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A report by Deutsche Bank
Date: Saturday, August 21, 1999

(The following report was prepared by investment analysts at Deutsche Bank. These analysts, even while they still believe biotech industry propaganda about the long-term benefits of GMOs, are advising investors that GMOs are a poor investment because of consumer resistance).

GMOs Are Dead

We see a two-tier grain market developing with GMO (genetically modified organisms) corn and soybeans at a discount to non-GMO. Very bad news for farmers. · If a two-tier market takes hold, we see price premiums for high-value-added GMO seeds collapsing. Very bad news for seed companies. · If GMO seeds become a liability rather than a driver of growth, we see growth rates and valuations coming down. Very bad news for seed stocks.

Despite the fact that the science and logic in support of GMOs is very strong, GMOs are being demonized by their opponents. What food manufacturer will "take a bullet" for GMO corn in the face of such controversy? · We are reducing our rating on Pioneer Hi-Bred to SELL from HOLD. And we're calling into question the valuations of the other seed-related companies. Is this a sector one should be invested in?

A MAJOR CHANGE IN THE MARKET'S VIEW OF GMOS

Perhaps we don't yet fully realize it, but genetically modified organisms (GMOs) have just crossed the line. Thirty days ago, the investment community accorded only positive attributes, such as innovation, productivity and progress, to GMO corn and soybeans. The success of GMOs was, to a great degree, the basis for the strong growth rates and the huge public and private market valuations accorded this sector.

Today, the term GMO has become a liability. We predict that GMOs, once perceived as the driver of the bull case for this sector, will now be perceived as a pariah. We are reducing our rating on Pioneer Hi-Bred to SELL from HOLD, and we would broadly recommend a sale of the seed sector. Biotech crops are ubiquitous, yet few consumers realize it.

Here are a few examples of where you can find GMO products: soft drinks (GMO corn to make corn syrup), salad (GMO tomato, soy oil in dressing), hamburgers (engineered yeast in bun, rennet, soy isolates in cheese, delayed-softening tomato in ketchup, soybeans in mayonnaise, genetically altered tomato). The perception has been getting worse... What happened? On May 6, 1999, we published a warning piece entitled "The Trouble with GMOs." We spelled out the positive case for transgenic seed and outlined what we believed to be the illogical, but persistent, arguments advanced by GMOs' opponents.

We recently returned from an important industry conference (Deutsche Bank was the only Street presence), where we heard from representatives of the major seed companies (Monsanto, Stauffer Biotech, Demegen, and Seminis), major food processors such as Campbell Soup and Nestle, the corn growers' associations, and representatives of the biotech community. What to do when GMO's trade at a discount? The message is a scary one - increasingly, GMOs are, or in our opinion, becoming a liability to farmers.

A two-tier market for grain may develop, where the GMO "improved" grains will trade at a discount to non-GMO product. This is, in fact, already happening with European processors paying premiums of up to $1 per bushel for "non-GMO" product. Archer Daniels Midland recently announced that it would pay an $0.18-per-bushel premium for DuPont's STS soybeans - a non-GMO variety. Regarding the move, ADM said: "Our goal is to contract acreage reasonably near our Decatur processing plants.

Under this program, the farmer has a definite home for his high-yielding bean crop; he's locked in a premium of 18 cents per bushel over the Decatur price, and he stays out of the political fray that surrounds the genetically modified issue." For ADM, the program assures the company a supply of non-genetic beans. When it buys beans on the open market, it can't be sure they'll all be unmodified. Dozens of Biotech Products have been Approved Around the World United States 34+ USDA, EPA, FDA Japan 20+ MAFF, MHW Canada 30+ AG Canada, Health Canada EU 9 Argentina 3 Australia 1 Mexico 3 Brazil 1 South Africa 1

