S&W Seed Co - Quarter Report: 2015 March (Form 10-Q)

Intangible assets acquired in business acquisitions are reported at their initial fair value less accumulated amortization. Intangible assets are amortized using the straight-line method over the estimated useful life of the asset. Periods of 10-30 years for technology/IP/germplasm, 20 years for customer relationships and trade names, and 2-20 for other intangible assets.

Goodwill is assessed annually, or when certain triggering events occur, for impairment using fair value measurement techniques. These events could include a significant change in the business climate, legal factors, a decline in operating performance, competition, sale or disposition of a significant portion of the business, or other factors. The Company first assesses qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill. If management concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, management conducts a two-step quantitative goodwill impairment test. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. The Company uses a discounted cash flow methodology to estimate the fair value of a reporting unit. A discounted cash flow analysis requires various judgmental assumptions including assumptions about future cash flows, growth rates, and discount rates. The assumptions about future cash flows and growth rates are based on the Company's budget and long-term plans. Discount rate assumptions are based on an assessment of the risk inherent in the respective reporting units. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired, and the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit's goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit's goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. That is, the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit.

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Research and Development Costs

The Company is engaged in ongoing research and development ("R&D") of proprietary seed and stevia varieties. All R&D costs must be charged to expense as incurred. Accordingly, internal R&D costs are expensed as incurred. Third-party R&D costs are expensed when the contracted work has been performed or as milestone results have been achieved. The costs associated with equipment or facilities acquired or constructed for R&D activities that have alternative future uses are capitalized and depreciated on a straight-line basis over the estimated useful life of the asset.

Deferred tax assets and liabilities are determined based on differences between the financial statement and tax bases of assets and liabilities, as well as a consideration of net operating loss and credit carry forwards, using enacted tax rates in effect for the period in which the differences are expected to impact taxable income. A valuation allowance is established, when necessary, to reduce deferred tax assets to the amount that is more likely than not to be realized.

The Company evaluates its long-lived assets for impairment annually or more often if events and circumstances warrant. Events relating to recoverability may include significant unfavorable changes in business conditions, recurring losses or a forecasted inability to achieve break-even operating results over an extended period. The Company evaluates the recoverability of long-lived assets based upon forecasted undiscounted cash flows. Should impairment in value be indicated, the carrying value of long-lived assets will be adjusted, based on estimates of future discounted cash flows resulting from the use and ultimate disposition of the asset. A triggering event during the quarter ended December 31, 2014 prompted a review of certain farmland related costs. The carrying value of these assets was deemed in excess of fair value, and the Company recorded an impairment charge of $500,198 in the consolidated statement of operations.

The Company's subsidiary, SGI, is exposed to foreign currency exchange rate fluctuations in the normal course of its business, which the Company at times manages through the use of foreign currency forward contracts.

The Company has entered into certain derivative financial instruments (specifically foreign currency forward contracts), and accounts for these instruments in accordance with ASC Topic 815, "Derivatives and Hedging", which establishes accounting and reporting standards requiring that derivative instruments be recorded on the balance sheet as either an asset or liability measured at fair value. The Company's foreign currency contracts are not designated as hedging instruments under ASC 815; accordingly, changes in the fair value are recorded in current period earnings.

The Company reviews the terms of the common stock, warrants and convertible debt it issues to determine whether there are embedded derivative instruments, including embedded conversion options and redemption options, which are required to be bifurcated and accounted for separately as derivative financial instruments.

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Fair Value of Financial Instruments

The Company discloses assets and liabilities that are recognized and measured at fair value, presented in a three-tier fair value hierarchy, as follows:

• Level 1. Observable inputs such as quoted prices in active markets;
• Level 2. Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
• Level 3. Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

The assets acquired and liabilities assumed in the Pioneer Acquisition were valued at fair value on a non-recurring basis as of December 31, 2014. No assets or liabilities were valued at fair value on a non-recurring basis as of March 31, 2015 or June 30, 2014.

The carrying value of cash and cash equivalents, accounts payable short-term and long-term borrowings, as reflected in the consolidated balance sheets, approximate fair value because of the short-term maturity of these instruments or interest rates commensurate with market rates.

Assets and liabilities that are recognized and measured at fair value are categorized as follows:

Certain reclassifications have been made to prior period amounts to conform to classifications adopted in the current period.

