The Bayer-Monsanto merger reveals truths about Monsanto and its product cycle that have led CLSA to downgrading the stock to “underperform” from buy. In a September 15 report, analyst Mark Connelly says the details of the proposed deal point to structural weakness inside Monsanto and their product cycle that should be of concern to investors – concerns that are not properly priced into the market. Yesterday former US Department of Justice officials expressed concern over the merger.

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Worries over merger are justified on several levels, report says

Worries raised by farmers that the two largest providers of crop fertilizers, pesticides, seeds and related products are justified. Saying those that suggest the proposed merger would not represent a major concentration of power were “highly disingenuous, and highly misleading,” Connelly wrote in a report titled “Disappointing terms, high regulatory risk.”

On Wednesday Bayer sweetened the deal, offering $66 billion for the firm in a $128-a-share deal, boosting the previous big by just $0.50. The stock was trading near $104.73, down $2.03 on what normally would be positive mid-Thursday morning news.

The stock price heading lower by near 2% on a day the offer was sweetened is a sign the market is not liking the takeover prospects, which is a logical response when viewed through the eyes of CLSA.

Bayer wants to buy Monsanto on a drawdown, why is CEO Grant selling at a low point?

Bayer launched its bid at a strategic moment, following Monsanto’s had disappointing earnings. Connelly suggests that the company’s ability to consistently deliver strong earnings is “far more sensitive to crop prices than it was in the last cycle.”

It is the cyclical ability of the company to deliver earnings being called into question. While Monsanto’s CEO claims the company is “one bad harvest” away from a stock price rally – their product use is at times negatively correlated to farmer success – CLSA notes the takeover bid doesn’t coalesce with this view.

The Bayer offer is based on what is a weak cycle for Monsanto stock and represents a relative muted a 19% premium to the average stock price across both strong and weak markets. In other words, why wouldn’t Monsanto wait for a strong cyclical market environment to sell rather than take what is a weak premium offer relative to its cyclical history?

The answer to this question can be, in part, seen in Monsanto’s product development cycle.

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Monsanto has been talking up its development cycle and they don’t need Bayer to succeed, merger is anti-competitive

Monsanto has sold investors on the concept that its research and development investments are going to pay off, but that time-frame might have to wait until 2020. In particular, research on the Sumitomo molecule has a positive outlook, according to public statements.

Those advocating for a merger point to the research and development benefits when the company is combined, but CLSA says don’t buy this line. Using Sumitomo research as an example, the merger is unnecessary to propel innovative success. In fact, Connelly writes that after the merger the likelihood of investing in product innovation is not likely to materialize.

The merger “is just as likely to reduce Bayer’s (and Monsanto’s) inclination to pursue innovation outside of the combined company – in effect, reducing the potential range and breadth of innovation, in favor of greater competitive advantage against those other potential innovation partners,” Connelly wrote, pointing to an important public policy argument against the mega-merger. “From that perspective, the deal is obviously anti-competitive, and likely to reduce the breadth of innovation across the industry, even as it increases Bayer’s ability to innovate.”

Perhaps Connelly’s most persuasive argument against the merger is when he considers Monsanto CEO Hugh Grant’s own words what have pointed to such positive research and development opportunities and the potential for the cyclical market environment to positively change. “If he believed those things, one might have expected him to prefer to stay the course, or at least opt for equity over cash.”