Farmer Brothers Co. (Ticker: FARM on Nasdaq, $9.06 as of 9/12/2012), founded in 1912, is a manufacturer, wholesaler and distributor of coffee, tea and culinary products.  FARM was run as a family business despite having public shareholders.  With gross margins averaging over 60% for most of the Company’s history, it was able to offer its employees stable long-term employment with defined benefit pensions and superior healthcare plans.  The Company is now emerging from a difficult period due to poorly integrated acquisitions and spiking coffee prices with a leaner and more modern cost structure.  I believe an inflection point has been created and that an investment in FARM offers the opportunity to at least double in value due to business and management changes and a stabilized coffee price environment.  An investment in FARM also offers downside protection due to the Company’s ownership of properties that it purchased in the 1940’s, 1950’s and 1960’s at prices well below current market levels. 

Headquartered in Torrance, California, FARM manufactures multiple brands of coffee, teas and spices out of their production facilities in Torrance, CA, Houston, TX and Portland, OR.  FARM is a direct distributor of coffee to restaurants, hotels, casinos, hospitals and other foodservice providers as well as being providers of private brand coffee programs to grocery retailers, restaurant chains, convenience stores and independent coffee houses.  FARM services its customers through 500 delivery routes, 117 (51 owned) branch warehouses and 6 (3 owned) distribution centers.  For many accounts, FARM offers value-added services including beverage equipment service, menu solutions and inventory management.  National accounts are offered a menu of services including private brand development, green coffee procurement, category management, and supply chain management.

FARM manufactures and distributes products under its own brands, as well as under private labels on behalf of certain customers. FARM’s branded products are sold primarily into the foodservice channel, and are comprised of both national and regional brands. National foodservice brands include The Artisan Collection by Farmer Brothers™, Farmer Brothers®, Superior®, Metropolitan®, Island Medley Iced Tea®, Farmer Brothers Spice Products™, Sierra Tea™ and Orchard Hills Estate™.  Regional food service and retail brands include Cain's®, Ireland® and McGarvey®.

FARM has a product line of over 3,000 SKU's “Stock Keeping Units” (excluding private label), which includes roasted coffee, liquid coffee, coffee-related products such as coffee filters, sugar and creamers, assorted teas, cappuccino, cocoa, spices, gelatins and puddings, soup bases, gravy and sauce mixes, pancake and biscuit mixes, and jellies and preserves. For the past three fiscal years, sales of roasted coffee products represented approximately 50% of its total sales and no single product other than roasted coffee accounted for more than 10% of FARM’s total sales.

FARM has over 39% of its common shares held by the founding Farmer family.  The founder’s son Roy F Farmer controlled the company from the 1950’s until he died in 2004.  Then his son briefly took the reins until he committed suicide in January of 2005.  Since then, FARM has been run by outsiders and the family currently has only one position on the board with no members in the executive team.  You can read more about FARM’s history here:
http://www.referenceforbusiness.com/history2/14/Farmer-Bros-Co.html

In the mid-2000’s, FARM was losing market share due to the shift towards the consumption of  premium coffee made by companies like Starbucks (SBUX) and Peet’s Coffee (PEET).  To offset this issue, FARM acquired specialty coffee roaster Coffee Bean International in 2007 for approximately $22 million.  While this gave them entry into this market, FARM was still just servicing the western part of the United States.  In 2009, FARM solved this shortcoming by acquiring Sara Lee’s (SLE) direct to store distribution (DSD) Foodservice coffee unit for $45 million which expanded the coverage to a national footprint.  Unfortunately, FARM had difficulty fusing the two large acquisitions into its culture and systems. This lead to the firing of the management team that undertook the transactions and the elimination of the dividend.

FARM had traditionally distributed dividends to shareholders, including an ESOP (Employee Stock Ownership Program) which used the dividends to pay off a loan from the Company to buy approximately 16% of the shares.  Dividends increased steadily over time to 46 cents per share in 2010.  However, in the quarter ending in December of 2010, FARM lowered the quarter’s dividend to 6 cents per share, and then subsequently eliminated it in the following quarter.  It has been nearly 2 years since the Farmer family has received any dividends from FARM and it is logical to assume that they have been putting pressure on the Board to do what’s necessary to be able to re-implement the dividend.  FARM’s Board of Directors has replaced senior management and has pressured them to bring business practices into modern times. 

FARM’s new management has been decreasing General and Administrative “G&A” as well as Selling expenses since the dividend cut.  G&A has gone from a $13 million level per quarter in 2010 and 2011 to the mid $9 million level per quarter presently.  The company has frozen two of its pension plans and in December 2011 took a $4.3 million pension withdrawal expense to withdraw from one of its pension plans.  FARM has cut its expenditures to retired employees by reducing what it covers for post-retirement benefits. Finally, FARM will have a decrease of nearly $6 million in annual depreciation expense coming off its books at the end of fiscal 2013 from $25 million in improvements it made to the Portland facility to increase the amount of roast premium coffee it can roast in 2007.  These improvements will aid the company as it looks to achieve profitability.

