Description

Monsanto is a risk arb which offers a nice risk-adjusted return today, with a decent absolute P&L opportunity over a realatively short duration and simple technical dynamics which explain the recent weakness (& buying opportunity).

Business

Monsanto is the global #1 in the production of genetically modified ("GM") seeds and traits and the global #5 in the production of crop chemicals. The seeds/traits business contributed 75% of FY17 revenue but 90% of FY17 EBIT with the remainder coming from crop chemicals. In seeds/traits Monsanto has an extremely strong franchise while in crop chemicals, they basically just produce glyphosate (glyphosate is an off-patent herbicide and this is a low margin and very volatile business where pricing is determined by Chinese market conditions and where the rest of the world's producers are price takers).

In the seeds/traits business, Monsanto benefits from enormous barriers to entry - seeds are a relatively small portion of total farmer budgets but a mission-critical item, the relationships between ag. product salesmen and farmers are often multi-decadal affairs meaning that farmers tend to be very sticky customers, the pool of intellectual capital that Monsanto has developed over the last ~ 30 years of R&D represents an unassailable barrier to new entrants (breeding new seeds/traits takes place over a seasonal cycle, so even if you started from scratch with $100b of capital, you'd still be missing 30 years worth of seasons in order to continually test and refine your products). In the US, market shares reflect these barriers - with Monsanto & Pioneer (part of DuPont, now DowDuPont) holding ~ 75% of the market for corn seeds and ~ 60% of the market for soybean seeds between themselves, pretty consistently for the last decade (if there is a direction of travel it is that these two playesr have gradually been taking share over time). Where GM seeds are accepted internatnioally the picture tends to be similar, I just don't have hard data. Further reflcting the strength of this business, over the last 6 years, the average annual price increase taken has been just over 5%. This is not quite an apples-to-apples number however, as these price increases were accompanied by seed yield increases over the same period, so the price per unit of seed output from the farmers' perspective rose at a slower rate. The typical rule of thumb historically has been that the seeds/traits companies split 50/50 between themselves and the farmers incremental productivity gains, so (using that math) from the farmers perspective real pricing has risen at a more stomach-able ~ 2.5% per year.

So 90% of Monsanto's EBIT comes from demonstrably competitively advantaged business. On top of that, the LT growth prospects look pretty good. Monsanto (as do its peers) benefits from the combination of a growing global population and growing levels of per capita food consumption (between population growth and per capita growth, total food consumption is expected to double by 2050 = 2-2.5% global volume end market growth for 30+ years). Combine this with the fact that arable land is a finite resource and it becomes clear that yield enhancing strategies are required. There are three basic yield enhancing strategies - (1) better capital equipment (tractors, harvesters etc), (2) more chemicals and (3) better seeds. Its beyond the scope of this write up but better seeds are likely the best choice for most farmers given their fast payback periods (vs capital equipment) and lack of negative externalities (vs incremental chemical usage).

Monsanto also owns a nascent "precision farming" product called Climate FieldView which is immaterial to earnings today but could be material down the line. The business provides software as well as easy access to 3rd party applications to farmers in order help them better manage their crops by using data/analytics related to temperature/rainfall/soil conditions etc. This business made for good soundbytes and catchy investor day TAM slides for a few years but lately has actually started to excceed expectations in terms of paid acreage in the US and Monsanto is now beginning to widen its geographic exposure to Canada, Brazil and Europe. This business contributes almost nothing to current earnings (in fact, it might even be negative) but is a nice LT option within the company's overall product portfolio.

Risk Arb

Moving onto the risk arb, Bayer agreed to acquire Monsanto in September 2016 after ~ 4 months of back-and-forth on price and terms. This deal took place after a busy 2 years for agriculture bankers - Monsanto spent quite some time trying to acquire Syngenta, before ultimately ChemChina bought the Swiss comapny, Dow & DuPont announced a merger (which recently closed). In the adjacent fetilizer space, Agrium and Potash are now merging. The spate of consolidation in the space, which focused on bringing together seed and crop chemical businesses, reinforces the strategic nature of this deal for Bayer.

The deal was initially slated to close before the end of 2017 but the companies are now saying Q1/early 2018. I'm assuming end of April 2018.

The consideration for Monsanto shareholders is $128.00 + dividends (which run at $0.54 per quarter).

In the event of the deal not closing, Monsanto will receive a $2b break fee, which equates to ~ $3.30 per share on a post-tax basis.

If the deal was to fail, where might Monsanto be trading?

