S&W Seed Company: Avoiding What Should Be Its Main Focus

Nov.25.13 | About: S&W Seed (SANW)

(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

There's no doubt that S&W Seed Company (NASDAQ:SANW) is growing fast with a three-year revenue growth rate of 77%. In the company's last quarter it enjoyed top-line growth of 84%. In addition to an acceleration of growth, the company also improved gross margin to 18.6% from 16% last year. Yet, regardless of this growth S&W is a pressured stock, seeing six-month losses of nearly 50%; this comes as a result of a failing segment that could create hundreds of millions in annual revenue. This segment is stevia, and after a closer look, it is really hard to determine how stevia becomes a part of this company's future.

The Single-Business Risk

There's nothing wrong with being a sole alfalfa seed grower. It has been a strong business and S&W is still small enough to where it has growth opportunities globally. Yet, by focusing solely on alfalfa seeds, S&W becomes exposed to problems that are out of its control.

For example, in its last quarter weather posed a major challenge, as an estimated 20% of all alfalfa seeds were wiped out in California's Imperial Valley due to weather. The company's CEO, Mark Grewal, notes rain, hail, and even snow destroyed many alfalfa seed fields. However, S&W performed well because of its Australian operations, which interestingly had two poor years back-to-back. This fact provided a little hope for investors, as Australia remains an important region in S&W's plan, being called the gateway to Asia with great expansion opportunities.

Second-Business Optimism & Disgust

With all things considered, unpredictable weather patterns can give investors an idea of the risks associated with S&W, and all single-product agricultural companies. Due to this fact, investors were enthusiastic when S&W entered into a five-year supply agreement with PureCircle to produce stevia. This agreement would make S&W more diversified while proving the company able to be more than just an alfalfa seed grower.

S&W then soared from $3.00 to $11.00 between 2010 and early 2013, but has since fallen to $5.00. While some of this fall is in relation to the harvesting problems with alfalfa seeds, the bigger problem is with stevia.

As most S&W investors are aware, the company initially harvested stevia on 114 acres, its Los Banos crop. Before the harvest could be realized, S&W expanded another 150 acres for a second-generation stevia crop. Unfortunately, S&W wiped out all but 10%-20% of its Los Banos crop due to herbicide. Since then, the company has re-shifted its focus and is constantly trying to belittle stevia's fundamental relevance to the company's future. Over the last six months, the company's problem with stevia has been a major overhang on the stock.

Why is Stevia Important?

It's important for investors to realize the seriousness of S&W's failure with stevia.

First, for a little background: You may have never heard of stevia before today, but the World Health Organization (WHO) estimates that stevia intake could eventually replace 20%-30% of the $60 billion sweetener market. Stevia is the fastest growing commodity in the alternative sweetener industry, and the reason has to do with increased knowledge regarding the health dangers of sugar, and consumers' focus towards living healthier and longer lives.

In retrospect, stevia production is still in its infancy. Most stevia comes from oversees, but as large food and drink companies look for healthier alternatives to sugar, stevia stands ready to benefit as a sweeter alternative that is healthy with zero calories. In the past, I have covered the beverage giant Coca-Cola's (NYSE:KO) continuous decline in market share and its newfound sense of urgency to combine and test stevia with its products despite not having the ecosystem in place for large-scale production. I have covered these topics here, here, and here.

So what does this mean for S&W? It means that S&W had a prime opportunity to become a U.S. leader in stevia production, and even after its failed harvest could have still learned from those mistakes to produce a better harvest next time. Investors must realize that S&W got into this business for a reason-- because of its growth and outlook and because of the opportunity that's present for a large-scale stevia producer to partner with large food and drink companies.

What's the New Plan?

Back in 2012, I was certain that S&W could see its stock double with success in stevia. Now, I believe that Stevia First (OTCQB:STVF) is that company, as noted in my previous article(s). Stevia First has over 1,000 acres of land in California's Central Valley; it has a fermentation process that removes the aftertaste from stevia and allows it to be modified for better taste with individual products. Also, Stevia First spent many years in research to ensure it maximized its first harvest - something that S&W did not do - and Stevia First is planning the commercial launch of its first product in the coming weeks (also many steps ahead of S&W). As a result of the growth opportunity with stevia and the lack of competition, Stevia First has soared 52% in the last month following news of its product launch.

Now, the reason that Stevia First is relevant relates to both S&W's initial stevia goals and its transition to a more conservative approach. Digging deeper will reveal why S&W failed and why the grower might continue to fail. Back in 2012, S&W's wording was very aggressive: the company was rapidly prepared to expand acreage and was spending aggressively to develop an ecosystem for stevia production. However, in the company's latest 10-Q, the wording changed significantly. Below you can see what S&W has to say regarding its plans for stevia:

"In May 2013, as the result of substantial herbicide damage to our then-existing stevia crop, we determined to shift the focus of our stevia program away from commercial production and towards the breeding of improved varieties of stevia. Our stevia efforts are focused on breeding improved varieties of stevia, perfecting our harvesting and milling techniques, and developing our marketing and distribution programs for stevia products. In order to minimize risk going forward, we have decided to delay new commercial replanting until we have optimized our farming methodology and our new stevia varieties under development are ready for production."

