S&W continues to plant seeds for future growth

Author: Stephen Simpson

Summary

•  S&W has largely moved past a period of more limited growth potential caused by a poor harvest that left the company with low inventories of attractively-priced seed.

•  Acquiring its way into sorghum and sunflowers and moving forward with engineered alfalfa hybrids are key steps in positioning the company for long-term growth.

•  The shares remain undervalued on a DCF basis, and the prospect of 30%-plus EBITDA growth in the coming years could excite growth investors in the coming quarters.

The ag sector has shown a little life since the last time I wrote on S&W Seed, but this small grower of alfalfa seeds has done better than most with better than 15% improvement in the share price since the time of that late March piece. While the company's growth in recent quarters has been hampered by low inventories (caused by disappointing yields due to weather), the company has shown good discipline with its seed pricing and sourcing, as well as its corporate costs.

The rebound in the share price has taken some of the easy money off the table, but the company has made multiple moves that should improve the stability and growth potential of the business over time. Diversifying into new crops seems like a risk worth taking, but the key for the company, in my view, remains its ability to improve seed prices and push adoption of higher-value seeds by emphasizing the yield and value advantages of its hybrids.

Moving On From A Tough Year

The last two quarters were challenging for S&W, as low levels of inventory limited the company's options and forced it to buy seed on the market to meet its commitments. Revenue fell 18% in the fiscal third quarter and then turned around for 21% year-over-year growth in the fiscal fourth quarter on better shipments to DuPont.

Weak yields in Australia have loomed over the company's gross margins for a little while, and both the third and fourth fiscal quarters saw year-over-year declines. Improved price discipline helped mitigate the damage, and the decision to move away from contracts priced on yield will help in the future, but the Australia harvest was too much to completely overcome. S&W likes to use lower-cost seed from Australia in blends with seeds grown in California, but the weak harvest/inventory position limited the company's ability to do that in recent quarters.

On the plus side, management has shown that it can step up with controllable expenses. While the company has been spending more on R&D to develop innovative alfalfa hybrids, SG&A spending was restrained relative to revenue growth.

Building Toward Long-Term Improvements

It will take time for the results to show up in the financial results, but S&W management has been making smart moves to better position the business for the long term.

The deal with DuPont continues to be a key part of this process. This was an expensive deal for a company of S&W's size, but two years later, the deal looks like a good one for the company. Improved U.S. distribution has helped S&W as has greater exposure to the market for dormant alfalfa varieties and the acquisition of a deep R&D pipeline.

The company has boosted its acreage for the next year by double digits (even more for DuPont dormant varieties), but also ended its yield-based growing contracts. S&W will now be sourcing at a fixed price, and that should reduce some of the volatility in the financials.

S&W is also close to seeing the benefits of some past investments into R&D. Genetically-modified varieties developed in partnership with FGI and Monsanto are going into the ground this fall and should be available for marketing in North America in FY 2018. Although there's relatively less demand for non-dormant alfalfa seed in North America, it's a starting point for the company and the global demand for Round Up-resistant, salt-tolerant alfalfa should be more significant. The company has also been making progress on trials of products produced through its relationship with Calyxt (which uses gene editing technology that isn't technically genetic modification under current standards).

Better seeds and better pricing remain key to S&W's future. A third of the company's sales come from Saudi Arabia, where there is a real demand for seeds that require less water and can tolerate higher salt levels, likewise for Mexico and Sudan which together are about 10% of S&W's business. S&W also has more work to do on the sales and marketing side, as farmers are not accustomed to paying up for higher-yielding alfalfa varieties; as awareness grows (and more is demanded of shrinking alfalfa acreage), S&W should be able to improve its mix towards higher-yielding, higher-priced varieties that generate better revenue and margins for the company.

A Move Toward Diversification

Arguably the biggest change at S&W in recent months is the acquisition of Australia's SV Genetics and the move toward a more diversified business mix. With SV Genetics, which uses a licensing-based model, S&W will have a presence in the sorghum and sunflower markets. The sorghum market is roughly the same size as the alfalfa market and it is also similar in that most of it goes toward livestock feed and it tends to be a more drought-tolerant crop. This deal will give S&W the opportunity to sell alfalfa to existing SV Genetics customers (in Eastern Europe, for instance), and likewise to sell sorghum into exists S&W alfalfa customers. The sunflower side is a step further into the unknown for S&W, but it is a $1 billion global market.

I like that S&W is looking at smaller niche markets. The odds of S&W competing effectively with Monsanto, DuPont, Dow, or Syngenta in corn and soy is almost nil in my view, but there is a lot of money (for a smaller company) to be made in crops like alfalfa, sorghum, sunflowers, teff, millet, clover, and so on. There has been less innovation here than in the major row crops, and I believe S&W can find success offering improved yields and/or other value-added characteristics (drought tolerance, salt tolerance, herbicide tolerance) in these markets, though it will take time for those opportunities to develop.

The Opportunity

While the SV Genetics deal was not in my model, it's a small business that doesn't dramatically change my near-term modeling assumptions. As the company's performance has been in line with my expectations, the changes to my model don't really alter my value calculations much at all. I continue to believe that S&W can generate double-digit revenue and FCF growth over the next decade, with 30%-plus annualized EBITDA growth over the next three and five years.

The next year isn't likely to see a major rebound even with a good harvest, as the company will need and want to rebuild its inventory levels. Likewise, there is an ongoing risk of bad harvests and the risk that market adoption of alfalfa hybrids (GM and otherwise) is underwhelming and/or that S&W can't capture as much value.

The Bottom Line

On a free cash flow basis, there's still some upside to S&W and the shares do still look priced to generate double-digit returns. It's also worth noting that investors are often happy to pay for growth and multiples could expand as that 30%-plus EBITDA growth materializes, allowing the stock to overshoot my FCF-based target. Although I don't think S&W is "the next Monsanto", I think it's still an interesting off-the-radar ag play that's worth a look as management continues to take smart steps toward building and improving the business.