Description

Elevator Pitch

Farmer Brothers is a left-for-dead microcap coffee roaster and distributor that is quietly setting up for 100-200% returns within the next 18 months. This is a self-help, turnaround, and COVID-reopening story that has 3 main drivers which we believe will take the stock from $7 today to $18 and potentially beyond. 

1. Self Help. The company has just completed its major, multi-year supply chain optimization initiative which we believe has fixed the underlying cost structure issues. They replaced old, unionized factories with a new automated facility. So far this turnaround has been obscured by COVID-related volume declines.

2. COVID Reopening. As vaccines proliferate, FARM’s heavily-hit customer base will begin to increase orders, allowing for enough volume to show the benefits of the new cost structure through improving fundamental results.

3. Visibility. By themselves, the numbers do not tell this impending turnaround story and management has not been very vocal either. There hasn’t been an updated presentation since before the new CEO took over in September 2019. There are multiple indications that once the tide of COVID starts receding and there is visibility on the path forward, management will start giving, and then beating, guidance.

Ultimately, all this company needs to do to be a homerun is for them to get their costs down, and for volume to return to be profitable. We believe all the pieces are in place.

Company Description

Farmer Brothers is an importer, roaster, and distributor of coffee and some coffee-related products. It has no segments, but broadly divides its business into two categories: Direct-Store-Delivery (DSD) and Direct Ship. In the DSD business, Farmer Brothers trucks make their daily rounds delivering their clients such as small cafes, restaurants, hotels, and other customers. The DSD business also supplies and services coffee brewing equipment (CBE) to customers as part of their value proposition. In the Direct Ship business, they use third party services to bulk ship their products to customers. Some examples of this business would be coffee for a large convenience chain or private label coffee for a small grocery chain. The DSD business is much smaller volume (about one third of the volume pre-COVID) but is much more profitable than the bulk Direct Ship business.

Background

FARM’s stock reached into the $30s twice in the last twenty years, which gives some indication of this company’s potential upside should takeover rumors swirl again. However, fundamental results have been uneven and lackluster since about 2005. The problem has always been the same: solid gross margins didn’t translate into bottom line profits due to the inefficient cost structure. In the past few years, they have had other execution related issues as well.

This was originally a family company, but when the family ran out of members that were interested in running it, they brought on a professional CEO in 2012. The new management’s plan was to shut down the aging Torrance, CA plant, and shift volumes to their Houston plant (also aging and unionized) and to a newly constructed, more automated facility in Northlake, Texas (Fort Worth area). You can read about this effort in the 2015 VIC by mitc567. The problem was that they overbuilt the Northlake facility such that the volumes they were doing weren’t high enough to realize the anticipated cost savings. This caused them to try and get the volumes up by focusing on the bulk Direct Ship business. They never really got volumes high enough, and the business they did get wasn’t very profitable. After a last botched attempt to get those volumes up by acquiring Boyd’s coffee in 2017, management was ousted by the board.

New Management 

In September 2019 the board brought in Deverl Maserang who spent most of his career in supply chain at Chiquita before becoming Starbucks EVP of Global Supply Chain from 2013-2016. After Starbucks he became CEO of Earthbound Farm Organic (an orphaned and underperforming unit of Danone), fixed it up, and sold it to a strategic acquirer. This guy has the right background to fix this company. In the CEO’s first year most of the previous management was replaced: new CFO, new head of HR, and new Chief Sales Officer.

Turnaround

The most important part of the turnaround plan is the supply optimization initiative; the last major component of this initiative was just completed this quarter. Now that this initiative is complete, not only will the company start seeing operating benefits but expansion capex should go way down.  The supply chain optimization initiative had three main components:

• Shut down the Houston plant. This plant was old, unionized, and its retirement takes unnecessary and expensive capacity out of their system. This plant had its last day of production in January 2021. 

• Retool the Northlake plant. Despite being old and inefficient, the Houston plant was running near capacity because it was configured to service the smaller and more profitable DSD business rather than the bulk Direct Ship business that never fully materialized. Before they could shut Houston down, they had to retool and move equipment to the Northlake plant. This is now done.  We estimate this plant to have cost about $120 MM in total which compares favorably to the company’s $220 MM enterprise value.

• Open a West Coast distribution center in Rialto, CA. Many of Farmer Brothers’ customers are on the West Coast and when they moved everything to Texas it created logistical problems. This center, opened in February of this year, will help improve customer turnaround times and thus improve retention. It also allows for more refurbishment instead of customer coffee brewing equipment (CBE), this will allow for fewer new purchases of CBE and thus lower capex going forward.

