Ceres gardening company funding growth in organic products case solution

________________________________________________________________________________________________________________ Professor John H. McArthur and writer Sunru Yong prepared this case specifically for the Harvard Business School Brief Case Collection. Though inspired by real events, the case does not represent a specific situation at an existing company, and any resemblance to actual persons or entities is unintended. Cases are developed solely as the basis for class discussion and are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2009 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

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Ceres Gardening Company: Funding Growth in Organic Products

Jonathan Wydown, CEO of the Ceres Gardening Company, scrutinized the figures presented by Annette O’Connell, vice-president of Marketing. It was December 2006, and the two were finalizing the firm’s marketing strategy and objectives for 2007. Having just received the latest industry report on growth and trends, they discussed the implications for Ceres (see Exhibit 1). O’Connell observed:

This report confirms what we believed—growth in organic gardening products is strong, and the trends should support long-term growth. And our own growth is outpacing the industry, especially since we launched the GetCeres™ program. We are clearly doing something right, and we’ve got to remain aggressive.

Wydown nodded. It was true that Ceres had shown impressive growth, increasing revenues by over 70% in just five years while growing profits by over 25% (see Exhibits 2 and 3; also see Exhibit 4 for additional information on finances). He had set ambitious goals for the company, and now they had to focus on executing the 2007 plan. O’Connell’s proposed marketing initiatives for 2007 included expanding the GetCeres™ marketing program, adding new products to the organic seedlings line, and pursuing a pilot program with Menards, a major do-it-yourself home center. Wydown set the report aside and said to O’Connell:

Annette, I agree we should pursue growth, but let’s be sure to think through all the implications. Expanding GetCeres™ and the Menards pilot will require additional marketing spend, plus attracting and training good sales talent. Adding new SKUs1 to the seedlings line opens up opportunities, but we have to be certain the supply chain can deal with the added complexity. We also need to think about the financing needed to drive this growth.

1 Stock Keeping Unit – essentially a different product.

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4017 | Ceres Gardening Company: Funding Growth in Organic Products

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History of Ceres Gardening Company

Jonathan Wydown founded Ceres Gardening Company in 1989 with a mission to promote sustainable organic gardens and landscapes. He had long been a proponent of soil preservation, biodiversity, and natural fertilizers and pest control. Reflecting on the early days of the business, Wydown recalled:

I was confident that the same principles behind organic farming would eventually apply to home gardens and lawns. I believed that consumers would start to recognize the value of avoiding genetically modified seeds and synthetic fertilizers, and I wanted to build a business that was consistent with my own convictions.

Under Wydown’s leadership, Ceres developed a selection of certified organic seeds and seedlings for vegetables, culinary herbs, and flowers.

Ceres’s principal farm was located in central California. As the business grew, Ceres expanded its product offerings to include more open-pollinated, organically grown, and heirloom varieties. The company also added live plants, such as one-year-old fruit trees. Customer demands quickly exceeded Ceres’s capacity, so Wydown developed a network of small, independent organic farms, offering them a commitment to purchase goods in exchange for an exclusive supplier relationship.

Sales and profits grew steadily through the late 1990s and early 2000s. Wydown took Ceres public as a microcap in 1999, giving the early investors an exit opportunity. He was particularly gratified when a number of Ceres’s independent suppliers and key dealers became shareholders. Wydown commented:

The notion of “doing well by doing good” is not an easy one to execute. Getting a unique concept like ours to the next stage requires everyone involved—not just Ceres employees—to believe in the cause. It meant a lot that many of our stakeholders demonstrated their confidence by investing in us. It was a testament to the strong relationships we knew would ultimately drive our success. We are all part of something special, and it’s satisfying to see the stock market recognizing the potential of this model (see Exhibit 5).

Channel Strategy

In the early years, Ceres operated primarily as a mail-order catalog company. The company shipped vegetable and flower seeds to gardeners across the United States. Although certified organic products were significantly more expensive, Ceres developed a loyal following that valued its quality, reliability, and hands-on customer service. A free, bimonthly company newsletter provided gardening tips, introduced new products, and created a sense of community among the expanding customer base.

