Seeding a Better Investment

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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

March 23rd, 2014

Seeding a Better Investment

  • We are more positive on seeds and Ag Chemicals – on the assumption that farmers will seek to maximize yield regardless of commodity prices (balancing demand by planting fewer acres). There is probably as much risk to the upside in the near-term or corn pricing because of delayed planting this year and some water issues than there is downside from lower corn ethanol demand.
  • We add MON to our favorite list as a result as we believe that quality seed and pesticide demand will remain strong, and this adds to our conviction DD. We also see some volume upside for potash, but caution that our “normal” framework is flawed for MOS given the cartel collapse – and would much prefer MON and DD.
  • This analysis also makes us less negative on Dow and makes us a little more interested. This is particularly true if the company is serious at exploring options to establish a market value for its Agriculture business as suggested by CEO Andrew Liveris in an analyst meeting last week. The story becomes more interesting, but the valuation support is missing.
  • We remain cautious on machinery – despite almost compelling trough relative values – as we see no near or medium term positive catalyst. Farmers will buy seeds and chemicals when margins are low, but not machinery.
  • The risk is a broad rotation into Capital Goods, which remains cheap as a sector, with AGCO and DE at the extreme of the low value range. Under such circumstances both AGCO and DE could be lifted with the tide, despite the reasonable risk of further negative revisions.
  • Our base assumption is that farm income is on or close to trend for the next couple of years – i.e. almost flat – Exhibit 1.

Exhibit 1

Overview

Today we have published a more comprehensive review of Agriculture, looking at the subject from a supply and demand perspective and attempting to pick through the trends that are taking place in the sector to look for investment conclusions. Agriculture is a difficult subject as in any given year as any expected “mega” trend can be completely distorted by an unusual weather pattern. What is clear is the following:

  • Population is growth as is global GDP per capita and the number of people who have the luxury of making food choices
  • Food demand is rising and large volumes of basic foodstuffs are moving around the world to match supply with demand – this will continue.
  • Agricultural productivity has been an integral part of increasing food supply without food price inflation over the last 20 years and it is highly unlikely that this will change.

As we think about the chemical and machinery companies that have large agriculture dependent businesses we see the last bullet point as an interesting point of distinction between the chemical/seed producers and the machinery producers.

Our premise in this research is that farmers will always pay for yield (productivity), regardless of commodity prices and farm profitability – the higher the yield, the more profitably you can meet demand, whether demand is weak or strong. On the other hand we expect machinery to remain cyclical, barring any step change in yield advances (such as the ability to reduce the spacing between rows).

With the exception of SMG, which is much more of a retail play, and DOW which is in part being influenced by the activist position, the Agriculture names in our universe look cheap – Exhibit 2. We think this is justified for the machinery names but represents an opportunity for the seed and pesticide names, especially MON because of the pure play nature and for DD where we are already positive. If Andrew Liveris really is interested in putting a market value on DOW’s agriculture business within the next 12-18 months – as stated in a strategy presentation last week – we could see some support for DOW’s current valuation here, though without such a move and further action to reduce costs we would be very cautious at these levels. See recent research for our views on DOW’s break-up/restructuring value.

Exhibit 2

Source: Capital IQ and SSR Analysis

While valuation looks interesting for MOS, it should be noted that our model relies on reversion to mean, and things have changed in the potash market with the break-up of the Russia/Belarus cartel. MOS will likely see a better volume environment in 2014 and probably longer term, but how that volume gets allocated between the producers is very unclear and we still see price pressure which could more than offset the volume gain. Note that in the long basic chemical trough of the 1980s, profitability was worse in the last year of the trough – the one in which volume growth was most positive – as producers fought for share of the new growth.

We would focus on MON and DD, but we would not be underweight machinery because of the discount and possibility of a rotation.

Seeds, Pesticides and Machinery – Different and Divergent Views

We had begun the year cautious about all of the Agriculture names in the Industrials and Materials group because of a fear of weaker corn demand, lower prices and fewer acres planted. For the most part the stock valuations have been discounting this.

The body of this report causes us to change our position on the seed and chemical guys, while making us perhaps more cautious on the machinery names. While there is a chance that the corn market is stronger this year, we still are of the view that farm income in the US will be at or below normal for this year and perhaps into next if we get another meaningful leg down in US gasoline demand in 2015, cutting into corn ethanol demand.

Seeds and Chemicals – A Change In Expectations

What has changed for us is that we have a higher conviction that farmers will strive for the highest yields regardless of prices because of the efficiencies gained by planting fewer acres in a weaker demand environment. The corn yield trend shown in Exhibit 3 supports the views by the seed and chemical guys in the US that they have very strong growth ahead.

