November 2006 Update and Company Reports

Monsanto (MON 48) is the undisputed leader in corn, cotton, soy, canola, and vegetable seed technology. Monsanto’s in-the-seed traits increase yield for the farmer, reduce pesticide usage, and make foods healthier. Monsanto invested over $5 billion over the past 10 years and $700 million last year alone researching new crop traits for farmers and consumers. The company concentrates its research and development efforts on new biotech traits, elite germplasm, molecular breeding, new variety and hybrid development, and genomics research. Monsanto is in the early stages of very rapid growth in revenues and earnings from leading innovation in the huge worldwide business of feeding humanity.

Monsanto placed a bet in the early 1980’s that the future of agriculture would be in biological solutions to farmers’ problems, rather than in using more chemicals. At the time a mundane chemical company, Monsanto embarked on an effort to map the plant genome before such an idea even dawned on its competitors. It built a decade of first mover advantage over its competitors by innovating the use of molecular breeding and genetic technology to create better performing plants. Monsanto’s seeds-and-traits approach has led to a 90% market share in high performance plant traits. Just as QUALCOMM is the only telecommunications company focused solely on wireless telecommunications research and development, Monsanto is solely focused on agricultural productivity.

Source: Monsanto company reports and presentations

Farmers buy yield. Seeds drive yield. The reason Monsanto grew its seed market share by 9% over the past five years is that Monsanto technology produces the highest yielding seeds. The farmer and the environment benefit from less pesticide usage and less plowing due to biotech seeds. The cumulative increase in U.S. farm income from biotechnology crops since 1996 exceeds $30 billion.

It is crucial for the Monsanto investor to understand the financial leverage of “trait stacking.” Seed traits is a pipeline type of business. Developing new products is a long, risky, and expensive process. The reward at the end of the rainbow is unique to the seed traits business. Monsanto gets paid for each trait it adds to a seed. Therefore, as more traits are added to a seed, Monsanto gets paid multiple times, even though it is still selling just one seed. Since it does not cost any more to make the single seed, revenue and gross margin per seed rise exponentially. The average gross profit value of a triple trait stack is almost 2.5 times that of a single trait. For the coming 4-gene stack, the premium over single could be 3.6 times. The return is well earned, because many years of risk and R&D expense precede even a chance of return.

Monsanto generally prices these traits at one-third of the economic value the farmer receives by using it. In other words, the farmer makes more money per acre from the higher yield produced by Monsanto seeds, and Monsanto shares one-third of it.

Corn is the most important crop for Monsanto’s growth. Forty percent of company gross profit is tied to corn, mostly from North America. This 50-million trait-acre market has the potential to expand to 100 million trait-acres. Ethanol demand alone could require the equivalent of up to 25 million U.S. acres by 2010, making Monsanto a superior ethanol play. Monsanto earns an incremental $3.00 of gross margin for each acre of market share gained. The farmer’s ethanol profitability is driven by crop yield. Monsanto’s yield improving corn traits currently include rootworm protection, corn borer protection, and resistance to Roundup weedicide. This is substantiated by the fact that trait penetration is 2.5 times greater in the proximity of ethanol facilities.

Monsanto has additional growth opportunities. European import approvals expand the U.S. Roundup Ready corn export market from 20 million to 60 million acres and open it to stacked traits. Biotech seed growth is particularly encouraging in Europe where insect protected corn is advancing in Spain, France, Germany, Poland, Portugal, and Slovakia. Brazil’s passage of a biosafety bill in 2005 commenced the first year of commercial planting of
Roundup Ready soybean seed in the world’s second largest soybean market. Monsanto expects to penetrate 45% of that market in 2007. Cotton technology is India is seeing very rapid penetration. Seminis, the world’s leading vegetable seed company with a diverse global library of 3,500 seed varieties, was acquired in 2005. It should deliver 12 cents of incremental earnings per share in 2007.

The heart of Monsanto’s growth is its new product pipeline. Its unmatched reach and depth should allow Monsanto to widen the lead over its competitors. Of approximately 40 publicly disclosed new traits in development, the most interesting include drought resistant corn, soybeans and cotton, Vistive soybeans, Omega 3 soybeans, and high yield/value corn and soy.

Soybean oil represents 70% of the total vegetable fats and oils consumed in the U.S. Vistive soybeans drastically reduce the saturated fat in soybean oil, below that of olive oil. Also, Vistive oil is very low in trans fats, because it does not require hydrogenation, a process that creates unhealthy trans fats. Trans fats lower good HDL cholesterol while raising bad LDL cholesterol. The FDA has mandated that all food products containing trans fat must be labeled, and food producers are highly motivated to substitute oils that do not need this ugly consumer warning. It has reached into the restaurant business, as KFC has committed to using this oil in its Colonel Sanders restaurants.

Omega 3 soybeans will allow soy products to be high in the components traditionally associated with fish oil and heart-healthy diets. Drought resistant corn will lower the risk of weather for farmers and allow food to be grown in geographies where moisture is scarce.

Financial brief: Sales in seeds and traits increased 40% last fiscal year. The growth trend should continue, although at a slower rate. Gross margins should strengthen while operating expenses should decline, as a percentage of sales, over the remainder of this decade. Free cash flow was about $800 million this year, much of it used to repurchase stock. The current consensus of Wall Street analysts for earnings per share in the period from 2007 to 2011 is $1.56, $1.85, $2.22, $2.66, $3.20. Intrinsic value is estimated at $38 currently and should grow to about $75 in five years.

Risks include the regulatory process worldwide and regulatory constraints on the timetable for approval of new traits. Trait piracy is commonplace in South America, and is being dealt with by offering seeds with more and newer traits than those in pirated seeds. It behooves farmers financially to switch to non-pirated seed, even if they have to pay for it. Farmers will pay for efficiency and functionality. Intellectual property litigation arises from time to time. Outside influence over the stock is exercised by weather, ethanol news and oil prices. The “ethanol play”, in particular, has created some level of premium in the stock price.

The visibility of long-term growth in the seed traits business is exceptional, as the business creates more and more value for the farmer and consumer. We have only seen the beginning of the impact of applying biotechnology to plant breeding. Biotech acreage penetrated in 2006 is about 217 million acres, and there remains about 200 million unpenetrated acres, considering only traits currently available. New traits, such as drought resistance, promise to increase plantable acreage worldwide. Monsanto is the only company to develop and commercialize in one seed the traits that protect crops from insects both above and below the ground, control weed growth, and increase yield. Monsanto’s current competitive position creates a unique window of opportunity for expansion of leadership to the point of dominance of the industry, driving double-digit earnings growth for years to come. As positive as we are on the company, we will be mindful of our estimate of intrinsic value when making trading decisions.

Steven L. Ré, CFA November 22, 2006

This report contains the current opinions of the author and such opinions are subject to change without notice. It has been distributed for information purposes only and is not to be construed as a recommendation to purchase or sell securities. The information contained herein 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 no guarantee of future results. Earnings projections often miss, and markets go up and down. The employees and families of Quality Growth Management, Inc. may own the above-mentioned securities in their own accounts, and may trade them at any time without notice.