Who has the liability if GMO pollen corrupts a non-GMO crop? Take that to the next logical step. If you plant GMO corn, and your neighbor plants non-GMO hybrids and pollen from your GMO crop drifts into his field, making his grain test positive for GMOs (even though he planted non-GMO hybrids), will your neighbor sue you? Will you be suing the seed company? Imagine the legal mess that could ensue if GMO = value destruction. Don't expect the food manufacturers and retailers to "take a bullet for GMOs." "Don't expect us to take a bullet for your GMO products." So said a representative of Nestle, the world's largest food company at the aforementioned conference. We predict the food processors will line up quickly in the "No-GMO" camp. The message is clear: GMO foodstuffs such as tomatoes, tomato paste, cooking oil, fructose-based sweeteners, etc. are just ingredients. They have costs and benefits. GMOs just became too costly.

In order for GMO crops to be viable they must be sold at a price that is as good, or better than, non-GMO options. While the dollar cost is the same (as long as the market views these products as "substantially equivalent"), it cannot be argued that there is not a real PR cost. Already, Unilever and Nestle have tried to duck the controversy by publicly insisting that their products will be made without GMOs.

Expect virtually all others to follow, because the anti-GMO crowd will threaten to stigmatize, demonize and boycott those that don't fall into line. Archer Daniels Midland has taken a different approach. It has said it won't buy any GMOs that are not approved by the EU. That has caused customers of Pioneer Hi-Bred to worry over its Liberty-Link corn and customers of Monsanto to reject Roundup Ready corn, two newer, thus unapproved, GMO classes. Monsanto's response to farmers? Keep the Roundup Ready seed and the company will provide free Roundup as an inducement to stay. What is the logical outcome? What if "value-added" is really value detracted? In the past five years, we - and virtually all analysts of the sector - have focused intently on the value-added that biotech would provide.

Bt corn was introduced in the 1996 crop and was a smashing success. Roundup Ready soybeans hit the market at about the same time and the estimates are that close to 50% of the soybean acreage, and 40% of the corn acreage, will be planted to these two GMO innovations. The best Bt-corn hybrids sell for $120 per bag, while the non-Bt analog might sell for $75. Similarly, Roundup Ready soybeans sell at a $5-$7-per-unit premium to the non-transformed varieties. The pickup in yield, primarily, and the cost savings on inputs drove these advanced products to premium prices and wide acceptance.

The value chain topples...

The way that we learned to visualize the value chain for biotech traits may be turned upside down. In theory (and in practice for the past several years), the seed companies can sell their genetically modified seed at a premium to the growers who can sell their crops at a premium to the market, because there is a premium value to the end user.

The resistance by food companies and grain processors alike has nullified the idea that end users will pay a premium for genetically modified crops. This lack of value will have to work itself back down the value chain in the form of reduced-to-zero premiums. Roundup Ready soybeans were adopted much faster than envisioned in the original time frame.

But with the negative psychology surrounding it, the market may be in for a negative surprise. Expectations for total GMO acreage for 1999 is about 84 million acres, up from just 14 million acres in 1997. If our concerns about GMOs are valid, the expectation of more than 140 million acres in 2001 is clearly at risk.

An earnings hit from the GMO-seed- premium collapsing

But all of those positive attributes are meaningless if the crops produced with GMO seeds are discounted in price. The best Bt hybrids would show a 5% improvement in yield versus non-Bt hybrids. On the current price of corn that would be negated by a $0.10-per-bushel discount. If GMOs trade to a discount, the price premium for the seed may collapse, and they could actually trade at a discount to traditional varieties and hybrids. That would be an earnings nightmare for Pioneer Hi-Bred and, we would guess, for Monsanto as well. Two hits: earnings and valuation We likely would see an earnings hit in the two companies mentioned above, but we foresee a valuation hit for virtually all companies connected with GMOs.