The many operational improvements that the new management team has already implemented have not yet shown up in FARM’s bottom line. This is due to a very sharp and sudden increase in the price of its largest raw material: coffee.  Here is the link to a chart dating back to 1997 (as of 9/13/2012) for the Columbia Milds New York Coffee Index.

Note:  I apologize, but I was not able to upload my charts and tables to this post.  Instead I have links to those items.
Link:Chart of COFECMNY from 1997 to present. Trend line added for illutrative purposes.
Source: Bloomberg and http://www.ico.org/coffee_prices.asp

The cost of coffee affects the gross margin of FARM immensely.  FARM and many other coffee service and distribution companies have had a difficult time passing on price increases to their customers on a timely basis.  To control the short-term risk, FARM utilizes a hedging strategy.  The strategy is to lock in nearly all coffee prices 3 months in advance since it is difficult to pass price increases onto customers quickly.  FARM hedges a bit less for a 6-month time period and continues to decrease the amount it hedges in 3 month increments up to a total of 18 months.  The bulk of the hedging is done for less than 6 months.  Large institutional coffee accounts pay for the cost of hedging done for their benefit, which amounts to about 20% of the overall hedging program.

I believe that coffee prices will largely remain stable over the next 1 to 2 years for the following reason.  When agricultural commodities have price spikes similar to the one experienced by coffee, which are not caused by extraneous factors like price fixing, farmers tend to respond by planting more acreage of that product.  Therefore, trees (coffee trees take 3 to 4 years to start bearing fruit {source: http://www.ico.org/harvest_e.asp) which were planted during the 2010-2011 price spike will begin producing harvestable beans for coffee in 2013 and 2014.  The last peak of coffee prices in the mid-90’s also led to a boom in coffee farming, particularly in Vietnam,  which sent prices to a record low about 5-years later.  As evidence to currently support this, here is the link to a chart showing Vietnam’s coffee growing area and production:

Link:Vietnam's Coffee Growing Area and Production Chart

Also, if you consider the trend line that I added to the first Coffee Index chart above, you will see that prices have roughly returned to trend and may be due to spend some time below trend given the excesses for the past two years.

From the end of 2008 to the middle of 2011 the price of coffee went from below $1.50 per pound to over $3.00 per pound.  During that same time period, FARM’s gross margins dropped from 48% to 22%.  The decline over the last year in coffee prices has allowed FARM to increase its gross margins back to 38% in the last quarter ending in June.  To try and predict how gross margins depend on the price of coffee, I charted FARM’s gross margins each quarter since fiscal year 2003 and the price of the coffee index shown above. Note that it is the sharp spikes in the index that most negatively affect gross margins. With more stable pricing (and the integrations of the acquisitions) margins should easily return to the mid to high 40s, as in the 2008 period.   Here is a link to a chart comparing the coffee index to FARM’s gross margins:

Link: Coffee Index vs. FARM Gross Margins

Now that I have covered the cost side of FARM, it is time to discuss growth opportunities.  At their January presentation at the ICR conference, FARM management disclosed that they have been aggressively pursuing national accounts now that they have a footprint that can service this customer base.  They had mentioned a couple of wins in the hospitality industry as evidence that this effort is beginning to take root.  Now, I have found internet message boards indicating that FARM has won a contract to supply McDonalds (MCD) with coffee.  This rumor is backed up by FARM’s 2012 10-k which adds QSR’s “Quick-Service Restaurant” as a specific type of customer which was not stated in FARM’s 2011 10-k.  Based on information from Coffee Habitat’s website (http://www.coffeehabitat.com/2009/08/mcdonalds-coffee/) it would make sense that FARM could replace Gaviña Gourmet Coffee’s contract as they are also based in Southern California. MCD’s website states that “McDonald’s customers enjoy over 400 million cups of Gaviña coffee a year.”
Source: http://www.mcdonalds.com/us/en/food/food_quality/see_what_we_are_made_of/meet_our_suppliers/gavina_gourmet_coffee.html
Depending on the quality of the coffee and how strongly it is brewed, one pound of coffee provides between 35 and 45 cups of coffee.  Creating a matrix (see table below) with FARM selling their roasted, ground and packaged wholesale coffee to MCD at $4 to $5 per pound with a gross margin of 30% would equate to an additional $36 to $57 million in additional revenues and $11 to $17 million of gross margin annually.  The bulk of this gross margin would go directly to FARM’s bottom line as MCD has its own distribution systems. 

