When I wrote on S&W Seed Company (NASDAQ:SANW) back in March, I was quite bullish on the prospects for the company, but relatively cautious on the stock due to very aggressive sell-side expectations and a big run in the stock. Since then, the stock has taken a few knocks as the company's fiscal third quarter earnings weren't great, the stevia business saw a big setback, and investor enthusiasm for all things ag has waned. While there's still ample execution risk here, and the scant sell-side coverage is arguably too aggressive with its targets, I think the valuation is pretty interesting for more aggressive investors.
Management Has Been Busy Doing Another Deal
It's pretty clear that S&W management is not afraid to think big and position itself as a leader in the market for alfalfa seeds. To that end, the company announced the acquisition of Australia's Seed Genetics International (SGI) for a combination of stock (865K shares), cash ($5 million), and a promissory note ($3 million). Done just five days after my initial write-up, this deal was valued at $16 million at the time of the announcement, just slightly more than the revenue SGI logged for fiscal 2012 (which ended in the middle of 2012).
Apparently management worked on this deal for about half a year, and it's not hard to see why. With this deal, S&W becomes the largest company in the non-dormant alfalfa seed company in the world. SGI is a leader in Australia's alfalfa market, controlling 17,000 acres of irrigated land and having access to another 12,000 acres of non-irrigated land.
Although production can be highly variable (5.5 million pounds in FY2012 due to weather issues versus over 8 million for FY2013) and SGI's gross margins have been running about eight points below SANW (due in part to the weather issues). This is a quality asset with good access to many of the international markets that make up S&W's core addressable market.
Improving IVS Is A Long-Term Project
When S&W reported fiscal third quarter results, there were some concerns about the company's weak margins. Part of this was due to an unforeseen setback in the stevia business (more on this in a moment), but the core profitably of the seed business was lower as well. Although revenue rose 65%, the adjusted gross margin fell almost 23 points from the year-ago period. To a certain extent the company was a victim of its own success - it was effectively sold out of higher-margin enhanced seeds and ended up with a much higher mix of the low-margin commodity seeds sold by IVS (with margins less than half of the normal company run-rate).
Although the magnitude of the margin impact in the quarter was surprising, the fact that IVS is creating some short-term pain shouldn't have been a surprise. IVS was acquired primarily for its acreage and distribution capabilities, with the idea that margins would get better over time as the company shifted the production mix away from commodity/public seeds and towards its enhanced products. The key words there are "over time" - IVS should allow U.S. acreage to grow to 15,000 in 2014 and eventually maybe 20,000, but you can't transform a seed business in a single quarter.
A Serious Setback In The Stevia Operations
I was hesitant to assign any real value to S&W stevia operations back in March, and the intervening months have supported my reasoning at the time - namely, that growing stevia in commercial quantities was a speculative endeavor for the company and one rife with risk. With the third quarter announcement, management revealed that the initial crop was basically wiped out by herbicide use - the Chowchilla project was basically a total loss, while maybe 10-20% of the Los Banos crop would be salvageable.
I don't pretend to have anywhere close to the expertise to second-guess how management handled these fields, other than to just harken back to my assumptions that there would be challenges getting this project underway. This year's failure led to a $2 million impairment charge and it will take some time for the company to try again (they have to at least wait for pre-emergent herbicides to fade away), but this wasn't going to be a huge near-term contributor to sales or profits either way.
On balance, I don't care much one way or another whether S&W stays at it in stevia. While it's true that stevia extracts are getting a serious look in the food and beverage industry as an alternative to sugar or sugar substitutes, I don't think anybody knows what the economics for growers are going to look like. It's worth a shot as a call option, I suppose, but it's going to be alfalfa that makes or breaks this business.
Opportunities To Improve Over Time
On balance, I think things are going reasonably well for S&W. The SGI business will likely contribute about half of the company's seed mix for the near term, with margins relatively close to the historical S&W levels. On an encouraging note there, management has recently indicated that the Australian harvest was stronger than expected and SGI will produce 9 million pounds (or more) of seed versus the earlier estimate of 8 million. It's also worth noting that demand from the Chinese dairy industry is leaving hay supplies in the U.S. relatively tight, which should improve alfalfa seed demand.
As before, most of the upside here is in the 2014 to 2016 timeframe. First, the company will be bringing out Roundup Ready alfalfa (most likely in 2014), and this should improve yields and profitability per acre. The company is also looking to grow more seeds for the dormant alfalfa market - the market that makes up about 80% of U.S. demand - and this could ultimately double the company's addressable market.
Last and not least, pricing is still a variable that should work in the company's favor. S&W only appears to capture about 10% of the value it provides for farmers who use its enhanced seed, and that's well below the 25% to 33% that's commonplace for Monsanto (NYSE:MON) and DuPont (DD). While I'm not arguing that the alfalfa market is identical to the corn or soybean market, I think the company will be able to charge more for its enhanced seeds over time, and I think the company can close some of the gap between its seed gross margin (historically in the high 20%'s) and that of Monsanto (well into the 50%'s).
Ag Is Getting Less Attractive To The Market
S&W's opportunities have to be set against some meaningful risk factors. First, growing anything is a risky proposition and a company as small as S&W could be adversely affected by weather in any particular growing season. It's also important to note that while Monsanto and DuPont seem ambivalent about alfalfa (though there is an agreement between S&W and Monsanto for seed development and marketing), Dow Chemical (NYSE: DOW) is a significant player in this market and has considerably more resources than S&W, though they've generally been less interested in the non-dormant market.
Still, weather has impacted planting and ag chemical usage, leading to a sizable quarterly miss (pre-announced) from American Vanguard (NYSE:AVD) and a mediocre quarter from Monsanto. What's more, ag was a very popular sector with institutional investors for quite a while, and it sounds like many of those investors have cashed in their positions and moved on to new ideas. Consequently, S&W shares could be up against a wall of indifference at the same time it tries to navigate some turbulence in its revenue mix and margins.
The Bottom Line
Not much has changed in my fundamental views of the company. While the dilution of a warrant exercise and the share component of the SGI deal largely neutralizes the near-term impact of the acquisition, I still believe these shares are worth something in the range of $11 to $12 on the basis of high single-digit long-term revenue growth (adjusted for the big step-up between fiscal 2012, 2013, and 2014) and free cash flow margins in the low to mid teens. Clearly there are risks that alfalfa growers will not adopt enhanced seeds and/or will not pay more for them, and there are likewise operational/execution risks (as seen with the stevia planting), but I see downside risk in the $7 to $8 area.
All told, the valuation on S&W is now considerably more interesting. I do worry that an investor exodus from agriculture could leave these shares as dead money for a time, but I don't think most value-motivated investors mind waiting for the payoff that this company could provide.
Disclosure: I am long MON. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.