In addition to the direct business, Ceres had developed a modest retail presence in the early 1990s. The company focused its initial efforts on independent nurseries and garden centers in the northern California region. As interest in organic gardening grew in the late 1990s, Ceres expanded distribution to retailers through much of the western United States. As more garden centers and nurseries demonstrated a willingness to carry organic products, Wydown shifted company resources accordingly, recognizing that sales through the retail channel could overtake the slow, steady growth of the direct business.

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Whereas the direct catalog and online business primarily served serious gardeners who tended to purchase seeds, casual consumers who purchased their gardening materials at nurseries tended to prefer seedlings (seeds recently sprouted) and more-developed plants. Wydown explained:

The serious gardeners are happy to buy seeds online and get exactly what they want. These consumers already know about Ceres and we value them deeply, but this segment will grow relatively slowly. We believed we would see faster growth among the casual hobbyists who like gardening and like the idea of organics. This segment prefers to buy seedlings or one-year old plants, which are much easier to grow. They are also more likely to buy at a local nursery or garden center where there’s someone to explain what to buy and how to care for it.

Ceres’s early investment in building a seedling and live-plant business gave the company an advantage in capturing the growing retail opportunity.

Building the Retail Business

Despite strong company growth through 2002, management doubted that Ceres was benefiting fully from the organic gardening trend. The company believed that the rapid growth of organic groceries and farmers’ markets was an important leading indicator for home gardening. Market research indicated that many gardeners considered themselves “definitely” or “very likely” to switch to organic. Although Ceres’s direct business remained steady, Wydown sought to accelerate penetration into the retail channel and recognized that his management team lacked the right experience. At the end of 2002, he hired Annette O’Connell as VP of Marketing, believing that Ceres needed her background in retail and consumer-packaged goods.

Aiming to establish itself ahead of its competition, Ceres began aggressively adding new accounts. Other than mass merchandisers and home centers such as Home Depot and Lowe’s, there were approximately 10,000 nurseries and garden centers in the United States. Wydown and O’Connell were confident that Ceres’s reputation for quality and customer service would give the company an advantage over other players. Their biggest challenge, they believed, was that its distribution system had not been developed adequately outside the western U.S., and many of its dealers outside the company’s core region tended to be poorly stocked.

This situation launched a new phase in Ceres’s development. By early 2004 the company had added a new farm and distribution center in Lancaster County, Pennsylvania. At O’Connell’s urging, the company expanded its sales force and added many independent sales representatives. The sales force concentrated mainly on training dealers on how to effectively sell Ceres organic seeds, seedlings, and live plants, which were often 30% to 50% more expensive than conventional products. Ceres also restructured compensation for the sales force to include generous bonus payments for adding a new account or expanding Ceres’s shelf space2 within an existing account. Meanwhile, the product development team continued to commercialize a vast array of new organic seedlings. The tomatoes product line alone grew to 53 seed and 14 seedling varieties.

This strategy led to significant revenue increases through 2004, with growth coming largely from new retail accounts. Even so, the management team questioned if its marketing efforts were sufficient. The prevalence of privately held competitors meant that market data was spotty, but Wydown estimated that organic gardening had grown at 8% to 10% per year. This meant that Ceres had merely kept pace with the overall industry. Further, some major gardening supply companies, such as Burpee Seeds, had moved beyond conventional seeds and begun competing with Ceres in 2 “Shelf space” is a commonly used term in retail industries for how much space (on the floor, shelf, or rack) a vendor has relative to other competitors and products.

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4 BRIEFCASES | HARVARD BUSINESS SCHOOL

select organic lines. Wydown and O’Connell concluded that the best way for Ceres to build its competitive position would be to push even more aggressively to enlarge its dealer base.

The GetCeres™ Program

Wydown and O’Connell believed the key to rapid growth was to enable the average nursery or garden center to stock a sufficient inventory of Ceres’s organic products. They knew that a large percentage of retail sales took place on four or five weekends each season. If a retailer ran out of organic seedling stock at those times, the customer would not return later—Ceres lost the sale entirely. O’Connell said:

The challenge is having plenty of the right product in the store at the right time. Casual gardeners may be interested in organics when they walk in, but they are ready to plant that weekend. They don’t want to deal with sowing seeds in a tray indoors just to grow seedlings—it’s Saturday, and they want to be out in their garden! Depending on what they want to grow, it may even be too late in the season to do anything but plant seedlings. Frankly, these consumers are happy to buy conventional seedlings or live plants if our product is not there.

