Description

Farmer Brothers Co. (Ticker: FARM on Nasdaq, $23.99 as of 2/18/2015), is a manufacturer, wholesaler and distributor of coffee, tea and culinary products.  FARM is in the final stages of a turnaround that started in late 2011 as the Company sought to absorb two large acquisitions made by its previous management team.  I believe that investors with a two and a half year time horizon will see more than a double (price target of $58.70/share in June 2017) in the value of FARM’s shares as it consolidates its manufacturing and distribution into a new plant in Dallas, TX or Oklahoma City, OK.  This opportunity exists due to the recent decline in the stock price from a small miss in sales and profits and an announcement of the cost and timing of its consolidation.  I believe that investors have missed the fact that this transition can be funded out of free cash flow, the sale of the Los Angeles (LA) plant, inventory savings, government incentives and short term debt without the need for long term borrowing or an equity raise.

FARM was founded in 1912 in the Los Angeles, California area.  It went public in the late 1950’s but was run by the family as if it was still a private company.  In the late 2000’s the Company made two large acquisitions of plants and businesses in Portland, OR (Coffee Bean International) and Houston, TX (Sara Lee’s direct store distribution (DSD) business).  Management was ill prepared to combine the three businesses and that coupled with a spike in coffee prices which FARM at the time did not hedge and the legacy of defined benefit pension plans, caused the Company to go from a profitable dividend paying stock to an unprofitable dividend-less one. 

The stock price fell from the upper 30’s to the middle single digits from 2005 to 2011.  Professional management was brought in over a period of time from 2011 to 2013 with the goal of running FARM as true public company with accountability to all stakeholders.  The management team has done a great job eliminating duplicative locations, rolling out an enterprise wide resource planning system, hedging coffee purchases and freezing the defined benefit plans.  The stock price rose from a low of $5.00 (12/31/2011) to a high of $32.50 (1/14/2015).  The final stage of the turnaround was announced on 2/5/2015 when FARM announced it was shutting down it Los Angeles plant which resides on 20 plus acres of land in Torrance, CA.  This announcement, coupled with a small miss in revenues and earnings, has caused the stock to drop down to its current price.  I will spend the rest of the discussion going over the industry, FARM and why this price drop represents an opportunity to buy into a stock that should double in price over the two and one half years.

The US Coffee Industry

Coffee is typically grown on small two hectare farms in countries like Brazil, Columbia, Vietnam and Kenya.  Most farmers are quite poor and lack well developed growing and marketing infrastructures.  Coffee buyers typically work through larger organizations that help the farmers distribute their beans across the world.  The purchase, importation, roasting, blending and sale of coffee to institutional and retail purchasers requires a sophisticated organization that can help farmers sustainably grow their coffee, roast and blend a consistent flavor profile of coffee despite purchasing beans from different locales at different times of the year and deliver its roasted beans across large swaths of the US.

The coffee distribution industry in the United States is heavily consolidated amongst six competitors that all have histories dating back nearly 100 years.   Four of these competitors are private and operate out of one plant each in the US.  They are S&D (North Carolina), Royal Cup (Alabama), Community Coffee (Louisiana) and Mother Parkers (Ontario, Canada).  The public competitor is Smuckers which purchased Sara Lee’s branded coffee business and Rowland Coffee back in 2011 and 2012.  FARM has been operating out of two large and one small plant since its acquisitions back in 2007 and 2009.  The Los Angeles and Houston plant are over 60 and 80 years old, respectively, and both are unionized and require significant annual maintenance capital expenditures due to their age. 

FARM announced during their quarterly release and conference call that they are shutting down LA as a production facility and headquarters.  They will be moving to either Oklahoma City, OK or Dallas, TX by June of 2016 (the “New Plant”).  This transition will happen in steps.  The LA plant’s coffee production will be shut-down by May 2015 and moved into Houston and Portland.  The corporate employees in LA will be paid stay bonuses until the new headquarters is opened by June of 2016.  Once the New Plant is functioning much of the production in Houston will be moved and then that plant will be reevaluated for closure.

