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SANW > SEC Filings for SANW > Form 10-Q on 15-May-2013All Recent SEC Filings

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Form 10-Q for S&W SEED CO


15-May-2013

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

This Quarterly Report on Form 10-Q, including, but not limited to, this "Management's Discussion and Analysis of Financial Condition and Results of Operations," contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. The statements contained in this Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including but not limited to any projections of revenue, margins, expenses, tax provisions, earnings, cash flows and other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements regarding our ability to raise capital in the future; any statements concerning expected development, performance or market acceptance relating to our products or services or our ability to expand our grower or customer bases; any statements regarding future economic conditions or performance; any statements of expectation or belief; any statements regarding our ability to retain key employees; and any statements of assumptions underlying any of the foregoing. These forward-looking statements are often identified by the use of words such as, but not limited to, "anticipate," "believe," "can," "continue," "could," "estimate," "expect," "intend," "may," "will," "plan," "project," "seek," "should," "target," "will," "would," and similar expressions or variations intended to identify forward-looking statements. We have based these forward-looking statements on our current expectations about future events. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward- looking statements. Risks, uncertainties and assumptions include the possibility that certain foreign markets into which our seed is sold could be adversely impacted by discounted pricing of non-proprietary seed by competitors, our alfalfa seed growers could choose to grow more profitable crops instead of our alfalfa seed and the dairy industry decline might not recover as quickly as we anticipate. Other risks, uncertainties and assumptions include macro-economic and geopolitical trends and events; the execution and performance of contracts by our company and our customers, suppliers and partners; the challenge of managing asset levels, including inventory; the difficulty of aligning expense levels with revenue changes; the outcome of pending or future legislation or court decisions and pending or future accounting pronouncements; and other risks that are described herein, including but not limited to the items discussed in the Risk Factors set forth in our Prospectus Supplement dated and filed with the Securities and Exchange Commission (the "SEC") on January 11, 2013 (as supplemented by the Supplement to the Prospectus Supplement dated and filed with the SEC on January 15, 2013) and that are otherwise described or updated from time to time in our SEC reports.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. Many factors discussed in this Report, some of which are beyond our control, will be important in determining our future performance. Consequently, actual results may differ materially from those that might be anticipated from the forward-looking statements. In light of these and other uncertainties, you should not regard the inclusion of a forward-looking statement in this Report as a representation by us that our plans and objectives will be achieved, and you should not place undue reliance on such forward-looking statements. Furthermore, such forward-looking statements speak only as of the date of this Report. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

Executive Overview

Our business includes (i) our core alfalfa seed business, which was expanded in fiscal 2012 to include our own farming operations; (ii) our more recently initiated stevia breeding and production operations; and (iii) our seed and small grain cleaning and processing operations that leverage the excess capacity in our mill. Until we incorporated in 2009, our business was operated for almost 30 years as a general partnership and was owned by five general partners. We incorporated in October 2009, bought out the former partners between June 2008 and May 2010 and raised capital in our May 2010 initial public offering in order both to grow the existing alfalfa seed business and take the company in a new direction. Since our initial public offering, we have raised additional capital to help fund the purchase of Imperial Valley farmland, the acquisition of Imperial Valley Seeds in October 2013, the acquisition of Seed Genetics International in April 2013 and for working capital purposes.


