Year-End 2003 Update and Company Reports

Monsanto (MON 29) is at the cusp of a very rare achievement, the rebirth of an old blue chip company. By creating the disruptive innovation of biotech seeds, Monsanto has transformed itself from an old chemical company into the leader of a worldwide quantum leap in agriculture. The company initiated its efforts to map the plant genome in 1983, eventually extending its newfound knowledge into the breeding of better plants. About 150 million acres worldwide were planted in 2003 in Monsanto traits, with future acreage projected to grow in the mid-teens. Monsanto’s seed trait acreage market share is similar to that of QUALCOMM’s CDMA chipsets: 90%.

Altering plant genomes is nothing new. Farmers and herders have selectively bred plants and animals for thousands of years. Gregor Mendel studied trait modification by cross-pollinating peas in 1866. Monsanto streamlines this process by directly inserting the desired gene into the plant genome. This has allowed very powerful, and more controversial traits, such as insect resistance, to be introduced.

Monsanto’s early vision set the standard in the plant biotechnology business. Its leadership is maintained through:

1. the breadth and depth of its germplasm base

2. broad seed market presence

3. first-to-market trait advantage

4. advanced position in the experience curve

5. farmer satisfaction near 100%.

Inserting the Roundup Ready gene into corn and other crops is just the beginning. A recently approved trait gives corn the ability to resist a very destructive pest, the corn rootworm. In line with giving the farmer more productivity and profitability, this trait does much more than just saving the farmer (and the environment) from spraying insecticides. It gives him the ability to improve his economics. By eliminating this pest, the farmer can replace soybeans with more profitable corn. To quote Fred Yoder, President of the National Corn Growers Association, “We’ve been waiting a long time for this. Rootworm is the No. 1 pest and No. 1 yield robber we have in growing corn.” Monsanto will add even more value by “stacking” the seeds with Roundup resistance and corn borer resistance. Trait stacking means Monsanto seeds have multiple proprietary productivity enhancements, each of which earns royalty revenues. Monsanto gets paid both for each trait and by increased corn seed sales, which are more profitable than soy seed sales. Stacking also keeps Monsanto ahead of the competition, which just now is introducing single traits. Farmers love Monsanto’s seed technology.

Monsanto is at a transition point. The development of seeds and traits in recent years was funded by sales of Monsanto’s biggest product, Roundup herbicide. Roundup patents have now expired, allowing 40% of market share to be taken by low-priced generics. Roundup gross profit contribution is falling as seed and trait sales grow. In fiscal 2003, gross profit of seeds and traits permanently passed Roundup, as seeds and traits gross profit rose 44% while Roundup gross profit declined 30%. Trait stacking really gains steam for Monsanto in about two years, while the decline in Roundup profits should flatten. This will accelerate gross profit growth, leading to an increase in the earnings per share growth rate, return on equity, and cash flow production, without requiring new capital investment.

Free cash flow production at Monsanto has improved markedly. Capital expenditure growth has stopped as Roundup production capacity has peaked. Ownership of Dekalb and Asgrow seed companies gives sufficient seed distribution capacity. Earnings per share in the August 2004 fiscal year are projected at $1.50, compared to $1.37 in 2003. The company is rapidly repurchasing stock and increased its dividend this year.

More traits are coming soon, multiplying stacking profits. They include resistance to more insect pests, increased Roundup tolerance, drought resistance, cold tolerance, nitrogen sensitivity, and crop yield enhancement. And, further out, in 2008 – 2010, Monsanto is working to introduce the “holy grail” of seed technology, “output traits.” Output traits include making soy oil healthier than olive oil through reducing saturated fats while increasing Omega 3 fatty acids, increased grain protein content, and improved nutritional density. These could be blockbuster products.

Monsanto has several overhanging risks. Monsanto exited the commodity chemical business in 1996 by spinning off Solutia. Pension and environmental cleanup liabilities of now-bankrupt Solutia have periodically come back to haunt Monsanto. Also, the Justice Department has investigated Roundup pricing to make sure that Monsanto, with its majority market share in the underlying chemical, glyphosphate, has not violated any anti-trust rules. Delta Pine and Land is suing Monsanto for canceling their merger, even though the Justice Department blocked it. Finally, like any agriculture business, the weather is important and even less predictable than the stock market.

Weatherford International, Inc. (WFT 42) is the only oil service company in which technological innovation is driving earnings growth. However, oil service companies as a group are difficult prospects for the long-term investor. The primary driver of oil service company stock valuation, oil and gas prices, is generally unpredictable. Graphing oil service company stock prices against crude oil futures shows a high level of correlation. Further, the P/E ratios of these companies expand and contract as oil futures trade above or below their 52-day moving average. Clearly, higher oil prices will drive more drilling, which in turn drives revenues and earnings for oil service companies. Hence, the stock prices in this group fluctuate with the expectations for oil and gas prices.

Due to the trade deficit, the weakness of the dollar, and the accelerating recovery in economic growth, inflation is a growing concern in the back of my mind. Oil is a time-tested inflation hedge. Additionally, the growth of manufacturing in countries like India and China is creating new demand for energy.

It is particularly interesting to find an oil service company that is developing technologies to make drilling investments substantially more productive. This characteristic of Weatherford gives it a dual appeal: if the investor is wrong on oil prices, the growth of its technology-based earnings over the next five years may still make it a satisfactory investment.

Weatherford’s most outstanding technology is called ESS, Expandable Sand Screen, a process of stenting a well bore. Similar to the stents we have discussed for humans, the ESS is inserted into a drill hole where the sand has collapsed, plugging the hole. The stent is expanded after insertion, re-opening the hole. This technology can also be employed from the top of the hole as it is drilled, greatly increasing the chances for a successful deep well. Tests show that utilization of ESS from the surface to the bottom of the hole nearly doubles production. These economics are driving 30%+ annual growth for the ESS.

Underbalanced Drilling is a technology that prevents drilling fluids from invading oil and/or gas producing zones as the well is drilled by reducing fluid pressure below that of the reservoirs being drilled. Conventional drilling employs high fluid pressure to reduce the chance of a “blow-out”, but at the cost of plugging potentially productive zones or even missing zones altogether. Underbalanced drilling is facilitated by Weatherford’s proprietary downhole flapper valve system that is operated from the surface. This technological advance enhances drilling productivity sufficiently to drive a 30%+ growth rate.

Weatherford has also developed a line of Electric Submersible Pumping Systems that create artificial lift from the bottom of the wellbore, economically increasing the production of aging wells.

It is difficult to predict earnings for oil service companies, because oil and gas prices are largely unpredictable. However, strengthening economies require more energy, and new oil discoveries no longer replace consumption. A reasonable estimate of 2004 earnings is $1.60. Assuming continued high growth of Weatherford’s technology businesses and modest firmness of oil prices lead to an earnings estimate of $3.25 - $3.50 in four or five years. An estimate of intrinsic value that incorporates this earnings growth assumption is in the low $40’s. The inherent risk of oil and gas prices makes this equity attractive only at a discount from intrinsic value. It is a unique economic recovery play and inflation hedge combined with the rapidly growing tangible value of technological innovation.

Steven L. Ré, CFA

January 26, 2004

The above is for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The above information is from sources deemed reliable but is not guaranteed. It should not be assumed that investments in any of the above-mentioned securities will be profitable, and past performance is not a guarantee of future results. Earnings projections often miss, and markets sometimes go down. The employees and families of Quality Growth Management, Inc. are likely to own the above-mentioned securities in their own accounts, and may trade them at any time without notice.