals. The company's patents on its current product portfolio will eventually expire, which creates the constant need for new innovation. There is no guarantee its investments in researching and developing the next generation of biotech traits or crop chemicals will bear fruit. Weeds, insects, and fungi could develop resistance to seed traits or crop chemical formulations, rendering Corteva's technology less and less effective. The company may not be able to develop new products that will be able to combat the superresistant pests. Additionally, consumer sentiment could turn against bioengineered crops in the United States and South America, similar to conditions prevailing in Europe.

As a crop chemical producer, Corteva faces regulatory scrutiny. Regulators may not approve a new seed or crop chemical to be used. The company may also be subject to future lawsuits similar to Bayer’s glyphosate cases, which could ultimately result in billions of dollars in fines. Finally, demand for Corteva’s seeds and crop chemicals is tied to highly unpredictable factors, including weather and commodity grain prices. While many of these risks represent low-probability outcomes, they are still present and potentially material.

Corteva is also at risk for litigation related to perfluorooctanoic acid and other related toxic chemical lawsuits and environmental cleanup obligations, as the company was spun off from DowDuPont with some historical toxic chemical liabilities. Although former DuPont subsidiary Chemours faces the bulk of the risk related to the lawsuits, Corteva will probably have to fund part of Chemours’ lawsuit settlements and environmental cleanup expenses. Ultimately, Corteva remains at risk as long as Chemours faces lawsuits and liabilities related to toxic chemicals while it was still a part of DuPont.

Corteva was spun off with roughly $4 billion in debt, including pension obligations. Net debt/EBITDA should sit at 1.5-2.0 times, which is manageable. Leverage ratios will fluctuate throughout the year due to the seasonal nature of the seed and crop chemical business. However, with over $7 billion in committed credit facilities, Corteva should be well equipped to handle that seasonality.

Corteva plans to pay at least $400 million in dividends annually, growing with net income. Management targets a 25%-35% payout ratio for dividends. We forecast Corteva to generate solid free cash flow that will allow it to meet all of its financial obligations, with remaining cash flow to support dividends.