• Monsanto traded at a median 18.9x 1 year forward PE during the 3 years prior to the Bayer bid, taking 1 year forward EPS based off consensus on my assumed exit date (when the deal with either have closed / broken), namely $6.03 - would imply FV of $117.2 per share
• Monsanto doesn't have any perfect listed comps but the "least bad" are arguably the listed Syngenta stub, Deere, Vilmorin and KWS - they trade on average at 19.4x 1 year forward earnings, a multiple which would imply FV of $120.5 per share
• Monsanto was trading at 17.3x 1 year forward PE the day before the Bayer approach was made public, if you adjust the multiple up for the +6% expansion in the MSCI World PE we've had since that date (i.e. 18.4x) and put it on 1 year forward EPS on exit, that would imply FV of $113.9 per share

Taking the average of these three numbers (all of which bake in $3.30 of after-tax break fee) is $117.2, marginally below where the stock is trading today. This also implies a 19.4x PE on a break, which with the S&P at 18.2x NTM EPS seems very fair (if not cheap) to me given the quality and LT growth prospects of the business that makes up 90% of Monsanto's earnings power.

None of the above numbers take into account two further factors - (1) regearing the balance sheet and (2) tax reform. In the event of a deal breaking, given FCF generation between now and then (net of dividends paid), I think Monsanto would be levered ~ 1.1x. If this rose to 2x, well within where Monsanto had historically been in the years before the Bayer deal, that relevering could be ~ 4% accretive to EPS. Whatever your view of tax reform's likelihood, its unlikely to be a net negative for Monsanto which generates ~ 60% of PBT in the US. Assuming a 10% ETR reduction on 60% of PBT would equate to a consolidated 8.3% uplift in Net Income. In the event of tax reform, I doubt the full benefit falls through to Monsanto given they probably have a bunch of IP/profit shifting strategies in place already to reduce US taxes but maybe its LSD accretive to EPS and this is not a busniess where I worry about that windfall being competed away.

The Monsanto deal is substantially de-risked from an antitrust perspective given that at the start of October BASF agreed to pay $7b for a divestiture package that includes Bayer's cotton and soybean seed business as well as Bayer's herbicide brand Liberty. Whether this precise pacakge is what the companies need to get various country regulators over the line is hard to diligence from the outside but to me what is important is that they've found a scale buyer who regulators are likely to be happy with (given their creditibiliy in ags/chems, ability to invest in the product etc) and with whom they've agreed a price. If the package needs to be tweaked slightly down the line to appease regulators, I'm comfortable betting that the over a good German beer, BASF and Bayer can figure it out. We also know that Syngenta was the underbidder behind BASF so even if I'm wrong on that assumption, Bayer has a back-up plan.

Bayer has also sold shares in listed subsidiary Covestro three times since the deal was announced for a total of roughly €3.75b, with the most recent placing at the start of September. This pattern of behaviour gives me incremental confidence that, based on what they are seeing/hearing from the antitrust regulators, they still think the process is on track.

I also think its worth flagging that Berkshire owns just under $1b of Monsanto. They popped up on the register in their Q4 2016 13F (i.e. after the deal was announced, albeit with the stock trading much lower vs today) and they haven't traded a share since.

Technical Factors

If there's not much downside to a deal breaking, why is the stock off lately and why is it implying such an asymmetric outcome?

On the latter, I think that mega-cap risk arb often poorly discounts likely outcomes given the size of the companies involved relative to the total pool of risk arb capital globally.

On the former, I think its largely a spillover from two other deals - (1) the AT&T/TWX/DOJ/Trump ding-dong that seems to be taking place right now and (b) Broadcom's hostile bid for Qualcomm. Over the last 20 days, TWX & MON stock prices have exhibited a 90% correlation - to me, this is clearly not fundamentally-driven given that the two names should be trading on their own deal-related idiosyncracies, as reflected by the fact that over the course of 2017, the average correlation was ~ 20%. I've no idea whether the correlated sell-off is risk arb managers selling MON shares to de-risk their book into year end after a nasty and unexpected blow up in TWX or whether they're selling MON shares to redeploy into what they now perceive to be an even fatter pitch in TWX (don't think it really matters either way). I think we also saw some risk arb capital get yanked out of MON in order to get redeployed into QCOM - as evidenced by the fact that the three days during which MON shares sold off most aggressively were almost exactly concurrent with the announcement of the AVGO/QCOM bid.

Returns

At the current price of $118.3, you stand to make 8.9% to close (I assume 1.5 divs to closing because my closing date is around the time the second div would in theory be due to be paid and I think its a coin toss as to whether you get it). Per my comments earlier, I think downside is very limited at these levels. If you assume an end of April closing, the annualized return is 19.9%. If you assume a 90% probability of the deal closing, then the annualized expected return is 17.6%. I think that in a rich market, those returns are not to be sniffed at, particularly if you have some cash burning a hole in your pocket.

Catalyst

- Continued progress with antitrust regulators

- TWX either closing/getting blocked, triggering redoployment of risk arb capital into Monsanto