Rocky Ground For Monsanto?

The new spin-off must sell investors on ag biotech

Not long after taking over as chief executive officer of Monsanto Co. in 1995, Robert B. Shapiro instituted a program he called the two-in-the-box system. The idea was to pair up a technology or science expert with a business or marketing manager to share one job. Shapiro's hope was that the marriage of those managers in dozens of key positions would speed Monsanto's rollout of pharmaceutical or biotechnology products. It was the sort of bold management stroke that showed how, under Shapiro's leadership, Monsanto came to be run more like a high-tech startup than the agriculture and drug giant it was.

These days two-in-the-box, like much of Shapiro's grand plan for Monsanto, is history. Battered by a massive backlash in Europe and growing controversy in the U.S. over its genetically modified seeds, and loaded down with the debt it used to buy up several seed companies, Monsanto was compelled to merge with Pharmacia & Upjohn in a $30 billion deal completed in March. Fred Hassan, Pharmacia's chief executive officer, lusted after Monsanto's pharmaceutical operation, Searle. But he was a lot less interested in the controversial agricultural business. That's why the combined company, Pharmacia Corp., plans to sell up to 20% of the ag operation, called Monsanto Co., to the public later this summer. Analysts anticipate it will unload the rest in the next two years.

DOWNSIZED AMBITIONS. The spun-off Monsanto will have a considerably more modest vision than its predecessor. Shapiro had pulled together cutting-edge science in agriculture, pharmaceuticals, and nutrition with the goal of creating everything from breakthrough drugs to heartier crops and disease-fighting foods. Under the old culture, the future payoff from Monsanto's science was all that mattered, and current earnings were less important. But the new ag-focused Monsanto will need to convince Wall Street--and a skeptical public--that agricultural biotechnology is not a dead end. And it has to motivate employees to concentrate on mundane tasks such as cutting costs and delivering steady earnings growth. "It went from a time when everything was possible and there were no limits to one where priorities matter and costs matter," says one current executive, who declined to be named. "That's a very different place."

Even with such downsized ambitions, the new Monsanto faces plenty of hurdles. For one thing, the U.S. patent on its single biggest product, the $3.2 billion Roundup herbicide, expires later this year. That could put price pressure on Roundup and lead to loss of market share as rivals market copycat products. Sales had been growing close to 20% in recent years, thanks to acquisitions and moves by farmers to scoop up products such as herbicide-resistant soybeans. But SG Cowen Securities Corp. analyst Ian C. Sanderson expects the global backlash against genetically engineered foods--combined with a weak farm economy-- will mean revenue grows just 8% this year, to $5.7 billion.

In Europe, where mad cow disease has left consumers particularly nervous about the food supply, widespread protests against what critics called "Frankenfoods" led to a 1998 European Union moratorium on the approval of new genetically engineered seeds for planting. Meanwhile, the controversy picked up steam in the U.S. last year as grain processor Archer Daniels Midland Co. asked farmers to segregate genetically modified crops from conventional products. Some food companies, such as Gerber Products Co., have gone on record saying they won't use bioengineered ingredients. And the uproar has delayed rollout of genetically modified seeds in Brazil.

At the same time, Monsanto will have to convince Wall Street that its current management team, led by CEO Hendrik A. Verfaillie, can manage in the new environment. Verfaillie is a 24-year Monsanto veteran who worked his way up in the herbicide business. A native of Ardooie, Belgium, Verfaillie is best known for having led efforts to boost sales of Roundup outside the U.S. While he is a longtime Shapiro ally, Verfaillie is said by some industry insiders to speak with less of Shapiro's almost evangelical zeal about the future of biotechnology.

That may prove to be a wiser approach in this environment. But it also means Verfaillie is an unknown commodity to many large investors. "The persona of Monsanto is very much the persona of Shapiro," says Roger E. Wyse, managing director at Burrill & Co., a merchant bank that specializes in life sciences. "The rest of the management team has been less visible." Both Verfaillie and Shapiro, who is now nonexecutive chairman at Pharmacia, declined to comment for this story. They cited the quiet period surrounding the public offering.

Such questions surrounding the company could result in a cool reception to the spin-off. "Our overall view is to stay away," says Dr. Faraz Naqvi, a portfolio manager and biotechnology investor at Dresdner RCM Global Investors who took a look at the offering. Speaking of the backlash against genetically modified crops, he warns, "We think it may get worse." Others who hold a less dire view still find little temptation in the deal. "The science is as good as ever," says Delaware Management Co. Senior Portfolio Manager John B. Fields, who studies the sector closely and doesn't expect to buy into the spin-off. "But the payoff keeps getting pushed further and further into the future."

To fight that attitude, the new Monsanto needs to prove it can deliver solid earnings growth now. The reconstituted company will have four main lines: crop protection chemicals such as Roundup; seeds for crops such as corn and soybeans; designer genes that can be inserted into seeds; and growth hormone for boosting dairy production. SG Cowen's Sanderson expects the new Monsanto to generate 13% average annual growth in operating income through 2003, bringing this year's total to $730 million. That would be an improvement over the weak results of the last two years, when hefty acquisition costs were a drag.