Unfortunately, many of the newer dealers had approached organic gardening conservatively, limiting their space allocation by carrying seeds rather than seedlings for the casual gardener. This approach did not surprise Wydown. As small, independent businesses, most dealers faced working capital constraints and could not significantly increase inventory without additional financing. They were cautious about a relatively unproven product from Ceres, particularly when the higher price point of organic seedlings meant even more dollars would be tied up in inventory.

It was industry practice to extend seasonal credit terms of 75 or 90 days to dealers.3 Payment for early spring shipments was due in early summer, and payment for summer shipments was due in late fall. The purpose was to encourage nurseries and garden centers to be fully stocked in advance of peak seasonal demand. But regardless of the stated terms of sale, many dealers did not pay for product until they had sold it, and dealers often asked for extensions of their payment terms. Ceres’s experience was that payment was received no later than 120 days after shipment. Seasonal dating alone did not lead to increased sales, but the practice was a prerequisite to serve the retail channel.

Wydown and O’Connell believed Ceres would have to provide additional financing for dealers to reach the targeted inventory buildup. Hence Ceres entered the 2005 season with a new tactic to accelerate growth in the retail channel: the GetCeres™ Program (see Exhibit 6). The company provided even greater discounting and payment terms. New dealers received a 15% discount for a minimum stock order, while existing dealers received the same discount for seedling and live plant purchases exceeding the level of the prior year’s purchases. For such purchases, both new and existing dealers received 120-day payment terms. To protect average gross margins, Ceres successfully raised prices slightly on most of its products.

The GetCeres™ program was based on market research and informal feedback gathered from the sales force. Wydown and O’Connell concluded the company had to become more aggressive to gain share and strengthen its competitive position. O’Connell explained:

3 “Seasonal dating” is a method of extending credit to customers based on seasonal sales patterns instead of a fixed number of days between delivery and collection.

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We believed deeply in our product’s ability to sell-through4 once we got it to the dealers. GetCeres™ offered very compelling terms to encourage dealers to stock abundantly. We were missing many sales because dealers were too conservative about inventory. GetCeres™ galvanized the sales force, particularly our team of independent sales reps. It made the buying decision much easier for small dealers. Our success in the first year was fantastic, and 2006 has been even better. The retail channel now accounts for over 80% of total revenues. We are still adding new dealers more slowly than we would like, but we know our success with current customers is generating great word-of-mouth and positions us for growth in the years to come.

Financing Company Growth

GetCeres™ accounted for approximately 25% of total sales in 2005, and 35% in 2006. The growth in accounts receivable was financed by a revolving line of bank credit, subordinated notes, and increased use of vendor financing from Ceres’s network of independent farm suppliers. Ceres had a $4.5 million revolving credit facility with a commercial bank. As of December 2006, Ceres carried no balance on this revolver. The purpose of the revolver was to cover seasonal funding needs in the spring and summer months, and since 2001 the maximum credit line had been used at some point each year.

At the end of 2006, Ceres had approximately $9 million of long-term debt repayable over 10 years. The debt covenants limited the company’s maximum long-term debt (excluding the revolving credit facility) to no more than 3.25 times earnings before interest, taxes, depreciation, and amortization (EBITDA). Further, the agreement required the company to be free of bank debt for 60 consecutive days each year and to maintain an EBITDA-to-fixed-financial-charges (defined as interest and long- term leases) ratio of at least 2.0 times (see Exhibit 4).

With respect to its accounts payable, Ceres had extended payment terms from 75 days to 90 days with most of the independent farms in its supplier network. Wydown had negotiated these terms by convincing the suppliers that helping Ceres establish a strong market position in organic gardening would guarantee consistent business in future years. The balances on the accounts payable were carried at no interest. However, Wydown was concerned that increasing these terms any further would likely result in increased costs going forward, putting pressure on margins.

