It’s a safe bet that most Americans have drank coffee from Farmer Bros. Co. (FARM, Financial), a national coffee roaster, wholesaler and distributor of coffee, tea and other culinary products. The company serves a varied range of customers, including small and large restaurants, department and convenience store chains, hotels, casinos, health care facilities and gourmet coffee houses. The company also distributes to grocery chains with private brand and consumer-branded coffee and tea items. Farmer Bros. also offers value-added services such as industry market insights, beverage planning and equipment placement and service.
Brands used by the company include Farmer Brothers, Artisan Collection by Farmer Brothers, Superior, Metropolitan, China Mist and Boyds. Artisan coffee products include Direct Trade, Project D.I.R.E.C.T., Fair Trade Certified and Rainforest Alliance Certified.
The company has a history dating back over 100 years, has been public since 1952 and currently has a $129 million market capitalization.
Coffee industry
The coffee industry has an addressable market worth over $76 billion and is growing 3% to 5% on an annual basis. Almost two-thirds of Americans drink coffee every day. The specialty coffee area is one of the fastest-growing segments as the refrigerated ready-to-drink coffee segment grew over 40% in 2021. The industry is largely consolidated with high barriers to entry due to the coffee bean procurement process as well as large-scale roasting operations.
There is wide consensus that drinking coffee may be beneficial to your health. In one of the largest coffee studies ever done, nearly 383,000 men and women who were part of the U.K. Biobank, were tracked over 10 years. They found that drinking two to three cups of coffee a day lowered the risk for heart disease, stroke, heart arrhythmias and death from heart disease. They even found that dying from any cause was reduced by 10% to 15%.
Operational problems
Before 2019, the company had been mired in certain operational problems and inefficiencies. Farmer Bros. relocated from California to Texas in 2016, but the new Dallas-area facility lacked manufacturing capacity buildout. In 2017, the company acquired Boyd Coffee, which turned out to be a problematic purchase. The integration was not largely successful, which led to poor customer and sales performance along with excessive write-downs and expenses. The entire company then suffered from a deterioration of operating and free cash flow, causing liquidity issues. The stock declined from highs of $34 in 2017 to lows in the $3 range in the fall of 2020.
A new management team was put into place with two focuses: fixing the inefficient manufacturing and distribution footprint and optimizing operations to increase total output. This included exiting an inefficient facility in Houston and expanding the Dallas-area facility as well as reopening a West Coast distribution center. The company is also investing in technology and digital platforms and has opened e-commerce sites for four of its key brands.
Financial review
On Feb. 3, Farmer Bros. reported results for its second fiscal quarter of 2022, which ended Dec. 31. Although the company is not out of the woods yet in terms of returning to historical margins, the quarter showed solid improvement. Revenue increased 13.3%, largely due to a strong recovery from Covid-19-depressed results in the year-ago quarter. Gross margins improved to 29.5% from 25.1% in the prior year. Gross margins are still not up to prior-year levels in the 35% to 45% range. As a result, the company is still reporting low Ebitda levels and net losses.
For the six-month period ending Dec. 31, operating cash flow was a negative $8.6 million and capital expenditures were $5.9 million. Total debt (excluding capital lease obligations) was $91 million and cash equivalents totaled $3.6 million at year end. The management team is optimistic that most metrics are heading in the right direction and expect further improvement. However, inflationary headwinds and labor shortages may affect the turnaround plans in the near term.
Valuation
Analysts are predicting net losses for the current fiscal year ending June 30 as well as for the following year. Ebitda is very low at this time and not a relevant metric for valuation purposes. On a price-sales basis, Farmer Bros. is trading at only 28% of estimated 2022 fiscal year revenue. If historical margins can be achieved over the next three to five years, then the stock has tremendous upside.
Guru trades
Gurus who have purchased shares of FARM recently include Jim Simons (Trades, Portfolio)' Renaissance Technologies and Mario Gabelli (Trades, Portfolio). Gurus who have reduced their holdings include Chuck Royce (Trades, Portfolio) and Paul Tudor Jones (Trades, Portfolio).
Conclusion
I am optimistic with regards to the company’s turnaround plan and believe historical margins can be achieved over the next two to three years. The company appears to be undervalued using a discounted cash flow calculation, which takes into account future cash flows over the next 10 years. However, liquidity and debt issues need to be monitored closely until the company generates decent levels of free cash flow.
