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Saturday, November 24, 2007

Secular Change of Food Prices Justify P/E Expansion for Industry Participants




(Stocks in this article: NYSE: MON, NYSE: MOS, NYSE: POT, NYSE: DE, NYSE: DF)

There is a significant difference between the variations of food prices today, versus changes of the past. Because of this difference, which I posit is the secular nature of today’s price change versus prior seasonal variation, I believe the expansion of P/E ratios and current valuations of some agricultural industry beneficiates like Monsanto (NYSE: MON) are justified.

The very reason "core" figures exist for the producer and consumer price indices is because of the volatility and perceived insignificance of short-term fluctuations of food and energy prices. Recall, the "core" figure excludes changes in food and energy, and the Federal Reserve has relied upon it as a trustworthy resource in its gauging of inflation. But, the times, they are a changing.

The Fed, following Alan Greenspan’s recent expression of concern (and the Greek’s warnings if you have been reading my blog from the beginning of the year), will be providing forecasts for inflation, including the headline figure. The new venture began this past week, and clearly highlights the significance of changing marketplaces for food and energy and the drivers of price change.

Here’s what’s going on…

Significant global supply/demand dynamics have, and are, altering the economic implications of changes in food and energy prices. The changes we have seen in recent times are not representative of random movement, but instead characteristic of clear and perhaps long-term trend. Food and energy prices are steadily rising, not fluctuating. The drivers behind today's change are not seasonal or short-term factors, like drought and OPEC production restrictions. Rather, the drivers of today's rising trend are secular in nature. Let me expound, and this next point is critical to your understanding...

Regarding food, bursting global population growth; the shifting of resource utilization in emerging nations; and new uses for agricultural commodities are raising demand for foods while at the same time limiting agricultural production. Regarding our crowded planet, the drivers of population growth are clear. While developed nations progress in a paced manner, birth rates in the emerging world run high. At the same time, advances in medicine and efforts to share advanced medicine and treatment across the globe, aided by Internet and media, have expanded the longevity of mankind. Now, don't get me wrong, this is a great accomplishment. However, it places increased burden on food supply.

The second point regarding foods is that as third-world nations emerge and develop, resource utilization is shifting. When countries like China industrialize, there is a great draw of farmers and laborers into industrial centers and away from agricultural production. As this occurs, there is increasing likelihood and risk that nations like China will gradually shift into consistent net importers of grain and other commodities. So, as China's industrial revolution progresses, its fuel and energy usage are directly impacted, but its food production is indirectly impacted as well.

The third point is that as science helps to solve existing problems through the development of new uses for corn and other agricultural goods, especially in the production of biofuels, it's at the cost of food and feed uses. Thus, crop production becomes inadequate and introduces pressure on grain prices. Supplies of surrogate grains like soybean and wheat, suffer as more acreage is dedicated to corn production. Thus, surrogate prices increase as well. As feed prices also rise, the costs of protein production, including beef, pork and poultry, rise and drive up those prices too. This leads to the pass-through of price pressure to processed foods producers like Dean Foods (NYSE: DF), distributors and finally restaurant goers as well as supermarket shoppers.

Now, what you haven't heard often, but may be a positive result of this predicament, is that while science is pressuring prices higher today, science may also provide the means of price reduction in the future. Companies like Monsanto (NYSE: MON) are working to develop genetically altered crops. Thus, the day may dawn when significantly less acreage produces adequate agricultural produce to help prices retract. This kind of scientific effort can protect plants from disease, while also otherwise improving production. As a result, Monsanto’s seeds are in high demand.Thus, we can see the logic behind the value creation at Monsanto. If logic is not enough, analysts' consensus five-year EPS growth estimate of 44% should be. As a result, Monsanto’s P/E ratio of 36X the consensus earnings per share estimate of $2.55 for 2008 (Aug.) does not look excessive to me. No, and despite the shares’ recent spike higher, I view them attractive for long-term purchase.

Company ---- Tic ---- P/E f1 ---- 5-Yr. Gr. Est. ---- P/E/G
Monsanto MON 36 44 0.8
Mosaic MOS 16 9 1.8
Potash POT 23 10 2.3

Mosaic and Potash Corp. have seen price rise as well, and analysts’ near-term EPS growth estimates, as compiled by Thomson Financial, are pretty hot for the two, but their five-year growth outlooks are not. If we take the analysts’ forecasts as infallible, then I would not buy MOS or POT now. However, with near-term growth forecasts both significantly higher than the long-term view, it’s possible that the analyst community is misinterpreting secular change for short-term variation. I would go so far as to say this is significantly possible, and the stocks’ short-term growth outlooks are screaming buy me if that’s the case. However, given the analysts’ expert view, I must be wary regarding MOS and POT, or take a much closer look at each individually. Regarding MON, despite its P/E ratio, I like the stock given its strong growth outlook and the credence I give to secular change in the agricultural sector.

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