Evaluating Next Steps

While fiscal year 2006 was not yet complete, Wydown and his team were happy with Ceres’s performance and the results of the GetCeres™ program. Wydown reviewed a pro-forma report from the company treasurer showing that company sales had increased from $35.1 million in 2005 to an estimated $42.6 million in 2006—approximately 80% of which were sales to dealers. Based on limited sell-through estimates from the sales force, dealer inventories were approximately $23 million at the end of 2006, compared with $10 million in the prior year. Wydown was comfortable with the company’s financial viability, with the breakeven point at approximately $30 million of revenues under the current cost structure.5

Setting aside the financial report, Wydown glanced at his “to do” list. First, he needed to prepare a motivational opening speech for the mid-January sales meeting. Ceres’s growth was exciting, but it

4 In the retail industry, “sell-through” refers to the sale by the retailer to the end consumer. “Sell-in,” on the other hand, is the sale by the vendor to the retailer. 5 Wydown’s breakeven analysis assumed that all Cost of Goods Sold are variable costs, but that Sales, General & Administration, Research & Development, Depreciation & Amortization, and Interest Charges are all fixed costs.

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would be important to build on the momentum. Second, the bank had asked to meet regarding Ceres’s growth prospects and cash flow projections for 2007 and beyond. It looked to be a very full day.

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0

20

40

60

80

100%

2006

Definitely Not

Unlikely

Do not know

Very Likely

Definitely

If you do not carry significant organic gardening products now, do you expect to add them in the next 1-2 years?

0

100

200

300

400

$500M

20 02 20 03 20 04 20 05

20 06 E

20 07 P

20 08 P

(02-06) (06-08)

Retail Purchases, Organic Gardening Consumables ($M)

8.2%

CAGR

9.5%

Exhibit 1 Excerpts from 2006 Organic Gardening Market, Industry Report

Key Industry Trends

• Increasing health consciousness and desire to avoid pesticides and genetically modified produce

• Aging baby boomer population showing greater interest in gardening

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4017 | Ceres Gardening Company: Funding Growth in Organic Products

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Exhibit 2 Consolidated Balance Sheets, 2002-2006E ($ thousands; some numbers are rounded)

At December 31 2002 2003 2004 2005 2006E

Assets Cash $ 705 $ 1,542 $ 1,818 $ 2,158 $ 1,955 Accounts Receivable 3,485 4,405 6,821 10,286 14,471 Inventories 3,089 2,795 3,201 3,291 3,847

Current Assets 7,279 8,742 11,839 15,735 20,273

Plant, Property, & Equipment (net) 2,257 2,680 2,958 3,617 4,347 Other Assets 645 645 645 645 645 Land 450 1,750 2,853 2,853 2,853

Non-Current Assets 3,352 5,075 6,456 7,115 7,844 Total Assets $ 10,631 $ 13,817 $ 18,295 $ 22,850 $ 28,117 Liabilities & Shareholders Equity

Accounts Payable $ 2,034 $ 2,973 $ 4,899 $ 6,660 $ 9,424 Current Portion of Long-term Debt 315 352 525 730 649

Current Liabilities 2,349 3,325 5,423 7,390 10,074

Long-Term Debt 3,258 4,400 5,726 7,123 8,480 Shareholders’ Equity 5,024 6,091 7,146 8,336 9,563

Total Liabilities & Shareholders Equity $ 10,631 $ 13,817 $ 18,295 $ 22,850 $ 28,117

Exhibit 3 Consolidated Income Statements, 2002-2006E ($ thousands)

For Years Ending December 31 2002 2003 2004 2005 2006E

Sales $ 24,652 $ 26,797 $ 29,289 $ 35,088 $ 42,597 Cost of Goods Sold 20,461 21,706 23,841 28,597 35,100

Gross Profit 4,191 5,091 5,448 6,491 7,497

General & Administrative Expense 1,999 2,138 2,372 2,877 3,578 Research & Development 203 203 212 222 232 Depreciation & Amortization 347 412 455 557 669

