Monsanto Company (MON) - Tier 2July 22, 2016

Analyst: Matt Renzi Dividend Yield: 2.1%Sector: Materials FCF Yield: 5.37%Industry: Agricultural Chemicals Debt to Equity: 56.4%Headquarters: St. Louis, Missouri Short Interest (Days/%Float): 1.7%Market Cap ($M): 44,012Enterprise Value ($M): 51,977Current Price: $106.1052 Week Range: $81.22 - $114.26  Next Earnings:  10/5/2016

Company Description

Monsanto Company engages in the development and distribution of agricultural products to farmers. The company operates its business through two segments; Seeds & Genomics and Agricultural Productivity. The Seeds & Genomics segment produces seed brands and develops biotechnology traits that assist farmers in controlling insects and weeds. The Agricultural Productivity segment manufactures Roundup and Harness brand herbicides.

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Segments

Seeds and Genomics:

Through the Seeds and Genomics segment, Monsanto produces leading seed brands, including DEKALB (for corn), Asgrow (for soybeans), Deltapine (for cotton), and Seminis and De Ruiter (for vegetable seeds). They also develop biotechnology traits within those seeds that assist farmers in controlling insects, along with precision agriculture products to assist farmers in decision making. In addition, Monsanto license’s their genetic material for their seed brands to other seed companies around the world, which contributes to even further reach of their products worldwide in the agricultural market.

Through their distributors, independent retailers and dealers, and agricultural cooperative and agents, they market their DEKALB, Asgrow, and Deltapine branded seeds to farmers in every agricultural region of the world. Under the Seminis or De Ruiter brand, they market to more than 150 countries either directly to farmers or through distributors, independent retailers and dealers, agricultural cooperatives, and plant raisers and agents.

Monsanto actively protects their intellectual property for seeds and genomics-related products and processes through patents, trademarks, and licenses. In soybeans, while the patent coverage on the first generation Roundup Ready trait for soybeans has expired, most customers and licensees are already switching to our second generation Roundup Ready 2 Yield trait for soybeans with patents that extend into the next decade. In Brazil, the new Intacta RR2 PRO soybean (resistant to worms and Roundup) has patents extending into the next decade as well. While Monsanto’s first generation patent coverage for corn has expired, many farmers have already upgraded to their next generation Genuity corn traits with patents covered into the next decade.

Agricultural Productivity

The Agricultural Productivity segment manufactures the Roundup brand herbicide and provides lawn-and-garden herbicide products for the residential market. The Roundup product is used in nonselective agricultural, industrial, ornamental, turf, and residential lawn and garden applications for weed control. The Harness brand herbicide controls preemergent annual grass and small seeded broadleaf weeds in corn and cotton.

Monsanto sells their agricultural productivity brands through distributors, independent retailers and dealers, and agricultural cooperatives. In some cases, outside of the U.S., they sell products directly to the farmer. In addition, they also sell certain chemical intermediates of their agricultural productivity products to other major agricultural chemical producers, who then market their own branded products to farmers.

Although patents covering glyphosate, an active ingredient in Roundup branded herbicides, have expired, Monsanto has multiple patents on different glyphosate formulations and manufacturing process in the U.S. and other countries. They have also obtained licenses to chemicals used to make Harness herbicides and hold trademark registrations for the brands under which their chemistries are sold.

Monsanto’s key growth drivers will come from its Seeds & Genomics business in the future

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The majority of Monsanto’s revenues have come from the U.S., but plan to capture market share in South America with the rollout of new product lines

Monsanto has proven itself as an industry leader, as demonstrated by taking significant share from rival DuPont

Near-term headwinds have hindered Monsanto’s financial growth in recent years, but its long-term growth drivers should be the area of focus

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Compared to its competitors, Monsanto has impressive margins across the board

We have seen a slight pickup in buy ratings since the announcement of the BAYN – MON deal

Drivers

The company has the most innovative product lineup and pipeline of its competitors by far, which will be its biggest driver for growth. We can expect this pipeline to continue to increase, as MON consistently pours 10% of sales into R&D each year

o Below is a chart of MON’s pipeline over the years. Currently they have the most projects that they’ve ever had, because of possible anticipation of patent expiration

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Patents that expire do pose a threat for generic brands to gain market share, however, new and innovative products that are in MON’s pipeline provide more efficient and effective crop yield than the products which have just come off patent. Big seed companies are switching to Roundup Ready 2. They said the older trait had problems that led to lower yields and they caution that university varieties aren’t competitive. Even if the off-patent seeds were free, farmers would still lose money by growing fewer beans

