Monsanto: Checking In On The Short Thesis
Must Read | Apr. 21, 2015 8:30 AM ET
Disclosure: The author is short MON. (More...)
Summary
•First half FY2015 net income is down 19% year-over-year.
•Corn gross margins have fallen 240bps YoY; Total Seeds & Genomics gross margins fell 80bps YoY; Lack of pricing power thesis seems on track.
•Ag Productivity operating profit decline accelerating, with operating profits falling 28% year-over-year in the second quarter.
•Soybean is the only bright spot, due largely to Intact RR2 in Brazil; the company exceeded its expectations by 3-5 million acres (sold to 15m acres vs. 10-12m guided).
•However, the impressive Intacta performance merely pulls forward soybean growth from future years to help plug the earnings shortfall this year.
I wrote a short thesis on Monsanto (NYSE:MON) about six months ago. It is time to check in to see how the business has performed, and if any changes need to be made to the outlook.
The basic premise of the entire thesis is simple: Since the "ag boom" that began in 2006, Monsanto has pushed through price increases of about 74% - helping drive a high-teens compounded earnings growth rate.
Would Monsanto have been able to achieve these price increases in a stagnant commodity price environment? What impact will a falling commodity price environment have on its pricing power and earnings?
In the article, I suggested that Monsanto's challenges would begin during 2015, and accelerate in 2016 and beyond as the global crop oversupply situation worsens. I projected that gross profits in Seeds & Genomics would be flat this year and that Ag Productivity gross profits would fall 20%, while Monsanto projected their Seeds & Genomics gross profit would rise "double digits" and Ag Productivity would only fall 10%.
See below for quotes from the fourth quarter 2014 conference call.
Regarding the Seeds & Genomics outlook:
“
First and foremost as I said the primary driver is our core seeds-and-traits engine where we expect to deliver double-digit growth on the GP line."
Regarding the Ag Productivity outlook:
“
our guidance assumes Ag productivity gross profit as the potential to be down in the range of 10% offsetting some of the coal growth from our seeds-and-traits engine... the majority of the full year Ag productivity downside that we discussed actually would be incorporated in Q1"
Actually, the results so far are worse than what I had projected. First, let's have a look at the Ag Productivity segment:
The company had suggested on the fourth quarter call that the majority of the full year Ag Productivity downside would be incorporated in Q1. As we can see from the table above, the results actually worsened further in the second quarter. I project continued deterioration in this segment, as global glyphosate prices continue to hover at multi-year lows with no signs of production slowing in China. Recall that this segment contributed over 1/3 of the company's operating profits in 2014, and that this same segment actually produced negative operating profits the last time the glyphosate market was oversupplied in 2010.
Now let's have a look at the Seeds & Genomics segment reported results:
I believe these results support the thesis that seed prices are driven by crop prices and that profits on selling seeds have a direct correlation to the price of the commodity itself.
Monsanto reported a flat price impact in its Seed & Genomics business for the second quarter of 2015 (page 36 of second quarter 10-Q) and gross margins have fallen year-over-year. Monsanto achieved significant price increases in their Soybean segment, driven primarily by Brazil (Intacta). Note that while soybean prices are down year-to-date in USD, they are actually up 10% in Brazilian Real.
It stands to reason that the Corn seed business likely had some combination of negative price and mix - and the corn seed gross margins seem to support this conclusion, falling 240bps in the first half of 2015.
Going forward, I expect continued pressure on the corn seed business, which represented 60% of gross profits in 2014. The soybean segment will continue to benefit from the Intacta RR2 update in Brazil, but investors should note that higher penetration this year means that the company necessarily has fewer acres left to target.
The early success of Intacta RR2 is a double-edged sword for modeling purposes: on the one hand, exceeding their own expectations by 33-50% is helping them maintain their EPS guidance this year (the company's Intacta sales reached 15 million acres in Brazil, versus its expectation of 10-12 million acres). On the other hand, this "beat" essentially pulled growth from future years in to this year, and investors should note that this outperformance was not met with an increase to the EPS guidance.
