Good Breeding

The Green lobby in Europe is worried, very worried. In early February, the World Trade Organization ruled against the European Union, saying its ban on genetically modified (GM) crops and foods is illegal. While Merrill Lynch analyst Don Carson says the decision “puts pressure on the EU to make science-based decisions” — after all, there is no credible evidence that GM crops and foods are unsafe — the ruling prompted this from The Observer Magazine, a left-leaning magazine published in the U.K.: “Certainly global trends suggest we should rouse ourselves from our complacent slumber. Last year marked the planting of the billionth acre of GM crops as 8.5 million farmers in 21 countries now farm GM crops.”

Even if Europe is slow on the uptake, total acreage devoted to biotech crops, which were first widely planted 10 years ago, has been steadily increasing. Last year, GM crop acreage increased by 11 percent from 2004. Of that amount, acreage planted with “stacked” seeds, which contain multiple genetically altered traits for added protection against pests and weeds, grew nearly twice as fast, according to the International Service for the Acquisition of Agri-Biotech Applications. In short, for investors, GM plants and foods are a growth industry. There are a couple of ways to invest: diversified chemicals giants, like Monsanto, DuPont and Dow, which produce biotech seeds, and companies that focus more exclusively on crop protection, like the Swiss-based agribusiness firm, Syngenta, which draws 80 percent of revenues from pesticides, but is ambitiously building its biotech seeds business.

Controversial? Not Here

Although biotech foods are controversial in Europe, they are already a mainstay in the U.S., where most soy and half the corn crop is GM; most processed foods, from corn flakes to salad dressing, contain ingredients from biotech crops. Though GM generates little controversy in medicine, where biotech treatments, for example, are embraced for cancer care, in agriculture the situation is more politicized, as some consumers and scientists worry that genes inserted into crops may contaminate other species via wind-borne pollen. The industry counters that GM crops let farmers use fewer chemicals, reduce production costs, cut tractor emissions and provide greater yields. Farmers, at least in the U.S., are enormously receptive: Between 1996 and 2002, for example, the proportion of soybean acreage planted with herbicide-tolerant GM seeds grew from less than 5 percent to 75 percent. And the Greens? Asserts Soleil Securities' analyst Mark Gulley: “The Greens don't have a shred of scientific evidence to distinguish ag-biotech from traditional crops. If it could be proved that biotech traits harm the environment, Monsanto's stock is going to $10, and maybe to zero.”

Monsanto is more of a pure play on GM than, say, DuPont or Dow. Monsanto is widely known for its crop protection-seed platform, known as Roundup/Roundup Ready. Roundup is a nonselective herbicide, while the Roundup Ready seed trait insures that crop plants do not fall victim to Roundup when weeds do. Going forward, Monsanto is developing more “stacked” trait seeds, by combining, for example, the Ready platform with traits like Bollgard, which is used to protect cotton against bollworms (pests that attack corn roots). Monsanto's strong patents also create a “moat” against the competition. Farmers who license Syngenta's Golden Harvest brand corn seed can get triple-stacked seeds if they want, but Syngenta, at least at present, has to license the traits from Monsanto.

For fiscal year 2005 (ending August), Monsanto increased its earnings by 29 percent, with seeds and traits making twice the contribution of pesticides, in large part because of the greater proportion of high-margin sales of stacked corn traits. In fact, GM seeds' contribution to gross profit is in mid-ramp, having gone from under 50 percent in 2003 to a forecast 70 percent-plus by 2007, as the company's emphasis shifts from its commodity-like pesticide offerings to its patent-protected core of heavily researched biotech traits. Monsanto stock, which trades at 30 times current year forecasts, commands the sort of growth multiple more closely associated with an Amgen than a Dow. No wonder: The consensus analyst earnings forecast predict earnings growth of 27 percent for fiscal 2006. Merrill's Carson sees earnings growth of “20 percent or more through the end of the decade.”

Syngenta, a six-year-old company created by the merger of the agrochemicals businesses of AstraZeneca and Novartis, vies with Bayer CropScience for the top spot in global agrochemicals and ranks third in commercial seeds. Like Monsanto, Syngenta has a growth story to tell, having beaten its high-teens earnings-growth guidance for 2005 with a nifty 31 percent earnings improvement. Management forecasts blue skies far into the future, having recently guided toward double-digit earnings-per-share growth through 2008. As with Monsanto, Syngenta is placing more strategic emphasis on its seed brands and genomics revenues than its more commodity-driven crop-protection revenues.

Citigroup analyst Andrew Benson sees Syngenta establishing itself as the solid No. 2 in GM technology by 2008, “with 2006 being a transition year and 2007 hopefully one of delivery.” The analyst believes Syngenta can get around making royalties payments to Monsanto and build a seed platform similar to Monsanto's Roundup Ready traits. In moving toward independence from Monsanto, Syngenta recently acquired an herbicide-tolerant corn trait from Bayer and already has a royalty-free license on herbicide-tolerant soybeans and its own corn rootworm trait. “Even though Syngenta still has to license the corn borer trait,” notes Benson, in some of the biggest applications they will soon be royalty-free.

Too Rich?

Over the past year, investors have fallen for ag-biotech (sending Monsanto and Syngenta shares up 49 percent and 29 percent, respectively) and shunned the diversified chemicals firms (Dow is down by 18 percent and DuPont is down by 23 percent). Is Wall Street valuing the shares correctly? Ag-biotech is entering a period of vibrant growth as farmers, not only in the U.S., but Brazil, India and China increase usage of the highly productive seeds. Current adoption rates support a growth assumption of 10 percent to 15 percent per year over the next four or five years. As competition heats up, Benson sees Monsanto's hold on GM seeds slipping a bit. In five years, he supposes, Monsanto may have a 75 percent share, Syngenta a 10 percent share and DuPont/Dow, perhaps, 6 percent. Though DuPont and Dow remain extremely committed to GM-seed development, the two companies are of less investor interest as they are so broadly diversified.

Right now Monsanto and Syngenta are the purest plays in ag-biotech. Monsanto garners over $2 billion in seed sales, plus huge trait revenues, which are due to its outlicensing arrangements. Syngenta's strategy, says Benson, is to push technology into its share of the seed market. “It's currently got 15 percent of the U.S. corn and soy seed acreage. If it can prove its technology, it would be perfectly feasible for Syngenta to outlicense along the Monsanto model. It's just not there yet.”

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