The key products that will drive future near to mid-term growth are the Inacta 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 growth is going to be seen from contributions from MON’s newly initiated digital agriculture platform called Climate, as well as MON’s microbials partnership with Novozymes, which increases corn yield from already existing fungus in the ground

Operating margins in the long run should improve as cost pressures retreat, Inacta penetration increases in Brazil, and the company rolls out its Xtend product in soybeans

o Monsanto is focused on becoming the lowest-cost producer with Roundup, by reducing SG&A while setting prices at a modest premium to generics

MON’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 MON enjoys premium pricing for its patented traits

Risks

Profits from the Roundup trait business face damages going forward from generic competition. The first generation of the Roundup Ready trait has expired, which has eaten away at profits throughout the first three quarters of 2016

Efforts to protect intellectual property rights are crucial to MON’s business, especially in the Seeds and Genomics segment. Even if protection is obtained, competitors, farmers, or others in the chain of commerce may infringe on the company’s rights through means that is difficult to prevent or detect (i.e. farmers may save seeds of non-hybrid crops containing MON’s biotechnology traits and replicate them at their own costs)

Potential for constant legal difficulties with outside parties in trying to protect their intellectual property

The degree of public understanding and acceptance of MON’s biotechnology and other agricultural products can affect sales and results of operations by affecting approvals, regulatory requirements, and customer purchase decisions

Growing revenues and margins are tied through MON’s increased business internationalization. Brazil, Mexico, Canada, and Argentina are the major foreign niche markets of Monsanto. These international operations are subject to both political and environmental headwinds. Most notably, the appreciation of the U.S. dollar has been weighing over MON’s international revenues and margins. The stronger dollar is increasing the competitive power of smaller rivals operating in those nations

Competitor discounting has forced MON to reduce their own prices of products. Over the past 10 years, Chinese glyphosate (main chemical found in Roundup) manufacturers with cheap manufacturing costs have increased

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their international presence. MON reacted to this in 2010 by reducing the price of Roundup by 50%. The fear that this can happen to other products in MON’s pipeline is concerning

Industry Outlook

The USDA forecasts a fourth-straight drop in U.S. farm incomes. Concern that farmers will minimize costs by choosing cheaper products is evident as consensus cuts EPS estimates for agchems makers (median consensus 2016 EPS decline is 20% for large cap companies). This trend will favor the low-cost, large-scale producers. Constant-dollar net incomes, a longer-term farm indicator, are the second lowest in over 30 years. Cash incomes best approximate farmers’ near-term decision drivers.

As of late, M&A has been the key driver of the recent AgChem valuation rise. Despite this, there is still a lack of clear catalyst for earnings growth. In 1Q, EPS fell a median of 6% across the AgChem peer group. Corn, year-to-date, has fallen almost 5%, while key fertilizer prices are down 10-30%

The DTN Total Crop Producer Confidence Index reached an all-time low in March with a second straight drop in expectations. The DTN Index determines the level of optimism that producers and agribusinesses have concerning their current future financial health of their operations. Incomes are being pinched as seeds, chemicals, and rent costs fail to decline significantly, while crop prices remain at multi-year lows. Ample corn supply, which has pressured prices, may worsen, given that the USDA projects U.S. farmers will plant 6.4% more acres throughout 2016 (as of 4/27/16)

Agricultural Chemical makers have accelerated investments in data offerings, as farms become smarter and tools of digital agriculture promise farmers efficiency

As crop prices fall, farmers typically become less willing to spend more for products that promise to boost yield. During these times, driven by concern crops will fall further, many shift strategy to the lowest-cost alternatives that will yield enough to cover cash costs

The pink index represents the USDA Farm Net Cash Income (sum of all cash receipts less all cash expenses, such as feed, fertilizer, property tax, interest on debt, wagers, contract labor, and rent to non-operator landlords). The green index represents Net Farm Income (sum of all cash receipts plus any non-money income, minus cash and non-cash expenses).

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The pink index is the amount of corn acreage planted, while the green index is the amount of soybean acreage planted, all plotted against Monsanto in the white.

Here we have the price of corn (dollars/bushel) in the green against Monsanto in the blue

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We see a tighter correlation between Monsanto’s price in orange, and the price of soybeans in purple

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The stock-to-use ratio in the agriculture industry tells us how much inventory of a particular crop is available for consumption. A higher supply of crops to its demand results in a higher stock-to-use ratio. The chart shows how the global corn stock-to-use ratio in 2016 has moved compared to the past four years. The higher ratio in 2016 has been driven by an increase in corn’s global ending inventory, which has been increasing over the years (global corn inventory was 10% higher in July 2016 than July 2015). A higher corn supply without change in consumption leads to lower corn prices, impacting farmer’s income.