Link: McDonald's Potential Impact for FARM Matrix

In addition to a potential McDonald’s deal, FARM has introduced a new premium line of coffee which was made available this past August called the Artisan Collection.  They presented it at the National Restaurant Association Show 2012 and demonstrated that they can produce specialty coffee at scale which allows them to provide a high-quality coffee into their nationwide DSD network.  The margins for their premium product will be higher than their traditional coffee products that they sell in the DSD network.

In addition to the business turnaround at FARM, there is substantial hidden value in its real estate holdings.  As of 6/30/2012, FARM owned 54 total properties.   FARM valued their buildings and facilities at $78.6 million before depreciation and land at $9.2 million.  Farm’s Los Angeles based headquarters is in Torrance California, approximately 50,000 square feet in size and has an assessed value for tax purposes of just over $21 million.  This value arises from its assessment in 1981 with maximum legally allowable 2% annual increases.  Needless to say this probably understates the property’s real value by a considerable amount.  A slightly smaller warehouse nearby at 19515 S Vermont Avenue, Torrance, CA 90502 sold on 8/22/2012 for $27.9 million; however the lot size was only 2.65 acres compared to the 20.17 acre lot that is owned by FARM.  It is therefore likely that FARM’s headquarters in Torrance is valued well in excess of $50 million.  FARM owns a distribution center in Oklahoma City that has a property tax appraisal of $3.7 million as well as one in Houston with a property tax appraisal of $3.6 million.  FARM also owns 51 other properties which were purchased in the 1940’s, 50’s and 60’s to act as branch offices.  I found property tax records for 4 of their properties (in Phoenix AZ, McAllen TX, San Antonio TX, and San Diego CA), which had an average assessed value of $715k.  Typically, property assessments are below actual market value.  This implies that FARM is sitting on real estate that is probably worth nearly as much as the stock trades for today.

The real estate that FARM owns allows it flexibility on how it creates value for the Farmer family and fellow shareholders.  In my conversations with management, they have indicated that the Company has integrated its acquisitions and has been looking to sell properties where there is overlap.  This should have the dual impact of increasing cash and lowering expenses as these properties are sold.  FARM’s Torrance facility also represents an opportunity to unlock significant value should management decide that they can run the business from a nearby location or move it to Texas instead of high-cost California.  If FARM sold its Torrance facility for $50 million, it could rent a nearby building with 66k square feet of space for approximately $416k/year.  FARM’s property tax on the Torrance facility alone is $470k/year.  The Federal tax on this gain would be shielded by FARM’s net operating loss (NOL) carry-forward.  The NOL’s are currently at approximately $121.7 million for federal NOL’s and $132.9 million for state NOL’s.  The NOL’s would normally be reflected on the balance sheet as a deferred tax asset, however, the tax valuation account hides the value of the NOL’s.  The tax valuation allowance is another valuable asset that does not show up in FARM’s balance sheet.  This is due to the FARM’s financial troubles over the last few years.  Assuming that I am correct in FARM hitting an inflection point in profitability, it will be able to avoid paying Federal taxes for quite a while.  California has temporarily suspended the use of NOL’s on the state’s corporate tax rate of 8.84%, so there will still be some cash taxes on future income.  Assuming FARM can generate $50 million in cash from the sale of its headquarters, it would generate approximately $2.80/share in cash.  Finally, if FARM decided to move their headquarters out of California and consolidate with their Houston, Texas plant it could save meaningful expenses on labor, taxes and real estate costs. 

If FARM were to decide to sell itself, I see two different ways in which the Company can do this.  1) It can sell the whole company, including the real estate or 2) it can sell the coffee assets and sell the real estate to a real estate investment trust (REIT) in an up-REIT transaction. 

When looking at what values FARM is worth to a buyer, there are very few comparable transactions.  The best comparable transaction I could find was J.M. Smuckers’ (SJM) purchase of a majority of Sara Lee’s North American foodservice coffee and hot beverage business.  They announced the purchase on 10/24/2011 for $350 million plus $50 million to be paid over the next 10 years. The business was expected to generate earnings before interest, taxes, depreciation, and amortization (EBITDA) of approximately $70 million to $75 million after one time transaction expenses.  Based on the $400 million purchase price, this comes to an EBITDA multiple of 5.3 to 5.7 times.  SJM expected to add annual net sales of approximately $285 million to their company from the transaction, which comes to a sales multiple of 1.4 times.  SJM also purchased Rowland Coffee in May 2011 for $360 million.  Neither Rowland nor SJM broke out Rowland’s EBITDA or any other info other than Rowland’s net sales of $110 million in calendar 2010, which makes the acquisition a sales multiple of 3.3 times.  The acquisition included Rowland’s manufacturing, distribution, and office facility in Miami, which SJM planned to consolidate into their existing infrastructure.  SJM mentioned that a key reason for the acquisition was to acquire Rowland’s brands which would allow them to establish a strong presence with Hispanic consumers in the U.S, which in addition to the real estate they acquired, is likely why they paid such a high sales multiple.

