A Crop-Dusting for Monsanto Shares

Concerns about smaller profit margins in the company's seed business put pressure on the stock, despite strong earnings

One disadvantage of the high profile that surging corn prices have created for agriculture companies is that investor expectations get ahead of themselves. One good example: Monsanto (MON), which posted better-than-expected results but saw its shares fall on June 25.

Corn seed and bio-genetic traits have been big drivers of the company's profits in recent years. On June 25 the manufacturer of seeds and herbicides reported a 41% jump in earnings, to $1.45 a share, for its third quarter, ended May 31, from $1.02 a share a year ago, thanks to a 26% rise in total sales.

A settlement of legal claims related to former subsidiary Solutia's emergence from bankruptcy contributed 23¢ aftertax to the $3.93 a share that Monsanto earned in the first nine months of fiscal 2008, an 81% jump from the year-ago period. On a continuing basis, earnings for the first nine months of fiscal 2008 were $3.70 a share.

Earnings Beat Forecasts

The St. Louis outfit sees reported earnings of $3.63 for the full fiscal year, excluding an estimate for the in-process research and development charge associated with acquisitions in the fourth quarter. Monsanto boosted its forecast for continuing earnings to $3.40 from a prior range of $3.15 to $3.25 a share.

Roundup and other glyphosates—herbicides used to kill weeds that choke the growth of crops—were the key driver of the earnings upside, while gross profit from cottonseed was also much higher, at $195 million.

The latest results beat Wall Street analysts' average forecast of $1.34 a share, but that wasn't enough to keep the stock in investors' good graces. The shares closed 3.1% lower at 131.52 on June 25, though they are still up nearly 18% year-to-date.

Investors may have been disheartened by lower margins in earnings before interest and taxes in the seed business, which fell from 33% to 29%, partly because of an increase in spending on research and development.

Seeds of Distress

Margins were hurt by an increase in seeds in the product mix, greater volatility in commodity prices that put pressure on soybean margins, and resolution of patent litigation and royalty disputes, which had a one-time effect of reducing corn margins by $12 million, or 1%, CFO Terrell K. Crews said on a June 26 conference call with investors and analysts.

Monsanto slashed its estimate for free cash flow for the fiscal year to $550 million from the previous forecast of $1.3 billion, mostly on higher acquisition-related expenses.

Monsanto said it expected the gross profit contribution from the Roundup products to be about $1.9 billion for fiscal 2008 and $2.1 billion to $2.2 billion in fiscal 2009.

The pace of growth in sales of corn seed and bio-genetic traits slowed to 9.4% from a year ago, compared with growth rates over 35% for every quarter in fiscal 2007, said one analyst on the conference. Gross profits for seeds and traits climbed only 7% in the third quarter instead of the projected 31%, analyst Laurence Alexander wrote in a June 25 research note for Jefferies & Co. (JEF).

Early Harvest of Profits

As Monsanto's market share in corn seeds and traits has grown, replacing sales from products it licenses to other companies, the timing of recording profits has shifted to earlier in the fiscal year, Crews said on the conference call.

"In the past, we had a lot more earnings from licensees show up in the third quarter," he said. Margins also narrowed on the absence of business from Latin America in the third quarter, he added.

Given the lackluster results in Seeds and Genomics, Monsanto shares are likely to be restricted to a narrow trading range and might even come under more pressure until the company's tour to raise capital slated for August, the Jefferies note said.

The higher earnings outlook of $3.40 for the full year points to a loss of 30¢ a share in the fourth quarter, more than the loss of 16¢ that Credit Suisse (CS) analyst Mark Connelly said he expected in a June 25 research note. "That is disappointing, but reflects, in part, the lack of visibility in cotton quarter-to-quarter," and represents a shift in profit between the third and fourth quarters, he wrote.

The Cotton Is High

While seasonality and the effect of the acquisition of seed producer Delta and Pine Land left little visibility about future profits from cotton, "it is looking like a bigger contributor overall than we had expected, which is very good news," Connelly said. (Credit Suisse does and seeks to do business with companies covered in its research reports.)

But analysts said they were encouraged by the market share gains in corn seed as Monsanto confirmed its estimate of 2% to 3% growth in market share of the DeKalb brand and an additional 1% to 2% growth at ASI, which UBS (UBS) analyst Chris Shaw called strong results in a competitive environment. The company also expects to pick up an additional 5% market share in Argentina, while Brazil will stay flat.

Whatever short-term concerns investors have about the company, Mondanto looks to be a powerful profit-making machine in the years ahead.