By David Sterman
As Warren Buffett, George Soros and so many others have said, you need to swim against the tide, finding values where others miss and shunning stocks that are loved by all.
Back in the summer of 2010, agriculture firm Monsanto (MON) was simply loathed. Low-cost Chinese competitors were eating into its Round-Up herbicide franchise, farmers were up in arms over a restrictive seed usage policy (which made its way to a story on 60 Minutes), the company was headed for a 10% drop in annual sales and analysts were uniformly tepid on the stock's prospects.
As I noted back then, Monsanto's $1 billion in annual research and development spending would soon make the company relevant once again. Indeed, in the subsequent fiscal year (ended August 2011), Monsanto's sales rose 13% to $11.8 billion and earnings per share (EPS) shot up a heady 49% to $2.96.
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Yet as you dig into just-released quarterly results and start to look at where Monsanto may be headed next, you may find reasons to sell. The stock's impressive rebound has set up a clear disconnect between a fairly high valuation and slowing growth. That's what happened to major drug stocks a decade ago and may be happening to Monsanto soon.
Another good quarter
Monsanto just announced fiscal second-quarter results that once again topped forecasts, this time with an EPS of $2.28 (roughly 7% ahead of projections). Almost all of the upside was attributed to stronger-than-expected demand for corn seeds, as farmers got an early start thanks to very balmy weather this winter. Some of that strength may also extend into the current quarter as spring plantings are underway, but many analysts decided to leave their full-year forecasts intact.
The pull-in for the planting season is expected draw demand from the summer quarter. Despite beating second-quarter estimates by $0.16, analysts have boosted their fiscal (August) 2012 full-year estimates by just three cents to $3.54.
It's the view beyond 2012 that becomes more concerning. The company is now so large, and the field so saturated, that unless Monsanto can take market share from Syngenta (SYT), DuPont's (DD) Pioneer Hi-Bred division or other emerging global rivals, then investors need to brace for slowing growth. The company has likely squeezed out all it can from the "ethanol play" -- ethanol-as-a-fuel mandates, which led to major corn planting, are set to expire in coming years.
After a good 20% growth in fiscal 2012, analysts at UBS, which rates the stock as a "neutral," recently wrote that "we expect only 13% growth in F13, then we expect less than 10% growth in F14."
It's important to note that after a strong two-year run, shares of Monsanto now trade for more than 20 times forward earnings. Recall that major drug companies finally stopped growing as their drug pipelines matured and new drugs failed to outpace older drugs that lost patent protection. Will that multiple compress, as UBS suggests, until Monsanto looks more like Merck (MRK) or Pfizer (PFE)?
With the exception of 2009 and 2010, when Merck completed a pair of large acquisitions, sales have not grown more than 5% at any point in the last decade. EPS in 2011 was roughly 30% lower than it was a decade ago. As a result, Merck's stock started to garner an ever-lower price-to-earnings (P/E) ratio.
There's one clear connection between Monsanto and Merck: Each once spoke of a blockbuster product or two that could fuel tremendous growth, but each eventually has come to rely on a series of smaller hits to keep that ball rolling. As UBS' Andrew Cash recently noted, Monsanto's CEO is "increasingly spending more time discussing its multiple sources of future earnings, including integrated farming systems, and almost no time on new blockbuster product introductions. We believe this is code for slowing overall EPS."
You can see that slowing growth by walking through updated projections provided by Merrill Lynch. After boosting EBITDA 22% (to $3.05 billion) in 2011, they see EBITDA rising 19% this year, 11% in fiscal 2013 and 5% in fiscal 2014.
When "neutral" is a "sell
Here's the tricky thing: Nobody on Wall Street will tell you this stock is going to go down.
Indeed, this is a stock that has made bullish analysts look smart in front of their clients, and they need a reason to keep getting in front of those clients if they are to secure a meeting at all. Sadly, that's what more than 10 years of working on Wall Street taught me.
UBS, in laying out its concerns, only has a "neutral" rating, lest the firm's analysts end up in the doghouse with Monsanto's management. Goldman Sachs also recently lost its appetite for this stock, removing it from the firm's "Conviction List." But they still suggest the stock deserves to trade at 20 times projected fiscal 2013 EPS of $4.38. Yet as noted earlier, slowing growth more likely argues for a slowly falling multiple. Monsanto's projected rates of growth are unlikely to support an EPS (and thus, a P/E ratio) that high.
Risks to Consider: Monsanto still spends huge sums on R&D, and those efforts may still yield another blockbuster product to bolster future sales.
Note the phrase "slowly-falling multiple." There's no reason to expect this stock to fall out of bed quickly, but it appears to have peaked after a solid two-year run. A high multiple and slowing growth is never the recipe for further upside.
If you own shares, then this looks like a good time to sell. And if the market rebounds and brings this stock back into the $80s, then it would only strengthen the case to short this stock.