Our alfalfa seed business consists of breeding our proprietary alfalfa seed varieties in order to be able to offer seed with the traits sought by our customers such as high salt and heat tolerance and high yields, fulfilling our seed requirements both by contracting with farmers in the San Joaquin and Imperial Valleys of California and internally farming acreage we have leased or purchased, processing and bagging the seed at our facility and marketing and selling it as certified seed to agribusiness firms and farmers throughout the world. Our principal business is subject to uncertainty caused by the following factors, among others: (i) our seed growers may decide to grow different crops when prices for alternative commodities are on the rise, which can create a shortage of our certified seed; (ii) farmers who typically purchase our seed to grow alfalfa hay may plant alternative crops either in reaction to a decline in the dairy industry, which in turn causes shrinking demand for alfalfa hay or because they can make a higher profit planting alternative crops, either way, with the result that smaller quantities of our seed are purchased; (iii) farmers may choose to convert their hay crops to non-certified common seed, and an overabundance of non-certified seed entering the market can drive down the overall market price for alfalfa seed, including the market for certified alfalfa seed; or (iv) the risks of internally farmed operations such as adverse agronomic decisions, weather conditions, natural disasters, crop disease, pests, lack of water and other natural conditions as well as other factors outside our control. While we are attempting to mitigate these risks, agricultural risks will always remain. As a result of these factors and others, including but not limited to the items discussed in the Risk Factors set forth in our Prospectus Supplement dated and filed with the Securities and Exchange Commission (the "SEC") on January 11, 2013 (as supplemented by the Supplement to the Prospectus Supplement dated and filed with the SEC on January 15, 2013) and that are otherwise described or updated from time to time in our SEC reports our revenue and margins can be difficult to project.

In connection with our alfalfa seed operations since our May 2010 IPO, we have
(i) leased acreage in Kern and Madera Counties in California's San Joaquin Valley and in California's Imperial Valley, on which we are producing a portion of our alfalfa seed supply ourselves; (ii) purchased farmland in the Imperial Valley; (iii) purchased the customer list of our principal international distributor from its owner in order to sell our alfalfa seed directly to customers in Saudi Arabia and other Middle Eastern and African countries such as Sudan, Egypt and Morocco; (iv) acquired the rights to a portfolio of dormant alfalfa seed varieties in order to expand our product offerings into new geographic regions; (v) contracted with additional farmers to grow our proprietary seed; (vi) completed our first material acquisition by purchasing substantially all of the assets of Imperial Valley Seeds, Inc.; (vii) expanded our sales and marketing efforts; and (vii) on April 1, 2013 completed our largest and most strategic acquisition to date by acquiring 100% of Seed Genetics International, based in Adelaide Australia. We began direct international sales in June 2011. Our first crop of internally-produced alfalfa seed was planted in the second fiscal quarter of 2012 and was harvested, cleaned, bagged and made available for sale to our customers in the first and second quarters of fiscal 2013, along with the seed we purchased from our contract growers.

While the dairy business on which our alfalfa seed business is largely dependent is subject to significant cycles of over-supply and under-supply, these fluctuations are generally localized. Consequently, although we are subject to the volatility of local markets, the breadth of our market and the quality niche of our certified seed have resulted in relatively stable demand in most years. However, the supply of seed in the marketplace is subject to substantial swings. Fiscal 2011 proved to be a particularly challenging year, but fiscal 2012 and the first nine months of fiscal 2013 reflected a significant turnaround in seed revenue.

From inception until 2003, almost all our seed sales were to distributors who exported our products to international markets. Modest sales efforts in the western U.S. were initiated around 2003, and in the fiscal year ended June 30, 2010, our seed shipments were allocated approximately 51% to the domestic market and 49% to distributors who sold into international markets. In fiscal 2011, both markets were negatively impacted by events beyond our control: The domestic market continued to be impacted by the dairy industry downturn that began in fiscal 2009 when dairy prices declined due to over-supply. While in normal years, we are typically able to offset this situation with sales to our distributors in our international markets, in fiscal 2011, our Middle East distributor experienced the most challenging year in its history due to an over-supply of uncertified common seed being sold at significantly reduced prices. We and our distributor elected to hold back much of our certified proprietary seed rather than sell into that depressed market in fiscal 2011. As a result of all of these factors, seed sales were down in fiscal 2011 compared to the prior year. However, because of our decisions in fiscal 2011, we had strong levels of certified seed inventory available for sale in fiscal 2012 when most of the common seed that glutted those markets in fiscal 2011 had been sold out. This allowed us to meet expected demand and, to some extent, control pricing during our first year selling directly into international markets. We plan to continue to expand our served markets and therefore minimize the risks associated with any specific geographic market.