The move is expected to decrease operating expenses by $12MM to $15MM on an annual basis and FARM will incur $25MM in one-time shutdown expenses, $35MM to $40MM in new facility costs and $20MM to $25MM in machinery, equipment, furniture and fixtures.  This will be paid for out of the sale of LA, estimated at $28MM to $35MM, free cash flow, government incentives and short term borrowings.  I believe that the drop in the share price was mainly caused by investors concern that this would be financed by long term debt or an equity raise.  I also believe that there are other cash generating opportunities that the Company did not discuss on the call but that are available to management to help pay for the move.

The analysis of the move and other opportunities

By closing the LA plant FARM will be moving away from an aging unionized plant in a high cost jurisdiction to a brand new non-unionized location.  FARM has been spending about $18MM per year on capital expenditures of which I estimate about $2MM to $3MM relate to unusual maintenance capital expenditures on the ancient LA plant to keep it functioning.  I have not included an estimate for inventory savings as the Company has not disclosed a firm estimate for this number.  LA also houses the corporate headquarters and the spice manufacturing business.  The initial savings yields a simple pretax return on investment (ROI) of between 19% and 33% as shown in the table below.

FARM has approximately $120MM in net operating loss carry forwards and the ability to use an IRS 1031 exemption for selling LA and buying like kind real estate.  This will enable the Company to utilize the full proceeds of this sale towards the transition.  The net cost of the new building will be temporarily financed by an expansion of FARM’s credit facility.   Free cash flow should enable FARM to fully repay the facility by the end of fiscal 2017.

It is unlikely that the Spice business will be moved to the new plant in TX.  In conversations with management over the years I have come to believe that the Company would prefer to just be a distributor for this category.  If it is assumed that the Spice division is sold to a third party who will then supply FARM with the spices it sells to its customers I believe that this can bring in between $12MM and $15MM (5x to 6x estimated division EBITDA) to a buyer who can make better margins than the Company due to scale.  FARM would lose some margin by buying third party, which I believe will be about 3% on its $32MM ($1MM annually) in sales.  The resulting ROI for the move increases to between 22% and 47% if my assumptions are correct.

Finally, FARM is not permanently putting the coffee production into its 80 year old plant in Houston due to its age and unionized workforce.  It is reasonable to assume that this plant will also be closed once Dallas or Oklahoma is up and running at full speed by June of 2016.  The property has an assessed value for tax purposes of around $4MM and would probably be worth some premium to that figure.  I have used a $4MM to $6MM range for the value of this asset.  Shutting down Houston won’t require the same cost as LA since there is no corporate workforce at that location.  I have assumed shutdown costs will be 50% of LA’s.  Finally, I have assumed that the annual savings from this move will be between $5MM and $10MM due to efficiencies and the benefit of using non-union labor.  This analysis, coupled with the LA shutdown and the Spice Business sale yields a pretax ROI of between 30% and 75% for FARM and brings net cost to between $32MM and $54MM.  FARM will also benefit from reduced maintenance capital expenditures from Houston in the range of $2MM to $3MM per year.

The above analyses show that this consolidation of both plants should be very accretive to investors on a pretax ROI basis.  The returns shown above will also be enhanced by the following items:

1.       The estimated savings in maintenance capital expenditures of between $4MM and $6MM per year which would bring the cash ROI of this transition to the 37% to 94% range. 

2.       Government incentives from the opening of the new plant in either Texas or Oklahoma, which at the current moment are unknown but will probably measure in the millions of dollars.

3.       A permanent reduction in inventory from the benefit of consolidating multiple locations into one and the operation of a more efficient plant.

