March 25, 2013 - Trade Monsanto for Growing Profits and a Hedge
Monsanto (MON) stock has risen over the last three years from $50 to the $105 range. With energy prices high, corn prices have remained strong, and farmers have planted lots of corn. Although there was a drought in parts of the country last year, the last few years have been good for farmers; more crops are coming in, prices are staying high and demand has remained strong both for ethanol in the U.S. and grains on the international market. With the US dollar weak, American grain becomes a better deal beyond our borders, helping famers make profits.
Monsanto has also gained market share by introducing innovative products, including genetically modified strains of corn which are round-up resistant and have better yields. The company is expanding products overseas, and the modified corn produces substantial repeat business. Revenues have risen from $10.5 Billion in 2010 to $13.5 billion in 2012. Sales are expected to rise 10% in FY 2013 as farmers switch to the newest seeds. Earnings per share have also risen from $2.01 to $3.78. Analysts project that in 2013 the company will make $4.41 a share. Revenues from seeds make up 74% of the business while chemicals, especially round-up, make up 27% of sales. About 87% of corn planted last year had biotech traits, along with 95% of soy beans. Over the last five years, Monsanto has had a return on capital of 18%. Research and development costs consume about 11% of revenues.
There is no doubt, things look good at Monsanto. While it lost the patents on roundup a few years ago, it remains a low cost producer of roundup while focusing on higher margin seed development and other new products. The company has also experienced the rising tide of the general stock market over the last few years.
It would be good to keep expectations in check; there is a limited amount of land that US farmers can plant. While some foreign countries are welcoming Monsanto seeds, others are not. If oil prices were to decline, a possibility given increased production from fracking, the demand for ethanol would likely decline, leading to a drop in corn prices. With 40% of the US corn crop being turned into ethanol, a drop in oil prices could cause a drop in corn prices. Another risk is that Ethanol is used largely to meet fuel-mixing mandates, which are subject to change, and some are now arguing that it makes more sense to just drill for oil than to try to grow it out of corn.
Given that there are potential risks to Monsanto's business model, a hedged position, where one can target a realistic return with some downside protection, might be the best way to trade the company. Monsanto stock is currently trading near $104. One can buy and hold the stock while selling a July 105 covered call for a 99.84 net debit. The call is only four months away and will return 5% if the stock is assigned. The trade has 4% of downside protection and allows a return at a 16% annualized rate (for comparison purposes only) before the dividend yield of 1.44%.
Farmers diversify so that if one crop fails, others will come through, but farmers also carry insurance. Investors should always be diversified as well, but by protecting against small declines of up to 5%, a covered call can act as a little extra insurance. Monsanto is a solid company, and with this trade, investors can profit even if its momentum falters a bit.
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