How about soybean gross profit growth potential in the United States? I do not believe there is much, if any, opportunity to increase gross profit dollars with their latest soybean plans in the United States.
Long-time Monsanto investors may recall that Monsanto introduced its Genuity Roundup Ready 2 soybeans in the United States in 2009. The ramp up of Genuity Roundup Ready 2, from 3 million acres in 2009 to 43 million acres in 2013, only drove a 2.1% CAGR in gross profits during these 5 years, from $871 million in 2009 to $948 million in 2013 (even though soybean prices were rising during most of this time frame).
Investors hoping for gross profit growth from soybeans in the United States may be disappointed.
2H15 Outlook
With respect to the remainder of the year, I still think it is unlikely Monsanto can achieve even the low-end of its earnings guidance.
During the second quarter conference call, Monsanto changed the "cadence" of its guidance, further back-end loading fiscal 2015 guidance. Recall that on the fourth quarter 2014 and the first quarter 2015 conference calls, management suggested this year's fourth quarter would show little, if any, earnings contribution. Fourth quarter 2015 would likely be "break-even to positive on an absolute basis."
Now, management is calling for roughly 15-20% of the second half earnings to fall in the fourth quarter. Street consensus estimates followed suit, raising fourth quarter earnings estimates from $0.02 per share just before the second quarter conference call to $0.35 per share today. Apparently, the third quarter is shaping up to be weaker than management expected, and there is a lot to "make up" now in the fourth quarter in order to meet the full year earnings guidance of $5.75-$6.00 per share.
Crop Outlook
With respect to the crop outlook, the bearish agriculture thesis remains on track as well. Soybean stockpiles are now the highest in recorded history and corn stockpiles are the highest in at least fifteen years.
The stocks-to-use ratio for soybean is also at a record high, and stocks-to-use for corn is the highest in over a decade. Worse still, soybean production appears set to grow even further next year, and corn demand is not growing as quickly as expected this year.
Conclusion
In summary, I believe the Monsanto short thesis remains intact. Based on current glyphosate prices, I believe Monsanto's Ag Productivity gross profits will continue to fall. I believe declines in corn seed gross profits will overwhelm any soybean gross profit growth in South America (as they have year-to-date). Further, I believe soybean seed prices in the United States will begin facing downward pressure.
Monsanto generated $1.65 billion of free cash flow in 2014, and has generated an average of roughly $1.7 billion of free cash flow over the past 5 years (excluding acquisitions). The current market cap is $55 billion, implying the company trades at over 30x free cash flow. Given my belief that Monsanto's free cash flow has peaked and should decline over the next two to three years, I think the current share price is quite overvalued.
Many companies whose earnings are correlated to commodity prices have historically traded with a high-single digit or low-double digit multiple of earnings. I believe falling crop prices are exposing Monsanto's vulnerability to commodity cycles, and the stock's earnings multiple may ultimately reflect this reality.
If operating profits continue to fall from current levels, I believe the stock may receive a lower, more commodity-like multiple. This should happen regardless of the share repurchase and potential earnings per share benefit, as multiples are primarily based on the quality and defensiveness of the underlying business. A business whose operating profits are falling lacks the defensive and competitive characteristics that I believe justify a premium earnings multiple.
If the company were to trade at a mid-teens multiple of free cash flow, and if free cash flow falls 10% from recent levels, the math implies a share price that is ~40-50% lower than today's price.
(Free cash flow is defined as cash provided by operating activities minus capital expenditures and expenditures on technology. Using this definition, free cash flow was $1.9 billion in FY2013 and $1.6 billion in FY2014.)
Additional disclosure: The author is short shares of MON and owns long-dated put options (LEAPS) on MON. This is an opinion piece, and is not intended to be relied upon as a research article. Several assumptions and opinions made by the author are included herein. Investors must check their own facts and draw their own conclusions. No information contained herein should be relied upon, and must be independently verified. No representations or warranties are made as to the accuracy, completeness or timeliness of the information contained in this article. Blue Pacific Partners disclaims all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained in this article.
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