There's no question that the biggest value-driving events for Monsanto (NYSE:MON) are yet to come, as this leading agriculture technology company will have to go through what is sure to be a rigorous regulatory oversight process to get to the finish line with its would-be suitor Bayer (OTCPK:BAYRY) and deliver the $128/share in cash that a successful deal promises.
In the meantime, Monsanto is Monsanto. The ag market is still in recovery mode, and 2017 is not likely to be a banner year for acreage, but Monsanto is doing well with new launches in South America and continues to upgrade its product portfolio in North America. What's more, Monsanto has long been an R&D-driven story and management hasn't been shy about continuing to reinvest and expand that research pipeline. While the shares do trade above my estimate of standalone fair value, it seems as though today's price factors in only about a 20% chance of the deal going through, and that strikes me as a reasonable risk/reward.
South America Boosts The Quarter ...
Although Monsanto management did not increase its guidance for the full year, the company's first fiscal quarter was stronger than expected. Revenue rose 19%, with strong growth in Seeds/Genomics (up 32%) and good results in both corn (up 27%) and soy (up 37%). The long-anticipated launch of Intacta in South America is working out well so far, helping to drive the stronger results. With the stronger revenue, Monsanto returned to double-digit operating earnings, with seeds reversing a year-ago loss and producing a mid-teens operating margin.
… But The Sector Is Still Sorting Itself Out
The ag sector is still working through a down part of the cycle. Corn prices have recovered recently, but are only just back to early 2016 levels and are still below 2015 levels. With that, it seems unlikely that North American acreage will build on last year's strong acreage (up 7% to 94M, the third-highest since 1944) and a decline back below the trendline (close to 93 million acres since 2011) seems likely. Making matters worse, pricing power has weakened, so Monsanto's corn business is going to need to continue taking share from DuPont (DD) and do well in South America.
The outlook is a little brighter for soy. While corn prices have come back up my estimate of cash production costs, soy is a little more comfortably in the black and I expect that soy acreage in the U.S. will grow at a mid single-digit level. That's a good time, then, for Monsanto to have started emphasizing its soy business, a business that has had good margins, but hasn't been quite as successful in terms of market share as the corn business. Here too South America is a big swing factor, as the company moves ahead with its Intacta launch.
Building, And Delivering On, The Pipeline
Monsanto continues to be an R&D-driven company, as it is through the company's efforts in the lab that it has pulled ahead and separated itself from the likes of DuPont and Syngenta (NYSE:SYT) over time. Monsanto has announced the first launch from its BioAg alliance with Novozymes (OTCPK:NVZMY), and while it is my understanding that the Acceleron B-300 SAT project was started before the two companies formed the venture, there are several more products in the queue due to be launched before 2019 and with multihundred-million dollar revenue potential each.
Looking further at the pipeline, Monsanto has numerous yield enhancement, disease control, weed control, and insect control projects underway in both corn and soy, and these projects could offer meaningful incremental revenue to Monsanto through enhanced yield and reduced inputs for farmers. Monsanto also continues to invest in other projects for cotton, canola, wheat, and vegetables.
The Regulatory Outlook Is Still Unclear
I was thinking that Bayer would offer $130/share the last time I wrote on Monsanto, and the final offer was close ($128/share), though the break-up fee of $2 billion was a little lackluster. Interestingly, Monsanto's proxy statement doesn't suggest rivals clamoring at the door - while the details were kept anonymous (as is the norm), it seems like there was an opportunity to combine assets with BASF (OTCQX:BASFY), with BASF taking a big stake in Monsanto (a scenario I laid out in that earlier piece), but that proposal didn't go very far.
It's hard to say how regulators will view this combination. The ChemChina-Syngenta merger has gotten a lot of scrutiny, as has the DuPont-Dow (DOW) deal, with those two companies recently meeting with EU regulators. The Monsanto-Bayer deal hasn't yet been filed with the EU regulators, and the fate of those two transactions will certainly go a long way toward handicapping the chances of this deal. While the new administration in the U.S. should be much more friendly to this transaction, trouble in the EU could make it moot.
There will certainly be some asset sales to get this deal done. Together, Monsanto and Bayer would make up more than 50% of the cotton market and over 90% of the canola market in Canada. While other parts of the businesses could be forced onto the block, those transactions have largely been anticipated since the first solid indications of Bayer's interest became apparent.
My basic outlook for Monsanto hasn't changed, as I see mid single-digit revenue growth and double-digit FCF growth on a standalone basis. Revenue growth will be driven by ongoing improvement in seed traits, supplemented with new offerings like the output of the BioAg alliance. On the margin side, operating leverage should help, but I'm also looking for the company to see better results from the Climate Corp. subsidiary - while enthusiasm has definitely cooled on this precision agriculture business, current conditions aren't exactly conducive to farmers taking chances on untested ideas and Monsanto will likely start to rationalize spending on the business if adoption doesn't improve in the coming years.
Discounting those projections back, my fair value ticks up slightly to $105. If my standalone fair value is accurate, the market would seem to be pricing less than a 20% chance that the Bayer deal goes through. While there most definitely is a risk that the deal won't go through, those odds seem aggressive and I think there is still a credible basis to think that shareholders will see the $128.
The Bottom Line
Buying Monsanto now is about your conviction that the deal gets done, or your desire to challenge the odds implied by today's price. With modest downside to my fair value if the deal dies (excluding the break-up fee) and meaningful upside if it goes through (even allowing for an extended process with delays), I'm content to continue owning Monsanto.
Disclosure: I am/we are long MON.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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