Agriculture Musical Chairs – But With Different Music

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 6th, 2015

Agriculture Musical Chairs – But With Different Music

  • Changing fundamentals in the Ag seed and chemical business appear to be behind the Monsanto move to buy Syngenta: low crop pricing is driving a weak farm economy that might last and depress organic growth – hence the desire to add synergies to a future driver of EPS.
  • Equally important, and relevant for the whole market, MON seems more interested in a balanced seed/chemical portfolio than it did in the past, perhaps suggesting a realization that the world’s food problems cannot be solved through GMO’s alone.
  • Things are changing in this space and we would want exposure to the group as a result – we would avoid Syngenta because of valuation but would buy a basket of DD, DOW, MON and FMC. We still believe that a DOW/DuPont Ag deal makes sense and that it would help both companies but be better for DOW than DuPont.
  • FMC looks more attractively valued than it has in some time, and could be a possible acquisition target in a broad realignment of the Ag business.
  • Weaker market conditions faced by the industry are in part a function of success in improving yield. Corn and Soy harvests have been good in part because of the higher quality seeds and despite lower planted acreage, broader use of the higher yielding seeds could keep prices low for a while.
  • Monsanto looks quite inexpensive based on a “normal” valuation framework that is based on its historic growth and improving return on capital. Whether or not it IS cheap depends on whether that trajectory can continue. Obviously the desire by the company to buy something suggests that it believes that maintaining the trajectory organically may be a challenge.

Exhibit 1

Source: Capital IQ & SSR Analysis

Overview

There is a lot of activity in the Agricultural seed and chemical space today, focused on Monsanto’s attempts to buy Syngenta. As the leader in Ag innovation for the better part of 2 decades, this move by Monsanto is driven, in our view by some fairly radical changes of view, behavior and strategy which have much broader implications for the industry.

For the last 15-20 years the central belief and strategy of the big guys, Monsanto, DuPont, Dow and Syngenta, has been that we can solve almost all of the world’s faming and food problems through the modification of seeds: we can reduce the amount of pesticides and fertilizers needed, we can increase water efficiency, reducing irrigation needs, and we can improve yield. Furthermore, there was a vision to change the protein and fat content of crops as well as add vitamins and other possible benefits, such as flavor enhancement for soy.

Over the last few years all companies have been coming up short on these objectives, despite increasing levels of R&D spending. Where they have been most successful is on the field of yield and this in turn has added to the problems. For example, in the US we are producing more corn from fewer acres and despite cutting planting we have a surplus – same with soy. Farm incomes are dropping, with 2015 expected to be one of the worst farm economy years in a decade or more. The yield issue has some legs to it and more adoption of higher yielding seed could keep the surpluses around for a while. Monsanto has fallen foul to the same problem they had as a chemical company – when you make a product better there is a real risk that your customer needs less of it!

Add to this the following:

  • Increasing crop and weed evolution such that some of the resistant traits and “kill all” herbicides are less effective. The crop protection chemical business is far from dead as farmers react to this!
  • Increasing anti GMO pressure, making it harder and harder to bring new seeds to market – new seeds that have cost a lot more R&D than expected to get approved.

Monsanto has clearly concluded that it needs a couple of things: a more balanced portfolio – seeds plus chemicals, and an opportunity to drive synergies through consolidation to offset possible slower growth. Monsanto is likely ahead of the curve with this view, as it has been with the space in general for so long. So what about everyone else?

There are a limited number of moves available and creative first mover advantage is going to be important. We have long advocated a Dow/DuPont Ag deal and we still believe that to be the best route for both sides. Unfortunately, both companies appear distracted with other, likely less important, issues today, and more so for DuPont than Dow, seem to still be in the camp that seed development is the only way forward. They hold this view despite billions of dollars of R&D spent and only real success on the chemical side of the business not really on the seed side.

A clever and creating Ag deal between Dow and DuPont would have more upside for Dow in our view, but if Dow were to buy the seed business that Syngenta would be required to divest in a Monsanto deal that might make a DOW/DD deal more complicated.

If MON and/or DD want a crop protection boost to their portfolio, FMC must be on the radar somewhere (probably more attractive to MON than DD as an Ag platform, but more attractive overall for DD).

If you believe that the Monsanto moves are going to create overall structural change in the Ag space, it would be good for Dow, DuPont and FMC, with FMC the more clear value play. Monsanto itself is very potentially very interesting here.

Is Monsanto Cheap?

Monsanto has underperformed the market considerably over the last two years as concerns over slower earnings growth and a weaker farm economy have compressed the multiple – Exhibit 3. At the same time the company has continued to grow its return on capital and its earnings (Exhibits 4 and 5) and while there has been some volatility, the progress has been very significant. There are very few companies outside the Tech space that can show this sort of ROC improvement and even fewer that have a large capital base ($17 billion using our inclusive definition).

The discount to “normal value” is shown clearly in Exhibit 6 – the most extreme discount since 2004. Trend net income growth to date supports normal value; it is doubt over forward earnings growth that has the stock valued where it is today.

Exhibit 3 Exhibit 4

Source: Capital IQ & SSR Analysis Source: Capital IQ & SSR Analysis

Exhibit 5 Exhibit 6

Source: Capital IQ & SSR Analysis Source: Capital IQ & SSR Analysis

The lack of confidence in the stock has come from a decline in farm income driven by crop price weakness as well as growing concern that advances in GMOs are slower to materialize and meeting greater social resistance. While Monsanto has stated that it has a good “go it alone” strategy and can continue to deliver growth, it is clear that the company is looking for optionality with the Syngenta deal, and given that it has indicated other possible targets if the deal does not go through, we doubt that the status quo will be maintained.

In the charts below DOW looks very expensive on a “normal” basis, but is overearning in its ethylene chain because of the attractive feedstock position in the US and this is unlikely to change for a while. That said, DOW displays more investor optimism in its share price than any other, while MON shows the highest level of skepticism.

Exhibit 7

Source: Capital IQ & SSR Analysis

Exhibit 8

Source: Capital IQ & SSR Analysis

Exhibit 9

Source: Capital IQ & SSR Analysis

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