Monsanto Looks A Bit Vulnerable At Current Levels

By Stephen D. Simpson, CFA | April 03, 2013 AAA

While Monsanto Company (NYSE:MON) may be evil incarnate to some people, the fact of the matter is that the company's products work quite well and the company has fixed its marketing problems such that it has become one of the go-to names for investors looking for exposure to agriculture. While Monsanto's fiscal second quarter results were decent and it looks like this will be a successful planting season, new investors may want to be careful about making a big new investment at today's levels.

Fiscal Q2 Results Beat … Sort Of
On first blush, Monsanto had a very strong fiscal second quarter. Revenue was up 15% as reported, and about 5% higher than analysts expected. Earnings were likewise quite strong, as pro-forma EPS grew about 13% and beat expectations by 6%.

How Monsanto beat the numbers is less convincing, though. Sales of seeds were up 11% and closer to expectations, and corn was strong (up 16%), but everything else was down and relatively weak compared to expectations. The big upside to sales came from the “Productivity” segment, where strong sales (up 37%) of products like Round-Up were surprisingly strong. (For more, see A Primer For Investing In Agriculture)

This was pretty much the theme through the release. Gross margin was a little soft, both in absolute terms (down 90bp) and relative to expectations, as softness in seeds (down 140bp) outweighed strength in Productivity (up nearly seven points). Operating income rose 15% at the segment level. This was slightly better than the average estimate and was driven, no surprises here, by the Productivity segment. (For more on this topic, check out Analyzing Operating Margins)

It's Not Over Until It's Over
Investors disappointed by the somewhat soft results in seeds and/or management's restrained boost to guidance should take heart, as it is the second and third fiscal quarters that really drive results for Monsanto.

Planting has seemed a little slow this year, perhaps due to weather. That said, it looks like the amount of acreage devoted to corn will grow slightly from last year, to the highest level since 1936. Soybean acreage is likely to decline very slightly. With much of the planting area still seeing significant drought conditions, more farmers may be inclined to turn to the hybrid seeds of Monsanto, DuPont (NYSE:DD), and Syngenta (NYSE:SYT) to boost yields.

That said, we won't know for a little while yet how this planting season played out, nor whether Monsanto maintained its recent trend of share growth. Management was pretty optimistic about the take-up of new (and more lucrative) products like Genuity Reduced-Refuge, so it sounds like 2013 is shaping up to be another strong year but only time will tell.

Approach With Caution
While Monsanto has the best pipeline in agriculture-technology, investors shouldn't be completely price-insensitive about it. For starters, Monsanto still gets substantial revenue and profit from its Productivity business and this has been a very volatile business in the past. I believe management has fixed a lot of what troubled this business, and its production costs are quite attractive relative to the industry, but I'm nervous whenever a company meets or beats estimates on the strength of volatile and unpredictable units.

Likewise, while I'm optimistic about the long-term growth potential of Monsanto's seeds, there are limits to what the company can do. Monsanto (and DuPont) have been very good at capturing a solid chunk of the incremental value created by their seeds (typically 25% to 33%), but still leaving ample economic incentive for the farmers. That said, the business can be lumpy as the company waits for products in the pipeline (like drought-resistant corn) to hit the market.

The Bottom Line
On the basis of a long-term free cash flow growth estimate of 9% to 10%, I believe Monsanto shares are worth about $100 to $110. Given today's price, that doesn't leave these shares priced for major outperformance in the near-term. Unfortunately, this is a pretty common issue across the farm sector, with names like Deere (NYSE:DE), Lindsay (NYSE:LNN), and Valmont (NYSE: VMI) likewise carrying relatively hefty valuations. That leaves riskier names like Adecoagro (Nasdaq:AGRO) as potentially the better plays in the farm sector. (For more, see Lindsay Corp Still Reaping The Benefits Of The Drought)

I've long maintained that it's better to hold temporarily expensive shares in excellent companies than cheap shares of inferior companies, so I'm in no hurry to sell Monsanto. Likewise, I believe the long-term picture here is still quite attractive. For new investors, though, it may make more sense to wait for the markets to cool off before establishing a new full position in these shares.

Disclosure: The author owns shares of Monsanto.

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