In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30) which requires debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The Company elected to adopt this update as of March 31, 2015 and debt issuance costs related to a recognized debt liability are presented in the consolidated balance sheet as a direct deduction from the carrying amount of that debt liability. The update was adopted because management believes it provides a more meaningful presentation of its financial position. This change in accounting principle has been applied on a retrospective basis and the June 30, 2014 consolidated balance sheet has been adjusted to reflect the period specific effects of applying the new guidance. The retrospective application of this change in accounting principle did not have an impact on the June 30, 2014 consolidated balance sheet as the Company did not have debt issuance costs at that date. The adoption of this change in accounting principle on the March 31, 2015 consolidated balance sheet reduced debt issuance costs of $1,272,676 which were previously presented as a long-term asset, and reduced the carrying value of the convertible notes by the same amount. The adoption did not have an impact on the Company's consolidated statement of operations.

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NOTE 3 - BUSINESS COMBINATIONS

On December 31, 2014, the Company purchased certain alfalfa research and production facilities and conventional (non-GMO) alfalfa germplasm assets (and assumed certain related liabilities) of DuPont Pioneer. The acquisition expanded the Company's production capabilities, diversified its product offerings and provided access to new distribution channels.

The Pioneer Acquisition was consummated pursuant to the terms of an asset purchase and sale agreement. The purchase price under the Agreement was up to $42,000,000, consisting of $27,000,000 in cash (payable at closing), a three year secured promissory note (the "Note") payable by the Company to DuPont Pioneer in the initial principal amount of $10,000,000 (issued at closing), and a potential earn-out payment (payable as an increase in the principal amount of the Note) of up to $5,000,000 based on S&W sales under distribution and production agreements as well as other Company sales of products containing the acquired germplasm in the three-year period following the closing. The Note accrues interest at a rate of 3% per annum and interest will be payable in three annual installments, in arrears, commencing on December 31, 2015. Principal on the Note is payable at maturity on December 31, 2017.

The Pioneer Acquisition has been accounted for as a business combination, and the Company valued and recorded all assets acquired and liabilities assumed at their estimated fair values on the date of the Pioneer Acquisition.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the acquisition data of December 31, 2014:

The fair value of intangibles assets, their useful lives and other items are provisional at March 31, 2015.

The acquisition-date fair value of the consideration transferred consisted of the following:

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The current liabilities assumed relate to inventory acquired in the acquisition. Subsequent to December 31, 2014, the Company determined that at the acquisition date, the seller had already paid the third party growers $9,688,881 for the inventory acquired in the acquisition. As a result, the carrying amount of the current liabilities assumed was retrospectively decreased by $9,688,881 on December 31, 2014, due to this new information, with a corresponding increase to the acquisition-date fair value of the consideration transferred. In addition, subsequent to the issuance of the December 31, 2014 financial statements, the Company obtained final support to adjust the estimates previously made on inventory purchases and grower payables assumed as well as acquired property, plant and equipment. The excess of the purchase price over the fair value of the net assets acquired, amounting to $10,467,735, was recorded as goodwill on the consolidated balance sheet. Goodwill is not amortized for financial reporting purposes, but is amortized for tax purposes.

Management assigned fair values to the identifiable intangible assets through a combination of the relief from royalty method and the multi-period excess earnings method. The contingent consideration requires the Company to increase the principal amount of the Seller note by up to an additional $5,000,000 if the Company meets certain performance metrics during the three year period following the acquisition. The fair value of the contingent consideration arrangement at the acquisition date was $2,200,000. The fair value of the contingent consideration was estimated using a probability-weighted cash flow model. The fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement. The key assumptions in applying the income approach were as follows: 12% present value discount factor and probability adjusted revenue assumptions based on the number of expected units produced. As of March 31, 2015, there were no significant changes in the range of outcomes for the contingent consideration recognized as a result of the acquisition.

The values and useful lives of the acquired DuPont Pioneer intangibles are as follows:

The Company incurred $831,737 of acquisition costs associated with the Pioneer Acquisition that have been recorded in selling, general and administrative expenses on the consolidated statement of operations.

In the transaction, DuPont Pioneer retained ownership of its GMO (genetically modified) alfalfa germplasm and related intellectual property assets, as well as the right to develop new GMO-traited alfalfa germplasm. The retained GMO germplasm assets incorporate certain GMO traits that are licensed to DuPont Pioneer from third parties (the "Third Party GMO Traits"). The Company was interested in acquiring the GMO assets at the time it acquired the conventional (non-GMO) alfalfa seed assets, and DuPont Pioneer was interested in selling those assets, but terms could not be agreed-upon, in part because of the need for agreements with the third parties from whom the Third Party GMO Traits are licensed.