CRASH DIET. But to hit those numbers, the new Monsanto will have to be much leaner. Late in 1998, the company went on a crash diet in the wake of its $6.5 billion buying spree for seed companies and biotechnology. Those deals gave Monsanto valuable access to seeds in which it could insert its crop-protecting genes. But they also saddled the company with more than $6 billion in long-term debt at the end of 1998, up from less than $2 billion the year before. To pay some of that tab, Shapiro sold off the nutrition businesses, including the NutraSweet unit, raising $1.7 billion.

In a further bid to streamline, the company is promising Wall Street it will save $225 million over the next three years by integrating the operations of the six seed outfits it bought in 1997 and 1998. Monsanto develops genes to do things such as ward off bugs or withstand strong herbicides. About 6% of sales come from selling those genetic traits for use in the company's own seeds or in those of other seed manufacturers. Now that Monsanto owns some of those companies outright, it must integrate the gene trait development with seed development.

As the consumer backlash gained momentum in late 1998--and Monsanto's stock fell nearly in half, from a high of 63--the company scaled back its research ambitions. Now it has refocused R&D exclusively on the major crops: wheat, cotton, soybeans, and corn. Gone is work on genetically modifying a variety of fruits and vegetables, as well as futuristic projects such as producing biodegradable plastics from plants. Going forward, the agriculture research budget is expected to be $600 million annually, down from $695 million last year. SG Cowen's Sanderson says that lower level of spending is adequate and makes sense given the tough market conditions: "The near-term outlook for the business has changed quite dramatically."

The cost-cutting effort becomes more critical as Monsanto's core Roundup franchise comes under fire. The U.S. patent on the popular herbicide, which generates more than 50% of the new Monsanto's sales, expires in September. Monsanto already is cutting Roundup prices. In countries outside the U.S., this strategy has proved effective, driving up volume sales enough to offset lower prices. Still, the patent expiration means that business is likely to see slower growth.

DESIGNER GENES. That puts more pressure on Monsanto's genetically modified seeds, which carry a hefty price premium. But analysts aren't expecting many breakthrough products for at least a couple more years. In the meantime, Monsanto probably will step up its introduction of seeds that contain two added genes--for example, one that kills insects and another that resists herbicides. SG Cowen's Sanderson expects Monsanto's revenues from these designer genes to be flat this year, but accelerate in 2001 and 2002.

Any expansion, of course, could be derailed if the backlash against genetically modified foods is not contained. Protests in Europe have effectively blocked the sale of genetically modified seeds for planting there. Analysts had expected Monsanto to start selling soybeans that can withstand Roundup, dubbed Roundup Ready soybeans, in Brazil last year. But consumer protests delayed the rollout. Alain Godard, chief executive officer of competitor Aventis Crop Science, warns that it will be a devastating setback for the whole industry if Brazil ends up blocking the designer seeds. If that happens, "I think [genetically modified seeds] will be delayed in large parts of the world...for five or ten years," he says. And while markets such as China and India are promising, Godard warns that their weaker patent-protection rules may limit profits.

In the meantime, U.S. farmers also have cooled on the high-tech seeds. The economics remain compelling: With Roundup Ready soybeans, for example, farmers can hit fields once with the potent herbicide, instead of applying a host of herbicides serially. But some farmers worry that the backlash will limit their ability to sell crops in markets such as Japan and Europe. Novartis Seeds Inc. CEO Edward T. Shonsey figures U.S. farmers are planting 5% to 10% fewer biotech crops this year than last. Warns Gary S. Goldberg, CEO of the American Corn Growers Assn.: "I don't see a sign that this will turn around soon."

Monsanto, along with other industry players, is fighting back. These companies, including Aventis, DuPont, and Novartis, have launched a $50 million advertising and information campaign aimed at convincing consumers of the value of agricultural biotechnology. The goal is to highlight the benefits of genetically modified crops, including the opportunity for reduced use of pesticides and, ultimately, the production of health-promoting foods. And many in the industry believe the recent move by the Food & Drug Administration to tighten oversight of biotech foods will help calm consumer fears. But Michael K. Hansen, research associate at Consumer Policy Institute, part of Consumers Union, thinks the awareness campaign may backfire: "As more information comes out, you will see people become more and more concerned."

ON A MISSION. Along with damage control on the outside, Verfaillie will have to find ways to mend Monsanto's corporate culture. Shapiro persuaded employees that they were on a mission to improve human health and help feed the world's growing population without devastating the environment. He challenged them with changes such as "two-in-the-box" and moving senior managers--himself included--into cubicles to improve communication. Says one former executive: "There was a real sense of a noble purpose, a sense of Camelot."

And for the first few years, Shapiro's vision paid off handsomely. Within three years, Roundup Ready soybeans accounted for over 50% of U.S. soybean acreage, says PaineWebber Group Inc. analyst Andrew W. Cash. But it soon became apparent that Shapiro was taking huge risks. He mounted an ill-conceived public-relations campaign in Europe to head off growing criticism over genetically modified seeds. But the effort seemed only to throw fuel on the fire. "We bought too many companies, paid too much money, and we didn't pay attention to the grassroots [opposition]," says former Vice-President Michael W. Winkel, who left in early 1999 to join printer R.R. Donnelley & Sons Co.

A deal to merge with American Home Products Corp. would have given Monsanto much-needed scale in its promising drug business, but that collapsed in 1998. Shapiro implemented a cost-cutting initiative and began selling assets. Now, as Monsanto prepares for its second act as an independent company, Verfaillie and his team must redefine Monsanto's mission. Then they'll have to prove that the scaled-down vision can still deliver for investors.

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