The normal products of the murine Steel (Sl) and Dominant white spotting (W) genes are essential for the development of melanocyte precursors, germ cells, and hematopoietic cells. The Sl locus encodes stem cell factor (SCF), which is the ligand of c-kit, a receptor tyrosine kinase encoded by the W locus. One allele of the Sl mutation, Sl17H, exhibits minor hematopoietic defects, sterility only in males, and a complete absence of coat pigmentation. The Sl17H gene encodes SCF protein which exhibits an altered cytoplasmic domain due to a splicing defect. In this paper we analyzed the mechanism by which the pigmentation phenotype in Sl17H mutant mice occurs. We show that in embryos homozygous for Sl17H the number of melanocyte precursors is severely reduced on the lateral neural crest migration pathway by e11.5 and can no longer be detected by e13.5 when they would enter the epidermis in wildtype embryos. The reduced number of dispersing melanocyte precursors correlates with a reduction of SCF immunoreactivity in mutant embryos in all tissues examined. Regardless of the reduced amount, functional SCF is present at the cell surface of fibroblasts transfected with Sl17H mutant SCF cDNA. Since SCF immunoreactivity normally accumulates in basolateral compartments of SCF-expressing embryonic epithelial tissues, we analyzed the localization of wildtype and Sl17H mutant SCF protein in transfected epithelial (MDCK) cells in vitro. As expected, wildtype forms of SCF localize to and are secreted from the basolateral compartment. In contrast, mutant forms of SCF, which either lack a membrane anchor or exhibit the Sl17H altered cytoplasmic tail, localize to and are secreted from the apical compartment of the cultured epithelium. We suggest, therefore, that the loss of melanocyte precursors prior to epidermal invasion, and the loss of germ cells from mature testis, can be explained by the inability of Sl17H mutant SCF to be targeted to the basolateral compartment of polarized epithelial keratinocytes and Sertoli cells, respectively.