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The June and July soybean stock-to-use ratios have been at their lowest points in recent years. According to the USDA, the global soybean inventory stood at 67 million metric tons in July 2016, a 27% decrease from the 91 million metric tons the previous year.

Despite the global stock-to-use ratio for soybeans being significantly lower than previous years, the prices are also sitting on the lower end of the price band. On a world basis a stock-to-use ratio for wheat under 20% has typically led to strong price advance, and for soybeans, a stock-to-use ratio under 10% has typically led to strong price advances.

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Bayer-Monsanto M&A Deal Commentary

On May 19, 2016, Monsanto confirmed that they had been approached by Bayer to be bought out for $122/share in cash

With the announcement of this proposed takeover, early sentiment began to build up as there are now three current major M&A deals happening at the same time (Bayer-Monsanto, Dow-DuPont, and Syngenta-Chem China)

Below is a graph of the crop chemicals market share. These are the only six companies that have over $5 billion in sales in this market, and five of them are already involved in deals. This would shrink 6 key players down to 4, which brings up concern with both politics and antitrust

Monsanto rejected the offer, saying the value of $122/share does not represent the fair value of the company. CEO Hugh Grant did, however, make a point to say that they are open and willing to continue conversations with Bayer and any other potential suitors at a valuation representative of Monsanto’s value

Monsanto, and the market, are waiting for a counter offer from Bayer, or potentially another company. Both parties have kept mum on the topic, with Hugh Grant consistently saying “I have been personally in discussion with Bayer’s management over the last several weeks, along with others regarding alternative strategic options

o Grant’s “others” comment is viewed as talks between other companies to establish strategic partnerships. It is unlikely that the “others” Grant is referring to are considering a takeout offer for Monsanto

The concern for many Bayer shareholders is that Monsanto is simply asking for too much ($10-$15 raise from previous offer), therefore a much higher offer from Bayer will not pass a shareholder vote

As of 7/7/2016, the $122 offer represented a 21.38% premium based off of MON’s price of 100.51 On 7/14/2016, Bayer raised their offer $3 per share to a takeout price of $125. While this means Bayer is still

interested in the deal, it is unlikely that a deal goes through at this price since it’s significantly less than the $10-$15 per share raise that Monsanto was looking for

The new offer represents a deal value of $65 billion, and a 17.81% premium from Monsanto’s closing price on July 21.

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Commentary Continued

Bayer Segment Breakdown:

Monsanto Segment Breakdown:

Overlap:

Between the two companies we do see a little bit of overlap. In the Agriculture Industry, Monsanto is clearly focused on seeds & genomics while Bayer leans much more toward the crop science (insecticides, fungicides, and herbicides). U.S. regulators may order Bayer to spin off some of its cotton seed operations, which is a significant portion of its seeds segment. Regarding the herbicide segment, we shouldn’t expect to see any divestitures needed. Monsanto’s only herbicide brand is Roundup (glyphosate). Since glyphosate has been off patent for some time and is a competitive market with several Chinese producers, it doesn’t pose any antitrust threat. Since there aren’t any competitive benefits that would accrue from combining Monsanto’s glyphosate business with Bayer’s generally more specialized herbicide offerings, regulators shouldn’t require any divestitures in herbicides. Seeds & Traits and Herbicides are the only two segments in which we would expect divestitures to occur.

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Risks:

While divestitures will most likely be needed, that’s not a huge risk to the deal going through. The biggest risk is that regulators may view the deal as a consolidation of the Agriculture Industry as a whole. Currently, there are 3 deals going on in the industry; Bayer-Monsanto, Syngenta-ChemChina, and Dow-DuPont. If all of these deals are approved, the number of big companies that supply farmers around the world would shrink from six to three. As farmers in the US are already worrying about their reduced incomes due to a drop in crop prices, the reduction of competition and choice as a result of the three deals rests at the front of their minds. The DoJ looks holistically at the market consequences. If approving all the deals would reduce competition, then staffers consider scenarios involving one or more rejections, or required spin-offs. The European Commission takes a different approach than the DoJ. They deal with the first transaction they are formally notified about, and then analyze the second deal on the assumption that the first will be resolved to their satisfaction. If the six big companies do in fact shrink to three, the number of independent research and development laboratories will also likewise fall, reducing the elimination of head-to-head competition in research and development, in traits and potentially even chemicals.

If farmers press their senators across the country to block it, then regardless of divestitures, the deal could fall through.