In general, if you read the transcripts you will be left with the sense that this company’s previous problems were internally generated and fixable. For example, they had too many SKUs and often struggled to fulfill customer orders which resulted in lost customers or decreased order volume. They also had issues with overproduction, scrapping, and inventory write downs. Additionally, with the changed strategy and less need for additional volumes to fill unused capacity, management has telegraphed they intend to shift their focus away from less profitable Direct Ship business towards more profitable DSD business, which had suffered due to lack of attention.  Management has not offered guidance but is enthusiastic about progress being made.

COVID Impact

COVID has greatly impacted the customers of FARM’s DSD business as people stay home and don’t go to many of the places they would normally buy coffee. Customer orders were down 70% in April, and have since been down something like 30 to 40% from prior year periods, depending on the stringency of the measured region’s lockdown. If COVID hadn’t happened, we believe we would already have started seeing the results of the turnaround and cost structure rationalization. We don’t need to get into the details, but with highly effective vaccines being distributed, we expect a continued softening of lockdowns with the economy substantially open sometime in Q3.

As many companies did, FARM cut costs during COVID which were recently quantified at around $6 MM per month (1/3 to COGS, 2/3 to Opex… some of these costs may come back with volume). That is a big number for a company that only did about $17MM of EBITDA in FY 2019. This benefit should show up in improved margins once volume returns.

Visibility

Management knows how the game is played and has understandably been reticent to give targets before the turnaround efforts took root and then while lockdowns were sending the business into a downward spiral. As noted above, the last investor presentation was produced in March 2019, before the new CEO joined. There are only two real analysts and neither is excited about the company. Importantly, management has committed to give cost savings and margin targets as COVID stabilizes, indicating this will probably happen on the FQ4 2021 call (after the June quarter). I expect this to be the first real catalyst that gets the stock going.

This pitch might be a little early as CQ1 ‘21 results likely won’t be impressive. COVID lockdowns are still stringent after the holiday surge, two facilities are in the first quarter of full operations and likely have some kinks to work out, and was been a large beneficial pension accounting amortization which will disappear. CQ2 ‘21 should be the real start of operational improvements from both a cost and volume perspective.

Valuation - EBITDA 

The below back of the envelope model illustrates the impact on share price should revenues rebound to 2017 levels but with higher EBITDA margins due to the operational, facility, and mix (more DSD less direct ship) changes discussed above.  In this scenario, we expect the EBITDA multiple to contract to a more reasonable 9 but the stock is still nearly a triple.  The key assumption here is margins.  This is just an educated guess until management starts giving targets.

Valuation - Free Cash Flow

Another way to think about valuation is free cash flow.  With volume rebounding and operational improvements, CFO should meet or exceed previous levels.  Capex, on the other hand should drop meaningfully going forward for 3 reasons.

1. No more expansion capex for new facilities

2. Less maintenance capex as present facilities are newer and need fewer expensive repairs

3. FARM spends significant capex on coffee brewing equipment they supply to DSD customers.  They have recently introduced a successful program to provide customers with refurbished, rather than new, equipment.  This has and should continue to reduce capex going forward.

The company’s press releases detail maintenance capex, which, for the 6 months ending December 2020, is already running at about 50% of the levels seen in the prior year period. The maintenance capex for those 6 months was only $3.7 MM while expansion capex remained elevated at $5.9 MM due to the finishing touches being put on retooling the Northlake plant and the opening of the Rialto distribution facility.

Due to historical losses, this company has $150MM in federal net operating loss carryforwards and will not be paying meaningful taxes for some time.

Risks

• The turnaround plan fails and management can’t get the cost structure under control.  Previous management tried and failed (albeit with a different approach).

• Mitigant: While this would mean the thesis is broken, we believe the downside is somewhat limited by the estimated cost of the Northlake facility and its potential value to strategic acquirers.

• This is a secularly challenged business due to changes in customer environment.

• Mitigant: This would not be good, but ultimately this pitch is about improving the cost structure. The coffee industry in general has strong positive trends.  Even if FARM is a flawed business, it will still be a more valuable flawed business if the cost structure improves and it becomes free cash flow positive.

• Variants drive additional lockdown cycles.

• Mitigant: This is another risk given it is not clear if the company would be free cash flow positive if the current environment persisted.  Last quarter the company bled $12 MM in OCF, but that included one-time costs associated with completing those supply chain initiatives.  As of year end they had $45MM of liquidity.  We can’t stay locked down forever can we?

Catalyst

Catalyst

• Management issues guidance on all the cost savings, most likely on the Q2 2021 call. Enthusiastic sell side coverage to follow.

• Improving fundamentals