Smart Stocks for the Ethanol Age

Several companies are benefiting as demand for the fueland the crops that produce itskyrockets. But keep a close eye on valuations

As a solution to the U.S.'s chronic energy supply problems, corn-based ethanol remains largely untested. As a product able to shape the business climate for many companies, though, its effect has been profound (see, 02/01/07, "Ethanol: Too Much Hype—and Corn").

Two weeks after President George W. Bush called for a major increase in ethanol use during his State of the Union address, corn prices remain stratospheric, close to $4 per bushel (Central Illinois Cash Price) compared with just over $2 at this time last year. That the crop has acquired such new cachet has thrown into question how best to use it and, of course, how investors can profit (see, 2/5/07, "Food vs. Fuel").

Corn watchers expect surges in production this year as farmers hope to cash in on the boom. Though the Agriculture Dept. has yet to release official figures, some estimates say there will be almost 90 million planted acres of corn this year, up from 78.3 million last season.

"Cadillac of Seeds"

Recently, took a look at some of the ripple effects corn could have on disparate companies (see, 1/10/07, "Commodities: Who Profits from Corn's Pop?"). Now we'll go straight to the cornfield in search of promising stocks in companies directly involved in the crop's production.

High corn prices can hurt major corn buyers like ethanol and sweetener producers, but they make farmers feel flush (for that hardy group, of course, that's a relative term) and perhaps more likely to buy the best seeds. Among the agriculture players that could see a pop in sales is Monsanto (MON), which specializes in genetically modified products. The company markets herbicide- and insect-resistant varieties of seed. The more genetically modified traits a seed has—Monsanto's "triple stack" offers protection against herbicide and insect pests such as corn borers and rootworms—the more profitable it is for the company.

Monsanto's offerings represent the "Cadillac of seeds rather than the Chevy of seeds," say BB&T analyst Frank Mitsch. In this segment, the primary competitor is chemicals giant DuPont (DD) which is too diversified to be thought of strictly as an agriculture play.

Fertilizer Forecast

For the current growing season, Mitsch says Monsanto's greater availability of seeds gives it an edge over DuPont, though he expects the market to tighten next year. Echoing a common opinion among analysts, he says Monsanto has exceptionally strong fundamentals but still gives it a hold rating on a stock valuation basis: Mitsch says it trades around 35 times projected 2007 earnings. He has a buy on DuPont. (BB&T plans to seek out business with Monsanto and DuPont in the next few months.)

Goldman Sachs is more bullish on Monsanto. In January, the bank elevated the company to its Americas Conviction Buy List, citing "unprecedented demand" for the company's products. The note came weeks after Goldman went against the grain to upgrade Monsanto to buy from neutral. (Goldman has an ongoing investment-banking relationship with Monsanto.)

Of course, crops need fertilizer. Compared with other industrial crops, corn is more fertilizer intensive. And since August, fertilizer stocks have followed corn prices skyward. However, Morningstar analyst Ben Johnson says their high valuations are "really just a proxy for corn prices." With money flowing into the stocks, it's a tough sector to play. Johnson sees even those outfits he likes, such as Potash Corp. of Saskatchewan (POT) and Agrium (AGU), an agricultural products business with a retail component, as overpriced.

Pressure on Pesticides

Potash Corp. has a big enough share to "sort of dictate the global supply [and] demand balance" Johnson says but smaller North American players like Terra Industries (TRA) and CF Industries (CF) could suffer. The North American companies have to compete against players from the former Soviet Union that have much lower natural gas costs, the primary raw material for fertilizer producers.

Johnson is also bearish on Syngenta (SYT). He believes the Swiss company will continue to suffer as crops are increasingly resistant by design to crop destroyers targeted by Syngenta pesticides. Meanwhile the company's foray into seeds lags "the competition by at least two generations," he wrote in a recent report.

Delta & Pine Land (DLP), a producer of cotton planting seeds, draws skepticism from Mitsch. He says that with all eyes on corn, it could displace cotton on some land. In August, Monsanto agreed to acquire the company, but government approval on that deal is still pending.

Will the heady times continue for those ag stocks reaping a bumper crop of investor interest? The demand picture looks bright, and the reliance on grain-based fuels looks to be strengthening. Investors may do well to sit tight until the stocks are more attractively priced.

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