Our alfalfa seed business is seasonal, and historical sales have been concentrated in the first six months of our fiscal year (July through December) when customers are planting their fields. This coincides with the period during which seed growers harvest and deliver seed to us. We contract with growers based upon our anticipated market demand; we mill, clean and stock the seed during the harvest season and ship from inventory throughout the year. The acquisition of Seed Genetics International on April 1, 2013 provides us with a geographically diversified and year-round production cycle. This will likely partially mitigate this seasonality of our business as the fourth quarter is typically a significant sales quarter for our newly acquired Australian operation. Tests show that seed that has been held in inventory for over one year improves in quality. Therefore, provided that we have sufficient capital to carry additional inventory, we may increase our seed purchases and planned season end inventory if, in our judgment, we can generate increased margins and revenue with the aged seed. This will also reduce the potential for inventory shortages in the event that we have higher than anticipated demand or other factors, such as growers electing to plant alternative, higher priced crops, reducing our available seed supply in a particular year.


Although we believe an opportunity exists to materially expand our alfalfa seed business without substantially overhauling our operations, we could nevertheless encounter unforeseen problems. For example, in fiscal 2011 and 2012, some of our seed growers elected to grow alternative crops, such as cotton, that yielded greater profit than alfalfa seed, and this could reoccur from time to time as commodity prices shift. However, by first leasing farmland in fiscal 2011, and then gaining long-term access to additional farmland in the San Joaquin and Imperial Valleys of California through additional leases entered into in fiscal 2012 and farmland purchases in fiscal 2013, we now have the ability to grow a portion of our alfalfa seed production ourselves, which could partially mitigate this risk in future years. Although we have an experienced farming management and operations staff, this recently implemented direct farming opportunity poses new challenges. As we obtain additional farmland, by lease or purchase, both our farming costs and risks could continue to climb, and as our direct farming operations account for an increasingly significant portion of our seed requirements, the farming decisions we make could have a significant negative impact on our results of operations. Nevertheless, we believe that by vertically integrating our alfalfa seed business to include our own production, we can leverage our management infrastructure, our experienced agronomics team and our milling capacity, while reducing our costs and more directly controlling our inventory.

Beginning in fiscal 2011, we also faced the new challenge created by the availability of Roundup Ready alfalfa ("RRA") in the U.S. We are still uncertain as to the extent to which RRA might negatively impact our business, if at all, but lack of regulations regarding field isolation could raise concerns about contamination of our non-genetically modified organism ("GMO") seed. In fiscal 2012, the first year in which RRA was planted in the San Joaquin Valley, some field contamination was discovered. Moreover, we sell into regions of the world that have a zero tolerance policy regarding GMO seed, so we will have to be able to maintain the integrity of our seed in order to sell in certain parts of the world. We have entered into a series of agreements with Monsanto Corporation and Forage Genetics International to produce and sell GMO alfalfa seed. Due to issues surrounding field contamination and the widespread ban of GMO-based crops in many international markets, including markets that are critical to our business, we will be required to take particular care in the planting of any GMO-based alfalfa seed we grow.

We currently are using less than 25% of our mill capacity, leaving room for substantial revenue growth without having to incur significant capital costs. In particular, we clean, process and bag seed and small grains for growers in the Five Points, California area during the periods in which we are not using the mill for our alfalfa seed business.

We have also been developing our stevia business, working closely with PureCircle, one of the world's top stevia breeders and the world's largest stevia processor, in an effort to breed and select the best stevia varieties for the climate, soil and water conditions in the San Joaquin Valley. In July 2010, we entered into a five-year supply agreement with PureCircle under which it agreed to purchase our dried stevia leaf produced from seeds, plants and plant materials sourced from the processor or its agents that meets the contractual specifications, up to 130% of the quantity agreed upon by the parties on an annual basis. In May 2011, we commenced the planting of our first commercial crop of stevia on a 114-acre property near Chowchilla, CA and harvested a portion of that crop in the fall of 2011. We earned a modest amount of revenue from that harvest during the second quarter of fiscal 2012 when the dried leaf was shipped to our customer. In that initial commercial planting operation, our agronomists focused their efforts on ensuring our plantation had a healthy stand for the first winter months, not on maximizing yield. This was essentially a test harvest in which we cut only the top portion of the plants and experimented with harvesting methods and equipment settings. In April 2012, we leased a second property, of approximately 156 acres near Los Banos, CA to expand our stevia production. Our second trial harvest took place during the second quarter of fiscal 2013. We again experimented with a different harvesting method and equipment usage.