Exhibit 3

If we look at the return on capital chart for Monsanto – Exhibit 4, the company has seen significant return and margin improvements since its public debut – in line with the drive for greater farm efficiencies. The stock and the market got ahead of itself in the middle of the last decade as demand peaked, but MON has come back to steep return on capital trend – which is not reflected in valuation if it can be maintained. Note that Price to Sales rose with return on capital, as you would expect, through the 2007 peak, but has not recovered from the correction – Exhibit 5. While it is likely that there is additional upside to return on capital at Monsanto, clearly the trend of the last 13 years cannot continue indefinitely. It is more likely that the rate of improvement will slow once returns exceed 20%. While the growth story may break-down at some point in the future, and rely more on volume growth rather than margin improvement, we see some near-term momentum.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Our normalized value framework is driven by return on capital trends and consequently shows MON to be very cheap, with as much as 35% upside to reach “normal value”. Clearly the company is going to need to deliver over the next 12 months to rebuild confidence that the sales and margin growth story can be achieved, but we have renewed confidence that this is possible and would now include this in our list of favorites.

For DD and DOW the story is the same – the quest for yield should be almost indifferent to agricultural commodity prices and sales and returns should continue to improve. DuPont has been confident that its Agriculture business is in good shape this year regardless of corn pricing and we support that view. As we have discussed recently, Dow Chemical’s Ag business is a very strong and valuable asset for the company and should DOW elect to establish a fair market value for it, either through a sale or a spin (partial or total), the value created for Dow shareholders would be high.

We already like the story at DuPont, and have written extensively on the company – this more positive view of Ag only adds to our enthusiasm – we think we have positive change, earnings acceleration and valuations support at DD.

DOW is a little less clear – again something we have written about – as there is not the valuation support, as with DD and MON, but change could still be good. We would recommend both DD and MON today, and are more on the fence with DOW, moving away from our more negative position, partly because of this work and partly because of the tone of the recent strategy presentation. To get really excited about DOW also we would want to see the company address its escalating operating, R&D and SG&A costs and capital spending. Current valuation metrics for all three stocks are summarized in Exhibit 6.

  • For MON, the stock appears cheap, based on history, and valuation is discounting a fall in returns and/or growth from current level, while our works suggests that the trend can continue for a while. We could easily see 20-25% upside in MON this year
  • For DD we have a stock that is not as attractive as it was – but still attractive – some positive catalysts for change and again an expectation that returns are going to fall – we see similar upside to MON if the company can deliver the earnings growth it expects
  • DOW is a little different as the valuation support is not there and valuation discounts improving rather than declining return on capital over the next 12 months – i.e. Dow has to surprise on the upside to support valuation while the other two are discounting disappointments in our view

Exhibit 6

Source: Capital IQ and SSR Analysis

Machinery – A Different Story – Value but No Catalyst

Both DE and AGCO are under-earnings and are very cheap, based on history and using our “normalized” framework. However, the fundamentals are against them, and we are not sure what causes a re-rating given that performance is likely to be lack-luster for a while. Equipment sales are strong when farm income is strong and weak when it is not – not complicated. We do not think farm income is going to be above trend this year and this is a view shared by both analysts and the companies.

Complicating what might be a more normal equipment cycle is the interest rate environment that we been in for the last 5 years. Low rates have made financing easy and this has encouraged equipment purchases – perhaps drawing forward some demand. Consequently forward expectations are low.

Our expectation is that in a weak price or farm profitability period, farmers will buy the best seeds and chemicals and fertilizers, but they will delay purchases of machinery. We think that this is likely to be the case for 2014 and possibly 2015.

The risk to this view comes from our strong value bias and where both stocks are languishing today. Neither company is trading all time relative lows to the market – though both are close – but they are attractive relative to the rest of the Capital Goods space and, in our view, Capital Goods is the most undervalued Industrials and Materials sector today with the exception of Metals.

Our current discount from normal value estimates for all of the larger–cap Capital Goods stocks are summarized in Exhibit 7.

Exhibit 7

Source: Capital IQ and SSR Analysis

The risk to not owning these stocks today is that we get a further rotation into Capital Goods and the rising tide lifts all.

The Machinery Ag stocks have seen more negative revisions in the last few months than the Chemical Ag stocks as they have provides some quite cautionary guidance – Exhibit 8. We are more positive on forward revisions for the chemical names than the machinery names – notwithstanding our expectations that all could have Q1 2014 problems.

Exhibit 8

Source: Capital IQ and SSR Analysis

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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