The huge prices paid for seed companies in both the private market and the public arena depend on the value-added and rapid rate of technology development that GMOs promise. Would DuPont complete the acquisition of Pioneer for $40 per share (five times sales) if GMOs were a liability? We have strong concerns. Why hasn't Monsanto's purchase of Delta & Pine Land closed? Will it? Monsanto trades at more than 45 times the $0.96 calendar 1999 EPS estimate carried by First Call. Can that be sustained? How much of the 35% earnings growth that the Street envisions for Monsanto's Y2K earnings are dependent on GMOs remaining viable?

Other concerns that came out of the conference

The real focus of the conference was "output traits," those genetic traits that are engineered to make crops more valuable. Output traits focus on adding more of something good or suppressing something bad. Very few output genes are in the marketplace yet, but output traits are thought to be the next big wave of product development. Key traits under development are improving the starch content of corn, raising oil content (which is in the market) of corn, improving the amino-acid content, etc.

Will anyone pay for product improvements? By definition, output traits create value, not on the farm but to the end-user. Thus, for output traits to be financially successful, the food manufacturer, swine feeder, poultry feeder, or grain processor must be willing to pay a premium price for the enhanced value of the grain. There was significant concern raised over this mechanism. Some participants reported that their customers expected product improvement to occur with no increase in prices paid.

The example of Wendy's $0.99 hamburger was raised. The company has been at that price point for more than a decade, and can stay there only through tight control on supplier costs and further improvements in productivity. We noted earlier that DuPont won some new business selling STS soybeans because of their "non-GMO" status. But before one ascribes a positive for DuPont's good fortune due to the demand for STS product, consider the negative outlook for output traits. Frank Mitsch, Deutsche Bank's Major Chemicals analyst is concerned about the uncertainty of when and if ag-biotech will pay off for DuPont.

Production Estimates, Planted Acres 1997 1998 1999 Growth Projection Premiums per Bushel White 550 725 775 6%-7% $0.35-$0.60
Waxy 420 500 525 3%-4% $0.20-$0.45
hard endo./ food grade 600-1,000 800-1,200 800-1,200 Very Low $0.02-$0.25
high oil 700 900 1250 High >25% $0.15-$0.30
nutrient dense 140 140 240 High >50% $0.10-$0.20 high amylose 30-40 30-40 40-50 Potentially High >10% $1.20-$1.90

1999 Value Enhanced Corn Projections Open Market Contract On Farm
White 50% 50% 0%
Waxy 25% 65% 10%
hard endo./food grade 70% 30% 0%
high oil 10% 40% 50%
nutrient dense 0% 25% 75%
high amylose 0% 100% 0%

Quick and cheap tests for GMOs are on the way. Strategic Diagnostics, Inc. presented its technology for quick and easy testing of grains for GMO content. Test tools are now available for farmers, grain buyers and regulators to quickly analyze the GMO status of grain. The company noted that no standards exist in the various regulatory areas, so the possibility exists that a load of corn could leave port in the United States as non-GMO, only to be turned away by a grain buyer in Europe who is using a different threshold to determine GMO content. These test kits will take away the argument that it is impossible to know the GMO status of grain.

We were disturbed by a presentation made by the Executive director of the U.S. Grains Council, an export-oriented industry advocate. He, too, focused on "value-enhanced" product, and one of his definitions of "value-enhanced" was non-GMO. What more evidence of a two-tier market do we need?

GMOs are good science but bad politics... GMOs are good science but bad politics... Are GMOs safe, good for the environment, and necessary to support the inevitable growth in the world's population? Yes, but the same arguments can be made for advancing nuclear power. Despite the support of the scientific community, it is unlikely that we will add any new nuclear power plants any time soon. >From a 25-year perspective, the world will be hard-pressed to feed itself without GMOs. The supply of arable land will continue to shrink and the only way to keep up with growing food demands will be by increasing productivity. Without GMOs, it won't be possible. Without GMOs, it's clear that we will use a lot more agricultural chemicals.