Essentially, S&W is slowing down its pursuit of stevia production to focus on research and "delaying" commercial replanting. This is big news for investors, because S&W was very proud of its PureCircle partnership and the speed of its harvest. In the last six months of 2012, S&W's components of crop production costs were $2,162,877 for stevia and just $1,794,637 on alfalfa seeds. Hence, stevia was an important part of the company's plan moving forward. However, today it really seems as though S&W doesn't know what it's doing (in regards to stevia), which can be seen in the following statement, also from the latest 10-Q:

"Because stevia is a new line of business for us, and the incorporation of stevia extracts into food and beverages sold in the U.S. is still a relatively new industry, our plans may not succeed to the extent we expect or on the time schedule we have planned, or at all."

While I understand S&W is being conservative, shouldn't the fact that stevia is a new line of business and is being incorporated into food and beverages be a reason to move forward rapidly into commercial production? And what about PureCircle? The two companies had a five-year supply agreement. Ergo, based on the fact that S&W is still supplying dried stevia leaf to PureCircle, investors have to wonder if S&W's entire stevia research business is nothing more than a supply agreement between it and PureCircle. In that event, will S&W ever ramp-up its commercial plans to become a leader in an industry that could capture 20%-30% of a $60 billion global market? Lastly, the company's plan becomes even more uncertain with the following statement, also taken from the most recent 10-Q:

"Our lines contain high overall steviol glycosides, including Reb A, Reb B and Reb C. We anticipate breeding these new lines with their higher overall steviol glycosides. We have been recently conducting extensive HPLC sample testing of stevia plants under development and will be making further selections and crosses of these plants this season based upon test results. The goal is to develop a stevia plant with an inherently pleasant taste profile, a large and hardy plant mass, and high Reb A content. We are focused on developing our proprietary stevia germplasm into commercial varieties."

Just to clarify, in a previous statement S&W stated that it was moving away from commercial production to focus on the breeding of improved varieties of stevia. Based on the above statement, the goal is to create a product with a pleasant taste profile high in Reb A content, which is the sweetest part of the plant. The problem is that this goal has already been accomplished. Stevia First's fermentation process and its research have yielded a high Reb A product with essentially no aftertaste. This product, and others alike, are now headed to the market. Resultantly, S&W remains several steps behind, even in its most recent conservative initiatives.

The bottom line: This new plan might also fail and cost the company millions. S&W should have stuck with commercial production, which investors want based on stock performance.

Conclusion

Look, I am not questioning the growth of alfalfa seeds, or the company's place atop the industry's elite as a grower of these seeds. But what I am questioning is the company's constant harvesting problems with stevia (and even alfalfa seeds), and the lack of transparency for what S&W's goals are with stevia, or even a timetable.

The company's commercial plans for stevia is what created such large gains, and the company made large investments to ensure a large initial harvest. Yet, today the company rarely speaks of stevia. In fact, S&W did not mention stevia one time in its recent conference call until an analyst asked the grower specifically about future acquisitions. In regards to acquisitions, CEO Mark Grewal said, "We're really looking at focusing on seed or genetics breeding and what that breeds of course you know we're still in stevia [sic], so if there's something that looks like it's going to help that opportunity or to do something in that avenue of the food business we're going to be looking at it."

It can be inferred that perhaps S&W's best approach right now is to acquire a stevia company with the research and success that is needed in order to be successful. To review, S&W has already spent millions on its stevia production, but after one bad harvest has almost completely backed out of its plans for commercial production, being very vague in discussing the company's direction.

I am not suggesting that S&W will acquire Stevia First, but a partnership would give both companies what the other lacks-- and Stevia First can provide marketing experience. After reading through 10-Qs and listening to conference calls, I am not convinced of how S&W is going to maintain growth without stevia. The company already has a hard enough time producing consistent harvests, after destroying the stevia crop and various periods of trouble in both Australia and the U.S. with alfalfa seeds.

To conclude: with there being so many unanswered questions, I find it very difficult to be bullish at this point in time. Personally, I want more clarity and I want the company to pursue stevia aggressively. When it's all said and done, stevia will be a multi-billion dollar business while S&W is already a leader in alfalfa seeds with just $43 million in annual sales. With this in mind, it doesn't make sense not to pursue stevia as a business-- and until the company understands this logic on a commercial scale, I can't be bullish.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.