NutraCea Q2 Earnings Preview: Bump or Crater in the Road?

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As shareholders of NutraCea (NTRZ.OB) are aware, 1Q07's bottom line results were a disappointment -- a reported loss of $247,000. Given that NutraCea management has announced 2Q07 results will be released after market close today, and an investor conference call to discuss results scheduled at 11:30 am EDT on August 15, I thought a recap of NTRZ's business and performance year to date would be helpful. What follows is a synopsis of NutraCea's positive performance, leftover concerns from 1Q, and kudos and concerns from known 2Q07 activity. Finally there are a couple significant questions company management might address during the conference call to maintain shareholder and analyst confidence in its business model. The following research is based upon the NutraCea's Edgar's filings and media releases for 2006-2007 YTD, and those of Vital Living Inc. [VTLV.OB].

NTRZ: Why own this stock?
NutraCea's Stabilized Rice Bran [SRB] has huge potential to enhance global nutrition as a commercial product, through NGO utilization, and as a nutritional supplement. It is a compelling long term revenue and product development story with significant stock value appreciation potential.

Nutracea's positive performance story
1) 2006 was NutraCea's first profitable year, with steady revenue and income growth.

2) Despite NutraCea's disappointing 1Q07 results, management has communicated and demonstrated ongoing execution of the company's growth strategy in 1H07 by:

a) Positive media exposure to create product and company awareness and maintain shareholder confidence, including:

- June 19, Hadassah Hospital research announcement for HIV/AIDS patient nutrition.

- June 26, Media event in NYC with Happy Hearts and Feed the Children.

- July 30, Brad Edson's CEO Spotlight interview on video network.

b) New revenue announcements to demonstrate new sources of business in 2Q 07 to counter concerns over 1Q07's earnings disappointment including:

- May 15, Press release that the 1Q07 revenue shortfall of $2.6 million was attributable to not realizing revenue for product produced, but not delivered to customers due to a labeling issue, and that NutraCea anticipated the revenue being realized in 2Q 07.

- May 17, $600,000 PO for private product purchase.

- June 25, $500,000 PO from Feed the Children.

c) Plant Expansions to produce more and different products including:

- May 16, equipment purchase for pelletized SRB production.

- May 24, opening of Mermentau, LA SRB facility which upped SRB production from 10,000 to over 40,000 tons. Another 20,000 tons production capacity is expected to be operational in LA before 2008. If Brad Edson's Forbes interview comment of $1,000 per ton of finished product value is realized, in 2Q07, NTRZ's operational production capacity was equivalent to at least $40 million in annual revenue.

- June 25, announcement of SE Asia JV expansion (PAHL) with an Indonesian company with construction of two new SRB SE Asian facilities planned in the next 18 months.

- July 6, expansion of NutraCea's Dillon, MT SRB facility to 2,700 tons.

- July 10, announcement that the Arbuckle, CA SRB facility with ADM was operational but no tonnage capacity was reported.

- July 16, announcement of Frito-Lay international introduction of whole grain rice crackers containing 12% SRB rice bran.

- August 2, lease announcement of approx. 27,000 sq. ft. warehouse space in Sacramento, CA, presumably to support the new ADM production, or product shipment to Australia and Indonesia due to its new JV and Frito-Lay product announcements.

d) NutraCea successfully increased capital by $50 million by private placement to finance its 2007 expansion. While dilutive to intermediate share value, it fuels the long term growth of NTRZ. Presumably management is not planning a second financing this year, and will be able to finance further expansion through future cash flows. However the March 30, 2007 S-1 shelf registration for future sale of 32.05 million shares at $3.075 to realize $98.6 million indicates that may not be so.

e) NutraCea management purchased NTRZ stock to reassure investors. Since May 16, open market share purchases have been made by NutraCea officers and directors totaling $115,000. Most reassuring to shareholders was the July 25 purchase by Kody Newland, Sr. VP Sales, totaling almost $50,000.

Lingering Concerns from Nutracea's 1Q 07 reporting and 2Q07 activity
Q1 07 concerns: Revisiting the financials. NutraCea's 1Q was not as "good" as it looked. In reality, the non-reported $2.6 million in revenue corresponds with an unknown non-reported cost of revenue. In other words, the upcoming 2Q financials may not only include the $2.6 million revenue shortfall not reported in 1Q, but also the cost of that revenue. The 1Q operating loss was, in reality, $2 million. This was offset by an extraordinary gain on settlement of a legal case settlement of $1.25 million, a fortunate windfall on what would have been, if these are the only adjustments, an abysmal $1.5 million loss for NTRZ in 1Q07.

NutraCea's 1Q07's balance sheet was a bit creative and disconcerting. First, was the shift in February of $3.5 million of one customer's A/R into a note receivable, due 4Q07. While NTRZ may like to maintain good relations with its customers, granting 10 months financing terms seems unusual, especially for a company NTRZ's size. More disconcerting was management's 10Q reporting that this was latest portion of $4.9 million of current notes receivable, presumably from other customers. To place this in perspective, the $4.9 million was approximately 95% of 4Q 06's, or 247% of 1Q 07 total revenues. It would seem NutraCea has "financed" a considerable portion of its current/recent accounts receivable through 1Q 07. It seems reasonable to expect management to update shareholders and analysts on notes receivable collection during Wednesday's conference call, especially in light of Note 9, Concentration of Credit Risk, in 1Q 07's 10Q. NTRZ management has stated that these are "secured" promissory notes. How "secured" is a concern given the context of the Vital Living Inc. transaction.