Our strategy for our stevia operations has been to utilize our research and breeding expertise to develop varieties that can thrive in the state of California, while obtaining attractive taste and yield profiles. Recently, due to weeding control practices, damage to a majority of the fields occurred and we believe it is unlikely that the existing plants will produce the desired levels of leaf that will make it economically viable to continue farming these fields. Stevia plants on the properties in Chowchilla and Los Banos have not emerged from the ground as expected, and we have tentatively concluded that the plants have suffered damage from application of certain herbicides. We are carefully examining the variables related to this year's application of the herbicides and believe that our eventual findings will improve our ongoing research and development of the stevia business. We currently believe that the field in Chowchilla will not produce a commercially viable harvest. We estimate that the Los Banos field has suffered an 80 to 90% loss rate, and expect that we will be able to maintain approximately 20 to 30 acres of stevia production at that site.

Based on our preliminary estimates of the damage to the stevia crops, we recorded an impairment charge of $1,840,209 and $2,140,209 for the three and nine months ended March 31, 2013, respectively. Our harvest of the surviving stevia acreage in Los Banos is expected to occur in August 2013, although the exact timing of the completion of such harvest will depend on the success of our efforts to quantify and mitigate the effects of the herbicides and on factors such as bloom rate and results of our internal tests, as we continue to evaluate and settle upon best farming practices. Our 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.


Because this 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. We incurred substantial expenses and earned no revenue during the 2011 fiscal year as we entered the stevia production business. In fiscal 2012, we moved into commercial production of stevia leaf, but we earned only nominal revenue from our stevia operations. In fiscal 2013, we increased our spending on research and development, but also recorded a stevia inventory impairment charge of $2,140,209. We expect our stevia revenue will be nominal in fiscal 2013 and fiscal 2014, but that our stevia expenditures will be substantially lower for these periods as we focus our spending on research and development.

Results of Operations

Three Months Ended March 31, 2013 Compared to the Three Months Ended March 31, 2012

Revenue and Cost of Revenue

Seed and Crop Revenue and Milling and Other Services

Revenue for the three months ended March 31, 2013 was $4,208,735 compared to $2,549,188 for the three months ended March 31, 2012. The $1,659,547, or 65%, increase in revenue for the 2013 third quarter was primarily due to the acquisition of IVS on October 1, 2012 which contributed $3,803,942 of seed revenue. This was offset by a $2,151,547 decrease in seed and crop revenue from S&W's existing ("organic") business. The $2,151,547 decrease in organic seed and crop revenue resulted from a decrease in volumes primarily due to timing of shipments to our customers internationally, primarily in Saudi Arabia. We continue to expect large orders out of Saudi Arabia, however, the timing of these shipments will likely take place in the company's fourth fiscal quarter this year.

Total international sales accounted for 89% of our current period revenue compared to 70% in the comparable period in the prior year. Domestic revenue accounted for 11% and 30% of our total revenue for the three months ended March 31, 2013 and 2012, respectively. The increase in the international sales percentage was due to the acquisition of IVS. Revenue for the three months ended March 31, 2013 included approximately $22,759 of milling and other services compared to $15,607 for the three months ended March 31, 2012.

The following table is a summary of revenue, costs of revenue and gross profits:

                                                     Three Months Ended
                                                         March 31,
                                                    2013                            2012

                                     S&W            IVS         Consolidated        S&W
Alfalfa seed and other crop
revenues
Alfalfa seed and other crop
revenues                       $    382,034    $ 3,803,942    $   4,185,976    $ 2,533,581

Cost of seed and other crop       2,234,419      3,422,798        5,657,217      1,740,130
revenue

Gross profit on alfalfa seed
and other crop revenue           (1,852,385)       381,144       (1,471,241)       793,451

Total GP% on seed and other
crop revenue                         -484.9%          10.0%           -35.1%          31.3%

