It's understandable why biotech is such a hot sector. An aging U.S. population provides a powerful demographic backdrop for increased demand for drugs and therapies, and large pharmaceutical companies are looking to snap up promising biotech stars to augment their skimpy new drug pipelines.
Although many investors associate biotech with companies that are developing treatments for cancer, diabetes and other life-threatening illnesses, few turn their attention to agriculture and nutrition.
, for instance, is a supplier of agricultural chemicals, but the company is also a global leader in the development and marketing of seeds and biotechnology traits (related to weed, insect control, weather resistance and improved nutrition) to the world's crop growers.
And while most biotech companies are still far from profitability, let alone break-even levels of cash flow, Monsanto became solidly profitable in its seeds and genomics business in its last fiscal year ended August 2003. Its free cash flow is expected to be $230 million after dividends this year, more than 100% of estimated net income. Trading at a P/E ratio of 18.3 times the consensus earnings estimate of $1.86 per share for 2005, it seems a little pricey by the chemical sector's standards. But the stock looks like a deal compared to the average biotech company's P/E of 40.
Considering that Monsanto's biotech seeds directly address farm productivity and economics, it's hard to imagine how the company's seeds and genomics business won't continue to be a big success, despite the political and environmental concerns that have arisen over the widespread use of genetically modified seeds. The company has developed seeds and genetic material that can be used to develop seed varieties that provide protection against herbicides (like the company's own best-selling Roundup brand) and insects such as the tobacco budworm, bollworm and corn rootworm. This enables growers to use more productive farming methods like conservation tillage and reduce their reliance on pesticides.
Monsanto is by far the world leader in this field, with a reported 90% market share of global biotech acreage. Roundup Ready soybeans have been its biggest success so far and were planted on 95 million acres last year, up 8% from 2002. Total Monsanto biotech (or GMO) acres rose 11% in 2003, and are expected to be up by that amount again -- at least in the U.S. -- in 2004 as well. These include seeds with other traits, such as its YieldGard Rootworm Corn, which received approval last year. Rootworm is expected to bring in up to $1 billion in profits lost to crop damage to corn growers.
The company is also developing "stacked trait" seeds, which incorporate multiple genetic traits into one seed, such as combining the YieldGard Rootworm trait with Roundup Ready, giving growers the convenience of both weed and pest control. Stacked traits have been most successful in cotton, where Monsanto's acreage rose to 5.4 million in the U.S. last year, up 13% from the previous year.
With its much higher profit margins, Monsanto's faster-growing seeds and genomics business is likely to overtake its struggling agricultural chemicals business for the first time this year. The seeds and genomics business is expected to produce an operating margin close to 30% in fiscal 2004, 10 percentage points higher than the agricultural chemicals business. It's also expected to represent 53% of total profits, compared to 39% last year.
But while the margin rate is likely to increase on the seeds and genomics business with the development of more traits, margins on the agricultural business could remain under pressure. Ever since Monsanto lost patent protection for Roundup -- 1992 in Europe and 2000 in the U.S. -- its prices and market share have been declining. However, with prices already down to about $16 per gallon in the U.S. from about $30 per gallon in 2000, the big declines are behind it and most analysts expect Roundup prices and market share to begin stabilizing. Meanwhile, Monsanto has been cutting costs aggressively to help offset the impact on its profits, and expects to save around 30 cents per share in 2005.
Some Dark Clouds
Monsanto is not without its risks. Despite the refreshing focus and pragmatism of new CEO Hugh Grant, Monsanto is still associated with a number of controversies. Solutia, which Monsanto spun off in 1997, filed for bankruptcy last year, which could expose Monsanto to some pension and health care liabilities related to certain Solutia employees.
The company is also dealing with litigation involving
Delta and Pine Land
, which it unsuccessfully attempted to acquire in 1998. Finally, there probably will be no shortage of headline risk associated with public concern over GMO seeds, especially in Europe. Monsanto did receive some good news on this front in March, though: The European Union safety authority declared Monsanto's Roundup Ready canola safe for human consumption. Then, last month, the EU effectively lifted its ban on GMO foods by approving a modified strain of corn. Monsanto has 11 of the 22 GMO products that are pending approval in the EU.
These risks seem manageable in light of Monsanto's strong cash flow and sturdy balance sheet. Monsanto's debt-to-capital ratio is just 24%. And the company is expected to produce $350 million to $400 million in free cash flow before dividends ($230 million after) in fiscal 2004, marking the fourth straight year that free cash flow has been solidly above $200 million. Free cash flow is likely to be used for share repurchases. The stock also pays a dividend, with a current yield of 1.7%.
Monsanto isn't your typical biotech stock. But its promising pipeline, solid earnings, strong cash flow and relatively attractive valuation make it worth considering.
Odette Galli is a freelance columnist for RealMoney.com. She has been a writer at SmartMoney Magazine and a senior manager at Ark Asset Management, where she co-managed $3 billion in institutional assets. In addition, Galli was a senior vice president at J & W Seligman. At the time of publication, she had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. She welcomes your feedback and invites you to send your comments to