2Q 07 reported activity to date
Potential 2Q revenue: NutraCea's publicized revenues, the deferred 1Q revenue, share sales, the PAHL agreement and two announced PO's totals is approximately $5.3 million. However, total revenue likely will be substantially higher, given the Frito-Lay production, etc. A rough 2Q 07 total revenue expectation might be $8-10 million.

Reported 2Q 07 expenses: Expenses and capital outlays already incurred in 2Q07 create heightened concern on profitability for this quarter, and even more, a very high concern for return on equity from some investments.

In April, 2007, NutraCea extended another note receivable to a customer for $500,000, including $365,000 in unpaid accounts receivable, seemingly "secured" by $4 million of the customer's assets. What the other $135,000 in the note receivable was for was not specified. Presumably this current note receivable is payable in less than 12 months. If added to previous notes receivable, and assuming no payments, other than interest, the total outstanding notes receivable would be $5.8 million, a very significant concern. If paid, the interest received will be helpful to NTRZ this quarter. Shareholders should expect management to clarify progress in payment of interest and principal on these obligations.

May 1, NutraCea entered into a $2.15 million purchase of manufacturing equipment, of which $1.65 million was paid in 2Q07. This purchase enhances its equine SRB product lines, seemingly a good investment.

June 25, NutraCea announced its new Indonesian JV/PAHL agreement which required a $1.5 million payment in 2Q 07 of a total $5 million NTRZ investment in the expansion. Given the licensing fees payable to NTRZ, and transaction structure, the deal is very beneficial to the company and shareholders.

"Phoenix, we have a problem," Acquiring Vital Living Inc. In April 2007, to quote NutraCea's 10Q, "In April, we acquired shares of convertible preferred stock and secured convertible notes of a customer from the holders of those outstanding securities, for an aggregate of approximately $5,200,000. Commencing in July 2007, the notes can be converted into shares of common stock of the customer." This innocuous statement is fraught with problems.

First, the acquisition price of $5.2 million represents more than 10% of NTRZ's recently gained private placement capital. A reasonable shareholder question is: Will Nutracea gain a return on this equity investment that will enhance its revenues, profit and future stock price? From the available evidence, -- No.

Vital Living Inc, is not named in this 10Q. Neither are the former note, nor former preferred stock holders. In a NutraCea 8-K filing dated June 1, the transaction is clarified. What NTRZ acquired for $5.2 million was all the Series D preferred stock of Vital Living, Inc. valued at $1.0 million and for $4.2 million, all of Vital Living's "senior secured convertible notes." Interest on the notes is payable by cash or Vital Living common stock. VTLV.OB stock currently trades at .0065 per share. Not much value there. Also, according to Vital Living's filings, the company has not been profitable on an annual basis. In 2006 it reported $4.9 million in revenue and an $82,000 loss, a monumental improvement over the $50 million in cumulative losses in 2004 and 2005. In 1Q07, on revenues of $1.49 million, VTLV recorded a loss of $29,000, but more worrying, it had no cash.

From NTRZ's and VTLV's filings, if interest payments on the notes are not made, NTRZ has acquired the option of having the shares converted to common stock to gain controlling interest of VTLV. One could point out that the notes are "secured'. However, the 1Q VTLV balance sheet reports $1.5 million in uncollected A/R, up 500k from 4Q 06, and $3.3 million of "good will" as its most substantial assets.

If we return to the NTRZ 8-K comment "Commencing in July 2007, the notes can be converted into shares of common stock of the customer," it is important to note that the conversion clause of the VTLV Series D preferred stock and secured senior convertible notes to common stock allows NutraCea to become the controlling shareholder of Vital Living Inc. What is it that NutraCea wants to acquire from VTLV?

It is not clear how arms-length this transaction is. NutraCea's 8-K reports "To NutraCea's knowledge, no officer or director of NutraCea owns any securities of Vital Living." It is not clear if this was pre- or post- this transaction. What is known is that some VTLV Preferred Stock changes that impact the potential outcome of this transaction occurred in December, 2006. To quote NutraCea's website: "Before joining NutraCea, (Dec. 2004), Mr. (Bradley) Edson was Chairman and CEO of Vital Living Inc. [OTC BB: VTLV]." Whomever the nebulous note and preferred stock holders were that sold their VTLV interests to NutraCea, they are $5.2 million happier.

If I were an analyst: Questions for the Conference Call
In addition to the normal comments and question on revenue, costs, growth, etc. it seems reasonable to expect NTRZ to address the following:

1) When will NTRZ end its practice of converting A/R into notes receivable to extend financing to customers?

2) What return on equity and operational benefit did NutraCea gain in directly acquiring VLTV's preferred stock and debt obligations, and indirectly acquiring the VTLV assets or potential control of the company, which seem of dubious value, in light that $5.2 million of NTRZ's equity could have been invested in a far less "risky" venture for shareholder and corporate benefit?

3) When does NutraCea expect to acheive positive cash flow on its operations?

4) Does NutraCea have any plans of issuing its new S-1 $98 million shelf registration in the next 18 months?

May this quarter not be a bump, or worse, a crater in the road for NutraCea. It has a great product and compelling investment thesis. It may not be operationally profitable this quarter, but it has the potential to be very profitable in 2007/08. More importantly it needs to begin generating positive cash flow from sale of its products. That is the greatest concern for its longevity, so it does not become a Vital Living.

Disclosure: author is long NTRZ.OB.

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