Earnings before Interest & Taxes 1,641 2,338 2,408 2,836 3,018

Interest 187 349 440 547 658 Earnings before Taxes 1,454 1,989 1,968 2,289 2,360

Taxes 264 696 689 801 826 Net Income $ 1,191 $ 1,293 $ 1,279 $ 1,488 $ 1,534

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Exhibit 4 Notes to Financial Statements, December 31, 2005

(a) 2005 Auditor’s Statement

The Board of Directors Ceres Gardening Company Kerman, California

We have examined the statement of consolidated financial position of Ceres Gardening Company as of December 31, 2005, and the related statements of consolidated operations, capital surplus, and retained earnings for the year then ended. Our examination was made in accordance with generally accepted auditing standards, and accordingly includes such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances.

In our opinion, the accompanying statements of financial position, operations, capital surplus, and retained earnings present fairly the consolidated financial position of Ceres Gardening Company at December 31, 2005, and the consolidated results of their operations for the year then ended, in conformity with generally accepted accounting principles which have been applied on a basis consistent with that of the preceding year.

Takazawa & Peng San Francisco, CA March 10, 2006

(b) Sales and Accounts Receivable

Sales are stated net of $871,000 for dealer adjustments and allowances. In 2005, the company adopted a plan of deferred payments for retail dealers operating under the GetCeres™ program. Accounts receivable at December 31, 2005 include $3,450,778 for shipments under this plan.

(c) Long-Term Leases

The main production, warehousing and office facilities used by the company in the Lancaster, PA, location and the distribution center in Fulton, MO, are leased under long-term agreements. These leases, all having over 10 years to run, required minimum annual rentals in fiscal 2005 of $965,000. It is anticipated that the fixed rentals under these leases will approximate the same amount in subsequent years.

(d) Long-Term Debt: Ten-Year Promissory Notes

The notes mature on October 31, 2021 and bear interest at 7.75% per annum. The loan agreement provides that (a) payment of principal may only be made when there is no outstanding balance on the revolving credit facility,a (b) provided no event of default had occurred, elections may be exercised annually by the holders to exchange the notes currently held for new notes having a maturity extended by one year for an additional period of five years, bringing the maximum maturity on the notes to 2017. The debt covenants for these notes limit the company’s maximum long-term debt at any time to an amount not greater than 3.25 times the company’s Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA). In addition, the agreement requires the company to generate EBITDA no less than 2.0 times its fixed financial charges (calculated as interest on debt and rentals on leased properties). Finally, the company is required to be free of bank debt for 60 consecutive days each year.

a This is the $4.5 million facility referenced in the case.

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Exhibit 5 Earnings, Dividend, and Stock Price Performance

Stock Price Performance 2002 2003 2004 2005 2006E

Share Price, End of Year $ 4.11 $ 6.21 $ 6.41 $ 8.01 $ 9.49 Shares Outstanding (Millions) 3.0 3.0 3.0 3.0 3.0 Dividends / Share $ - $ 0.08 $ 0.07 $ 0.10 $ 0.10 Dividend Yield 0.0% 1.2% 1.2% 1.2% 1.1% EPS $ 0.40 $ 0.43 $ 0.43 $ 0.50 $ 0.51

Exhibit 6 GetCeres™ Program, Excerpt from New Account Agreement

The undersigned Dealer and Ceres Gardening Company (Ceres) agree to participate in the GetCeres™ inventory financing program for 2006 according to the following terms:

1. Dealer agrees to purchase a GetCeres™ stock order, as described in the appendix below, consisting of a standard retail assortment of organic seeds, seedlings, and live plants. a. Dealer must accept no fewer than two replenishment deliveries during 2006. b. Orders cannot be less than the GetCeres™ minimum stock order. c. Dealer may purchase quantities greater than the GetCeres™ stock order under the same

discount and payment terms.

2. Ceres will extend a 15% discount for all product purchased under the program in 2006.a

3. Ceres will extend 120-day payment terms for all product purchased under the program in 2006. Full payment is due 120 days from the delivery date.

a This discount was offered only on incremental sales, compared to the previous year for existing customers.

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