Product Revenue:

Monsanto doesn’t specifically disclose their revenue breakdown between products within seed types, so there aren’t specific numbers for Roundup Ready vs. Roundup Ready 2 Yield. According to a Morningstar analyst, “we think a vast majority of previous RR1 farmers have upgraded to RR2 over the last few years. I would estimate that RR2 penetration is between 80% and 90% in the U.S., and I don’t think there are too many farmers that are still planting RR1.” Monsanto has established RR2 as the base platform which it has developed it next generation soybean products. Because of this, RR2 is getting the latest germplasm updated each year that would not be available on the RR1 platform. Because farmers want these new updates, they’ve switched to the RR2 platform. Ultimately, the vast majority of Monsanto’s current soybean revenues come from RR2, which are currently on patent.

This graph was released by Monsanto in 2013. It shows that Roundup Ready 2 had roughly 75% penetration at the time. The 80%-90% estimate is based on the fact that Roundup Ready 2 has a similar tracking path to that of the first generation shown in dark green.

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Model: Deutsche Bank

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Valuations

Monsanto: $125 All Cash Deal, 17.81% spread, P/E = 43.8

Monsanto is currently trading at 43.8 X earnings, up from 20.3X earnings just a year ago (August, 2015). It’s clear that the reason for this high valuation is the hope that the deal goes through, which would shoot Monsanto’s price up to the given acquisition price (currently $125). Their PE was 28.22 just before the first offer was announced in May. Monsanto’s P/E rose up from 28.22 to 32.53 between the months of May and July, and on July 15 when Bayer made their second revised offer, it went from 32.53 to 44.2. In addition, their growth and operating margins, 55.27 and 26.77 respectively, sit at 5 year highs. The current arbitrage of the deal sits at 17.81%, with Monsanto’s price at $106.1. This spread represents that there still is uncertainty in the market on whether or not the deal goes through. Monsanto’s price the day before the deal was announced sat at $89.75, and shot up to $100 within a matter of days. If the deal does not go through, we expect Monsanto to drop to around $95, as Monsanto’s willingness to engage in takeover talks will likely leave some takeout speculative premium in the price. Even with the current $125 takeout price, there is potential that Bayer comes back with an offer of $135-$140, which is what Monsanto has been asking for since talks began. This is possible because both parties are eager to get a deal done, and given the constant dialogue between the two companies, we think Bayer will come back with a best and final offer within that range. If a deal cannot be reached, there is still a premium to be had with Monsanto since they will still be considered as a takeover opportunity.

Syngenta: $469.9 All Cash Deal, 20.95% spread, P/E = 27.9

Syngenta is currently in talks with ChemChina over a $43 billion acquisition. It is trading at 27.9X earnings. When the deal was announced on February 3, its PE jumped from 24.18 to 26.95. The arbitrage of the deal right now sits at 20.95%, with a price of $388.50 on July 21, indicating that the market is factoring in uncertainty that a deal will not be reached. The deal terms are $465 cash plus a special dividend of $4.9 resulting in a takeout price of $469.9.

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Dow-DuPont: Stock Deal, 1.282 shares of Dow for every share of DuPont, -.2% spread, P/E = 28.4

Dow and DuPont are combining their business in a merger of equals valued at $130 billion. The terms of the deal state that for each share of DuPont shareholders hold, they will receive 1.282 shares of the new combined company (traded in parallel with Dow). Around 18-24 months after the completion of the deal, it is expected that the new company DowDupont will be spun off into three independent public companies focused on three different businesses; Agriculture, Material Science, and Specialty Products. The current stock price of DuPont sits at $67.76 while the acquisition price is currently at $67.64, resulting in a -.2% arbitrage.

DuPont Valuation

Why Monsanto?

Monsanto provides us with the best upside payout versus downside risks. If the deal does not go through, Monsanto has proven itself to be a leader in the Agriculture industry for years. Their product pipeline is far more superior and robust versus its competitors. Also, they have key growth drivers that will propel their business forward if the deal falls through. In regards to the other deals, Dow-DuPont has an extremely unattractive spread, so it would not make any sense to pursue this merger. While Syngenta-ChemChina has a slightly higher spread, their deal talks are not nearly as transparent as Monsanto and Bayer, and carry a higher risk of the deal not being completed. Monsanto and Bayer have made it clear that they are eager to get a deal done, which is why we have been pursuing this deal so aggressively.

Given the current takeout price of $125, this represents a 17.81% premium based upon Monsanto trading at $106.1. Monsanto has said this is financially inadequate, and expects the offer to bump up to $135. If this were to happen, the premium would be a 27.24% premium based on Monsanto trading at $106.1. Should the deal not go through and Monsanto falls to $95, this represents a 10.46% downside. The deal provides us with either 17.81% or 27.24% upside versus a 10.46% downside.

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