Wednesday, June 02, 2010

Monsanto (NYSE:MON): Bad news discounted; upgrading to Buy, add to Conviction List - Goldman Sachs

Goldman Sachs is making a significant call on Monsanto (NYSE:MON) upgrading to the stock to Buy from Neutral with a $65 price target (prev. $67) & adding the name to their Conviction Buy list.

MON has been the worst-performing chemicals stock in 2010 and the second-worst stock in the S&P 500. This former growth manager favorite has unraveled with its glyphosate herbicide franchise massively disappointing and its key Seeds and Traits franchise suffering from new product missteps. Goldman believes the bad news is exhausted, investor sentiment can bottom, and, with the shares below the $50 mark, now is the time to start building positions—they see 33% upside. The next possible positive datapoints could come at MON’s annual Whistle Stop Tour on 8/11/10 and as US harvest results begin filtering in late September 2010.

The last few quarters have witnessed an amazing fall from grace for the world’s leader in ag biotechnology. A well-deserved reputation as a consistent “beat-andraise” story with a one-time 40X forward P/E valuation multiple has unraveled, resulting in a shocking transformation that leaves MON as a “show-me” stock.

While many of the cracks in the MON story are troubling, Goldman believes most of the bad news has been factored into estimates and sentiment. This includes acknowledgment that the FY2012 profit targets are not achievable, that the launch strategies for RR2 Soybeans and SmartStax corn were flawed, and that Roundup herbicide profits are dramatically eroding due to generic competition.

With a string of negative datapoints depressing Street confidence, the firm believes the risk/reward setup strongly favors upside should any positive newsflow develop. They believe there is scope for such this fall when harvest results can validate claims of yield lift and help drive improved momentum and market share into the 2011 selling season. They also see MON as an investment idea that is much more insulated than other industrials from current anxieties around European and Chinese growth rates. A near-net-debt-free balance sheet and 2% yield are also attractive.

- 1. Roundup erosion
The last several years have seen remarkable volatility in the glyphosate markets. In hindsight, as an off-patent commodity chemical with a substantial generic producer base in China, perhaps the volatility should have been expected.

Goldman notes their analyst in China covering the local pesticide producers has noted that the high pesticide prices in 2008 prompted a 20% increase in the number of pesticide producers in China. Many of the local producers have shut down (MON relays that of 65 Chinese glyphosate producers, only 15 are currently operating and those are running at reduced utilization levels). Moreover, at current Chinese glyphosate acid prices of $3 per kilogram, theybelieve even China’s largest producer, Xinan, is only generating thin margins suggesting the older and smaller producers would be at a loss-making position. As they look toward 2012, they believe its quite likely market prices will recover as Chinese producers seek to re-establish more appropriate returns.

- 2. SmartStax corn
There is not a more important product to the MON investment case than SmartStax corn. Unfortunately 2010 did not get off to the exciting start that MON had anticipated. Following on the heels of RR2 problems and a lower-priced corn environment, it appears farmers were unwilling to accept the $23 per acre premium MON was seeking for this refuge reduction technology.

MON is addressing these issues by adjusting its pricing strategy in 2011. While specifics will not be fully revealed until later this summer, Goldman expects the company to substantially shave its pricing premium as it returns to “penetration pricing” for this new product. Simply put, penetration pricing means giving the farmer a greater share of the value creation on the front end to spur adoption. Then as the technology is proven, the company will seek to retain a greater share in the future

If MON can regain positive perception, Goldman sees that its Seeds & Traits heavy earnings (90% of FY2012E gross profit) stream can trade at 18X EPS. Based on their new FY2012 EPS estimate, this suggests MON can reach $65 (from $67 prior) over the next 12 months for 33% upside. Firm's new FY2010- FY2012 earnings estimates, incorporating the Roundup strategy change announced last week, are $2.55, $2.95, and $3.60 from $3.10, $3.65, and $4.45 and consensus of $2.65, $3.22 and $3.72, respectively.

Notablecalls: The sentiment in Monsanto (MON) has become so very negative over the past 6-9 months as generic Roundup has eaten into their profit margins. Yet, as Goldman notes, even the Chinese can't compete on price forever. The tipping point for pricing may be near.

Around these levels I would consider MON as a coiled spring, waiting for anything (anything!) positive to spring upwards.

I'm guessing the blessing from Goldman could work as a +ve catalyst here and cause the stock to trade up by 5% today, putting $51-$51.50 levels in play. All we need is for the general tape to hold.

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