Projections

I have projected the next two and one half years of FARM’s income statements, balance sheets and cash flows using the following assumptions:

1.       Asset sales

a.       Los Angeles plant sold for midpoint price of $31.50MM in the December 2015 quarter

b.      Spice business sold June 2015 quarter for midpoint price of $13.50MM

c.       Houston plant sold March 2017 quarter for midpoint price of $5.50MM

2.       Capital expenditures

a.       The purchase of the new plant and headquarters and their related furniture, fixtures and equipment will be done at the high end of the range and be evenly spread out over the quarters from June 2015 to June 2016.

b.      Maintenance capital expenditure savings of $2MM per year for Los Angeles start in June 2015 quarter.  Houston maintenance capital expenditure savings of $2MM per year start in the March 2017 quarter.  Both savings are at the low end of my estimates.

3.       Transition costs

a.       The $25MM cost of shutting down Los Angeles is divided 40% into fiscal 2015 (June) and 60% into fiscal 2016.  For projection purposes I assume that it is smoothly spent across the quarters.

b.      The $8MM cost of shutting down Houston is spread evenly throughout fiscal 2017.

4.       Savings from plant closures and Spice business sale

a.       The potential savings of $16MM to $24MM will not be fully realized until production moves into the new plant.  Prior to the transition I have assumed a normalized gross margin (GM) of 37.5% excluding the impact of the sharp move up in the price of coffee in calendar 2014.  In fiscal 2016 I added 130 basis points in gross margin for a recurring savings of $7MM.  In fiscal 2017 I added an additional 180 basis points of gross margin for a savings of $10MM. 

b.      I am assuming general and administrative savings of 60 basis points for a savings of $3MM per year.  These savings are spread out over the fiscal years of 2016 and 2017.

c.       This utilizes the midpoint of management’s assumptions for annual savings and exclude any additional impact from government incentives.

5.       Sales growth

a.       The March 2015 quarter benefits from lapping the poor weather conditions that limited sales in the same quarter of 2014 and the price increases that FARM put through in the December quarter due to the increase in the price of green coffee during calendar 2014. 

b.      For FY 2016 and 2017 I assume FARM just performs at a normal US economic growth rate of 3% for revenues.

6.       Green coffee prices

a.       I assume stable prices for green coffee purchases. 

7.       Taxes

a.       FARM utilizes its federal NOL’s to offset all US taxes paid during the period.

Valuation analysis

FARM has no publicly traded peers as the coffee roasting and distribution industry in the US is dominated by century old private companies.  There have been numerous acquisitions of coffee companies in the US and Europe over the last five years.  Most of the acquired companies had either a branded component or retail stores.  FARM does have some brands, but it is a minority part of their business.  The closest comp was DE Master Blenders, which owned the European sister company to the Sara Lee business that FARM purchased in 2009.  DE Master Blenders was purchased for 2.75X revenues and 36X EBITDA in 2013.  As you can see from the table below, the median transaction multiple of revenue and EBITDA were 2.75X and 22.58X.  The lowest deal multiple was for Caribou Coffee, a coffee store operator in the Midwestern US, which was bought for .92x revenue and 11.20x EBITDA.  If FARM were to be acquired by an industry competitor, the buyer would be able to eliminate all plants, distribution centers and corporate overhead.  It would also be able to reduce sales force headcount where there is overlap.  I have used a very conservative 12X multiple, which is approximately half of the average and only slightly about the lowest transaction multiple for the industry.

Using a 12x EBITDA multiple produces a range of values over the next two years of between $37.94 and $58.70 per share based on my projected adjusted EBITDA of $45.65MM for fiscal year (FY) June 2015 and $73.42MM for FY June 2017.  These values assume ending cash in 2017 of $77MM and debt of $9MM based on the projections provided above.

Catalyst

I believe that FARM offers an opportunity to double in value over the next two years as the benefits of its plant consolidations away from two ancient coffee roasting plants into a new state of the art plant in Texas or Oklahoma.  Investors have taken the stock down about 20% since the earnings release on 2/5/2015 due to concerns about a small miss in revenues and earnings and the cost of financing the transition to the new manufacturing facility.  I believe these concerns are over blown as the Company can finance this move through the use of free cash flow, the sale of LA, government incentives, inventory savings and short term borrowings.