However, from a three-year perspective, GMOs are a policy liability. GMOs increase productivity in a world that is currently drowning in too much grain. As we discussed in great detail in our above-mentioned May 6 warning piece, a fair bit of the European resistance to GMOs stems from Europeans' desire to keep their agriculture as people-intensive as it currently is. They view GMOs as a threat to their agrarian lifestyle. In the United States, low crop prices have farmers asking Congress for $6 billion-$8 billion in aid, just a day after the House of Representatives approved a $574-million farm bailout. We believe that GMOs, with their better yields, will only further depress prices this year. Thus, from a government perspective, one needs to take a very long view to see the positives.

ADDENDUM - WHY A SELL ON PHB AND A BUY ON ABTX? We believe the downside to Pioneer is limited, but is it worth holding the stock given the risk? We have downgraded Pioneer to SELL from HOLD. The GMO problem is not going away anytime soon, which calls into question the future earnings potential of Pioneer. Our SELL rating on Pioneer does not imply that we believe there is major downside to the stock - DuPont has announced its intention to acquire Pioneer at $40 per share. We are not saying that the deal will not close -- DuPont may already be locked into the deal. But the GMO problem does add an additional element of risk. Remember that the Monsanto/Delta & Pineland acquisition has yet to close and it was announced on May 11, 1998.

A news story that coincidentally hit the wires just after we downgraded Pioneer informed that the closing of the Delta & Pineland deal has been pushed back to December 31, 1999, from June 30, 1999. If the deal closes then, it will be 19 months after it was originally announced. Is it worth keeping your money tied up in a stock for the extra 7% return when there is this much risk involved? We don't think so.

Hence, our SELL rating on PHB. ABTX has little GMO risk AgroBiotech produces forage and turfgrass seed. By definition, turfgrass seed, whether it's GMO or not, will face less scrutiny than row crops. Unlike row crops, turfgrass is neither used directly or indirectly in human food. The concerns, if any, about turfgrass will relate to environmental issues rather than health and safety issues. In the end, we think it likely that consumers will still prefer to have grass varieties that can grow with fewer chemicals; thus, GMO turfgrass should face little resistance. The other half of ABTX's sales is forage seed. Forage is typically grown and used within the same vicinity and is not a product that the United States exports. Forage is also not directly consumed by humans. So, again, most of the concerns about GMOs should not impact forage sales. We are getting more bearish on the seed sector in general as a result of the looming problems with GMOs. This is less a problem for AgriBioTech than for the other seed companies.

Seed-company valuations have been pushed higher, based on expectations for sales of higher-priced, higher-margin, value-added seed (mainly GMOs). There is a built-in assumption in many seed-company valuations that the seed companies will be able to sell increasing numbers of GMOs at significant premiums. We are calling that assumption into question. Among the major seed companies, AgriBioTech is the furthest from commercialization of GMO products, and clearly no premium for valued-added seed is built into its current valuation.

GMOs are four-to-five years out for ABTX. Since most of the trouble with GMOs is political, and near-term in nature, the clouds may have cleared on the GMO story by the time ABTX has introduced genetically modified seeds. So, while we have turned more bearish on the row-crop-seed sector, we are not changing our investment opinion, or our $15 price target, on AgriBioTech. Companies mentioned:

AgriBioTech (OTC-ABTX-$-6 5/8-Buy)
Archer Daniels Midland (NYSE-ADM-$15 3/4-Hold)
ConAgra (NYSE-CAG-$26 5/8-Buy)
Corn Products International (NYSE-CPO-$29 7/8-Buy)
Delta & Pine Land (NYSE-DLP-$33 *)
DuPont (NYSE-DD-$69 1/16-Hold) Monsanto (NYSE-MTC-$44 1/2) Pioneer Hi-Bred (NYSE-PHB-$37 3/16-SELL) Wendy's International (NYSE-WEN-$26 9/16)

Timothy S. Ramey, CFA 212.469.5221 tim.ramey@db.com Marla J. Wimmer 212.469.5077 marla.wimmer@db.com Rachel M. Rocker 212.469.5799 rachel.rocker@db.com Stocks priced May 20, 1999.

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