Monsanto’s Mixed Signals

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Editor's Note: The GMO study mentioned below is highly contested, and the article has been changed to reflect this uncertainty. 

While Monsanto (NYSE: MON) is up roughly 23% year-to-date as of this writing, the company is trading at an elevated multiple and just below its 52-week high. The company’s strong momentum and position within the solid agricultural industry have made it an investor favorite thus far this year. However, as the stock has recently set new highs and released weak fourth quarter results, many are beginning to wonder if the stock’s run is over. Ultimately, based on interesting sector rotational forces, Monsanto looks like it has a fair degree of upside left and should be considered a buy.

Disappointing Earnings

In Monsanto’s most recent earnings release, the company disappointed investors on both a revenue and earnings-per-share basis (EPS). The fourth quarter has historically been the weakest for the company, so negative results are not a huge surprise for those familiar with the stock. Revenues contracted by 6.1% on a year-over-year basis, with totals falling from $2.25 billion to $2.11 billion; analysts had expected $2.23 billion. EPS came in at -$0.45 per share against expectation of -$0.43 and -$0.21 a year ago.

The reasons for the contraction are unclear and have been blamed on a variety of factors. The mild drought in the U.S. is cited as having had both a positive and a negative impact on results, depending on the report you are reading. Overall global economic weakness is likely a significant driver, particularly as the company’s fourth quarter falls after U.S. and Eurozone farmers have finished planting, but ahead of when the increasingly important South American market is in full tilt. Forward-looking expectations are positive, but not as strong as some analysts had hoped.

Larger Trends

An important consideration in evaluating any company involved in food production is the overall trend in population growth and the need for farm land. Double-digit growth is expected in fertilizer consumption by 2016, according to the International Fertilizer Industry Association. Furthermore, global population is projected to reach 9 billion by 2040. As the bulk of top-quality farm land is already in use, additional food production is likely to be driven by both the use of fertilizer and technologically advanced growing techniques. Both of these factors provide a long-term bullish outlook for Monsanto and the industry as a whole.

Positive Sector Rotation

If we consider the chart below, it is clear that Monsanto has significantly outperformed some fertilizer companies, like Potash of Saskatchewan (NYSE: POT) and Mosaic (NYSE: MOS), while underperforming another group including Agrium (NYSE: AGU) and CF Industries (NYSE: CF). The difference between the underperforming and outperforming groups is the role of nitrogen in each. Potash-based fertilizers from Mosaic and Potash have lagged, while nitrogen-based fertilizers from Agrium and CF have done well. This can be traced to the price of natural gas, a critical component in the production of nitrogen-based fertilizer. Gas prices have been extremely low, which has helped these companies thus far this year.

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MON data by YCharts

As the price of natural gas recovers, as it has begun to do recently, it is likely that there will be significant sector rotation because the cost structure of fertilizers will change. This should put pressure on nitrogen-based fertilizer margins and cause a shift back to potash-based. Monsanto has the potential to benefit from this as the clear strength of fertilizer becomes less certain. Investors looking to maintain a solid allocation to the sector may see Monsanto as a “safe haven” of sorts, as the relative positioning within the industry continues to play out.

Additional Risks

Even with the positive outlook for Monsanto, it is still trading at a relatively high forward P/E based on expected 2013 earnings. Having recently set 52-week highs, critics are concerned that the stock has made its run and has limited upside. While I do agree that there is an upper bound on the upside potential of Monsanto shares, it is sufficiently above current levels to warrant the risk.

One risk, however, that must be considered is the potential impact of Proposition 37 in California. The measure, which is set for referendum on Nov. 6, would require food that includes genetically modified organisms (GMOs) to be so labeled. If passed, the requirement is expected to have a negative impact on Monsanto and others who specialize in GMO seed products.

This is especially true given the results of a recent, yet highly-disputed, study that links GMO feed to cancer in lab rats.  If Prop 37 passes and consumers believe that Monsanto’s products will give them tumors, it’ll definitely be necessary to reevaluate any allocation to Monsanto.

The Trade

Despite some of the negatives for the stock, there is still enough upside potential to justify buying Monsanto for the medium term. As factors within the fertilizer market play out, the stock represents a stable, but closely-related, alternative. Proposition 37 is a significant risk, so shareholders need to stay appraised of that situation. Overall, Monsanto remains a buy with a somewhat volatile outlook.

Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of CF Industries Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.

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