Total GP% excluding stevia
impairment charge                      -3.2%                            8.8%

Milling and other revenue
Milling and other revenue            22,759             -            22,759         15,607
Costs of milling and other           20,192             -            20,192          7,514
revenue
Gross profit on milling and
other revenue                         2,567             -             2,567          8,093
                                         11%            -                11%            52%

Total revenue                  $    404,793    $ 3,803,942    $   4,208,735    $ 2,549,188
Total cost of revenue             2,254,611      3,422,798        5,677,409      1,747,644
Total gross profit             $ (1,849,818)   $   381,144    $  (1,468,674)   $   801,544
Total GP %                           -457.0%          10.0%           -34.9%          31.4%
Total GP% excluding stevia
impairment charge                      -2.4%                            8.8%


Cost of revenue of $5,677,409 in the three months ended March 31, 2013 was 135% of revenue, while the cost of revenue of $1,747,644 in the three months ended March 31, 2012 was 69% of revenue. The dollar increase in cost of revenue for the current year was primarily attributable to the $1,840,209 stevia inventory impairment charge taken during the quarter as well as the cost of revenue from IVS, offset by decreased cost of revenue from S&W's organic business.

Excluding the charge for the stevia impairment, total gross profit margins for the current period totaled 8.8% versus 31.4% in the comparable period of the prior year. The decrease in gross profit margins can be attributed to the following factors: 1) the newly acquired IVS business, which represented over 90% of the revenues for the quarter and generated gross profit margins of 10.0%;
2) an increase in seed costs in the current year on S&W's organic operations due to higher average costs paid to third party contract growers as well as higher costs of production on internally operated fields that have been in production less than one year; 3) while the Company has obtained increases in seed sales prices to offset increased costs of production, these increases have not yet offset the increased costs of production; and 4) the company had to burden its cost of goods sold during the third quarter with additional farming related expenses of approximately $70,000 not previously recognized.

We expect to obtain stable or increased sales pricing for the remainder of the fiscal year and anticipate that we will improve gross margins in our core business for the remainder of the fiscal year. Gross margins from our IVS operations improved in the third quarter of fiscal 2013 from 10.0% compared to the preceding second quarter of fiscal 2013 of 8.5%. Gross margins in S&W's organic business, excluding the stevia reserve, were a negative 2.4% in the third quarter of fiscal 2013. As mentioned above, the company had to burden its cost of goods sold during the third quarter with additional farming related expenses of $70,000 not previously recognized that negatively impacted the third quarters gross margins.

Stevia Breeding and Production Program

We began our stevia initiative in fiscal 2010 on a leased 114-acre property near Chowchilla. We moved from a pilot program to commercial production in fiscal 2011, planting the first commercial crop in the spring and summer of 2011. We earned our first stevia revenue of $25,382 during the second fiscal quarter of 2012 under a commercial supply agreement with a major stevia processor. Our agronomists focused their efforts on ensuring our plantation had a healthy stand for the first winter months, not on maximizing yield. This was essentially a test harvest in which we cut only the top portion of the plants and experimented with harvesting methods and equipment settings. In April of 2012, we leased a second property, of approximately 156 acres near Los Banos, to expand our stevia production. Our second trial harvest took place during the second quarter of fiscal 2013. We again experimented with a different harvesting method and equipment usage. We have experienced substantial herbicide damage to our current stevia crops on both the Chowchilla and Los Banos properties, and currently expect that we will be able to maintain limited commercial production of stevia on approximately 20 to 30 acres of the Los Banos property. We expect to ship modest quantities of stevia leaf to PureCircle in the fourth quarter of fiscal 2013. Based on our current preliminary estimates of the damage to the stevia crops, we recorded an impairment charge of $1,840,209 for the three months ended March 31, 2013. Our next harvest is expected to occur in August 2013, although the exact timing of the completion of such harvest will depend on the success of our efforts to quantify and mitigate the effects of the herbicides, and on factors such as bloom rate and results of our internal tests, as we continue to evaluate and settle upon best farming practices.

Our strategy for our stevia operations has been to utilize our research and breeding expertise to develop varieties that can thrive in the state of . . .

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