Using the above sales multiples to value FARM yields values many multiples above the current stock price and is probably not realistic with where FARM’s business has been over the last few years.  However, before these troubles occurred and gross margins were in the upper 40% range, FARM’s stock was trading in the high $30’s and supports this method of valuing FARM. 

Therefore, I am going to use EBITDA multiples as my primary valuation metric.  Prior to the spike in coffee prices and post the Coffee Bean acquisition, FARM routinely had gross margins in the mid to upper 40% range.  Coffee prices have fallen to levels in line with where FARM was paying in fiscal 2010 and 2009 when FARM generated 44% and 47% margins, respectively.  As the effect of FARM’s coffee hedges dissipate, the Company should comfortably generate gross margins of 43% plus this year.  Excluding the impact of the MCD win and the roll-out of premium coffee brands on sales, FARM would generate EBITDA of $59 million in fiscal 2013 (June 2013).  If I am correct in my MCD calculations then that new relationship would add a minimum of $10 million in EBITDA with a 1% negative impact to gross margins based on a full year of business.  I have included the following table to show the impact of lower coffee prices, increased premium coffee sales and MCD’s business on FARM’s business. It also anticipates a continued benefit from the cost reduction programs for the full fiscal years of 2013 and 2014. 

Link: Projected EBITDA Table

Using the mid-point of the SJM purchase of Sara Lee’s coffee business of 5.5 times EBITDA and an EBITDA level of $60 million, which excludes any MCD business, yields a share price of $19.01.  The table below shows FARM’s share price with different ranges of EBITDA and EBITDA multiples given their current level of net debt and 16.3 million shares outstanding.

Link: EBITDA Multiple vs EBITDA Range Table

FARM does not have any perfectly comparable public companies, however, I have created a list of the closest ones.  Sysco (SYY) does distribution, similar to FARM, but it does not focus on coffee or provide the level of service that FARM performs for its customers.  Green Mountain Coffee Roasters (GMCR) is a pure-play coffee company, but nearly 80% of their business comes from their K-Cups.  SYY and GMCR are both mentioned as competitors in FARM’s 2011 10-k.  Core-Mark Holding Company Inc. (CORE) and Nash Finch Company (NAFC) also have distribution as a key element to their businesses.  The JM Smucker Company (SJM) manufactures and markets food products, with approximately 25% of their revenue coming from coffee.  Pete’s Coffee & tea, Inc. (PEET), Kraft Foods Inc. (KFT) and Sara Lee Corporation (SLY) were also mentioned as competitors in FARM’s 10-k, however SLY sold off their North American coffee assets and became part of Hillshire Brands (HSH), KFT had too many well-known brands in non-coffee businesses and PEET’s is more of a retail coffee play like Starbucks and the multiples were quite high.  I excluded them from the comparable company table for those reasons. Below is the comparison table:

Link: Comparison Table

Since FARM’s business is a blend of the comparable companies, I believe the average EBITDA multiple of the companies is a fair way to evaluate FARM.  Also from 1990 to 2004 FARM’s annual average Enterprise Value (EV = Equity Market Capitalization + Cash – Debt) to EBITDA multiple ranged from 3.80 to 13.33 with an average of 6.46 over that period.  Given the comparable companies and the merger and acquisition transaction multiple, I think that an EV to EBITDA multiple of 5 to 7 times is fair to apply to FARM’s business, which ignores the real estate value.  Based on a conservative projection that the Coffee Index will average 210 over FARM’s fiscal year 2013 and an EBITDA multiple of 6 times, with EBITDA levels at $60 million, FARM shares will be worth $20.86/share. 

If a sale is approached by bifurcating FARM into the real estate assets and coffee business, shareholders would likely receive a higher total value for their shares.  Industrial property REIT’s trade at cap rates in the 6% range or about 16 times cash flow.  Assuming that FARM’s properties are not class A locations, it is safer to use an 8% cap rate or 12.5 times cash flow.  If FARM were to sell these properties to REIT for $100 million and lease them back at $8 million per year, shareholders would accrue approximately $50 million ($3 per share) in additional enterprise value using the 6 times EBITDA multiple due to the large NOL’s on FARM’s balance sheet.

Risks

1. Quick spikes up in coffee prices
2. Increased competition for national accounts

1. Stable coffee prices
2. McDonald’s relationship creating additional revenues and profits
3. Successful roll out of premium coffee program