The agreements related to the Pioneer Acquisition provide that both the Company and DuPont Pioneer will work towards obtaining the necessary consents from and agreements with third parties such that the GMO assets can be transferred from DuPont Pioneer to the Company. If such consents and agreements are obtained before November 30, 2017, the Company has committed to buy and DuPont Pioneer has committed to sell the GMO assets at a price of $7,000,000 on or before December 29, 2017.

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The following unaudited pro forma financial information presents results as if the Pioneer Acquisition occurred on July 1, 2013.

For purposes of the pro forma disclosures above, the adjustment for the three months ended March 31, 2015 includes the elimination of acquisition and financing related charges of $111,106, and adjustments to reflect the additional income tax expense assuming a combined Company's effective tax rate of -108.7%. Refer to Management's Discussion and Analysis of Financial Condition and Results of Operations for further discussion on the effective tax rate. The pro forma adjustments for the three months ended March 31, 2015 were nominal as the results of the Pioneer Acquisition are reflected in the Company's Statement of Operations for that period.

The primary adjustments for the three months ended March 31, 2014 include: (i) the reduction of DuPont Pioneer historical revenue to reflect the shift from end customer to wholesale pricing; (ii) the reduction of cost of revenue to remove DuPont Pioneer's historical sales incentives included in cost of sales; (iii) amortization of acquired intangibles of $245,950; (iv) depreciation of acquired property, plant and equipment of $25,824; (v) additional interest expense on the convertible notes issued concurrent to the acquisition, including non-cash amortization of debt issuance costs and accretion of debt discount of $1,306,563; (vi) additional interest expense of $75,000 for the promissory included in total consideration for the Pioneer Acquisition; and (vii) adjustments to reflect the additional income tax benefit assuming a combined Company's effective tax rate of 42.1%.

For purposes of the pro forma disclosures above, the primary adjustments for the nine months ended March 31, 2015 include: (i) the reduction of DuPont Pioneer historical revenue to reflect the shift from end customer to wholesale pricing; (ii) the reduction of cost of revenue to remove DuPont Pioneer's historical sales incentives included in cost of sales; (iii) the elimination of acquisition and financing related charges of $1,256,170; (iv) amortization of acquired intangibles of $491,900; (v) depreciation of acquired property, plant and equipment of $51,648; (vi) additional interest expense on the convertible notes issued concurrent to the acquisition, including non-cash amortization of debt issuance costs and accretion of debt discount of $1,083,756; (vii) additional interest expense of $150,000 for the promissory included in total consideration for the Pioneer Acquisition; and (viii) adjustments to reflect the additional income tax expense assuming a combined Company's effective tax rate of 24.4%.

The primary adjustments for the nine months ended March 31, 2014 include: (i) the reduction of DuPont Pioneer historical revenue to reflect the shift from end customer to wholesale pricing; (ii) the reduction of cost of revenue to remove DuPont Pioneer's historical sales incentives included in cost of sales; (iii) amortization of acquired intangibles of $737,850; (iv) depreciation of acquired property, plant and equipment of $77,472; (v) additional interest expense on the convertible notes issued concurrent to the acquisition, including non-cash amortization of debt issuance costs and accretion of debt discount of $4,865,885; (vi) additional interest expense of $225,000 for the promissory included in total consideration for the Pioneer Acquisition; and (vii) adjustments to reflect the additional income tax expense assuming a combined Company's effective tax rate of 42.5%.

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NOTE 4 - INTANGIBLE ASSETS

Intangible assets consist of the following:

Amortization expense totaled $464,044 and $234,622 for the three months ended March 31, 2015 and 2014, respectively. Amortization expense totaled $931,705 and $711,646 for the nine months ended March 31, 2015 and 2014, respectively. Estimated aggregate remaining amortization is as follows:

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NOTE 5 - PROPERTY, PLANT AND EQUIPMENT

Components of property, plant and equipment were as follows:

Depreciation expense totaled $202,107 and $80,759 for the three months ended March 31, 2015 and 2014, respectively. Depreciation expense included in cost of revenue totaled $85,786 and $0 for the three months ended March 31, 2015 and 2014, respectively. Depreciation expense totaled $364,759 and $235,523 for the nine months ended March 31, 2015 and 2014, respectively. Depreciation expense included in cost of revenue totaled $85,789 and $0 for the nine months ended March 31, 2015 and 2014, respectively.

Total debts outstanding, excluding convertible debt addressed in Note 7, are presented on the consolidated balance sheet as follows: