Farmer Bros. Co. (FARM) Q1 2015 Earnings Report, Transcript and Summary

Good afternoon, ladies and gentlemen, and welcome to Farmer Brothers' First Quarter Fiscal 2015 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Tom Mattei. Go ahead, sir.

Good afternoon, everyone. Thank you for joining Farmer Brothers' First Quarter Fiscal Year 2015 Earnings Conference Call. I'm the company's Vice President and Corporate Counsel. With me today are Mike Keown, President and Chief Executive Officer; and Mark Nelson, Treasurer and Chief Financial Officer. Earlier today, we issued our earnings press release, which is available in the Investor Relations section of our website at www.farmerbros.com. The earnings press release is also included as an exhibit to our Form 8-K available on our website and on the Securities and Exchange Commission website at www.sec.gov. Please note that all the financial information presented on this conference call today is unaudited. A replay of this audio webcast will be available approximately 4 hours after the conclusion of this call. The link to the audio replay will also be available on our website at www.farmerbros.com. Before we begin the call, please note various remarks that we make during this call about the company's future expectations, plans and prospects may constitute forward-looking statements for purposes of the safe harbor provisions under the federal securities laws and regulations. The company's actual results could differ materially from what is described in those statements. Additional information on factors that could cause actual results to differ materially from those forward-looking statements is available in the company's earnings press release and in our public filings, which are available on the Investor Relations section of our website. In addition, any forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any subsequent date. While we may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our views change. Therefore, you should not rely on these forward-looking statements as representing our views as of any date subsequent to today. Additionally, please note that the company uses certain non-GAAP financial measures including adjusted EBITDA and adjusted EBITDA margin in assessing its operating performance. Reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures is included in our earnings press release, which is available in the Investor Relations section of our website at www.farmerbros.com. I will now turn the call over to Mike Keown, our President and Chief Executive Officer. Mike?

Thank you, Tom. Hello, everyone, and thank you for joining us this afternoon. This is the second earnings conference call for Farmer Brothers and I'm glad you are here today. I will start with the top line review of our first quarter fiscal 2015 and conclude with some commentary on the overall business. I will then turn it over to Mark Nelson, our Treasurer and Chief Financial Officer, who will discuss our financial results for the quarter in greater detail. Overall, it was a solid quarter and we continue to make progress turning Farmer Brothers around in the current environment of higher coffee prices. At a high level, net sales were $136 million, up 5% versus the same period a year ago. Coffee volume was 22.8 million pounds, up roughly 7% versus the same period a year ago. Net income was $2.5 million, up 39% versus the same period a year ago. On an EPS basis, we delivered $0.16 per diluted common share versus $0.11 per diluted common share in the first quarter of the prior fiscal year. Next, I'll try to frame up the growth trends in the business. The core of the business is foodservice, which includes a broad array of channels such as restaurants, hotels, casinos, colleges and universities and convenience stores, to name a few. While the economy has improved from the lows of several years ago, this foodservice business is still in a state of very low growth. Recent trends show foodservice growth of approximately 3%. Within this, coffee is roughly growing at 5%. By comparison, our net sales in the first quarter were up 5% compared to the same period a year ago, higher than the industry trends, and our roast and ground coffee grew at 7%, also roughly 2 points ahead of the industry. One of our goals has been to drive our business with larger customers and we believe there's an opportunity because our penetration is still relatively low. With less than 5% -- excuse me, with less than 5 of the top restaurant chains, convenience store chains and grocery chains as current customers. And of course, improvement in a broader economy would be a good tailwind. In summary, it was one of the best starts to the year we've had over the past decade in terms of sales, volume and earnings. We are keenly aware that our operations need to continue to improve as we grow. I believe we have the team to do it. We are ramping up for the second fiscal quarter, which historically is our strongest revenue quarter of the year as there is seasonality in the hot beverage category. And we remain optimistic for the future, but grounded in the fact there is still much more to accomplish to make further progress in our turnaround. Before I turn it over to Mark for a deeper dive into our financial performance during the quarter, I wanted to give you a brief overview of 2 strategic initiatives underway relating to technology and e-commerce as one bucket and also supply chain optimization. First, e-commerce. As brief background, our technology strategy has had several components. First, we needed to upgrade and align on one ERP, or enterprise resource planning system, which we successfully completed last spring. Second, we needed to improve the connection and communication resources for our DSD network, or direct-store delivery, through an assortment of initiatives like improved rollout of e-mail, telecommunications, and so forth. That was completed on time as well this past summer. Third, we improved our website by optimizing our search engine capability and providing enhanced product information to make it easy for our customers to learn about our products and services. We are now in the process of taking the next step to provide an e-commerce platform to allow customers and consumers to order our great products online, which we plan to launch by the end of this calendar year. Our plan is that customers using this e-commerce site will be able to order products for direct shipment and so provide another access point to our products even in remote areas not currently served by our direct-store delivery network. I believe we will also learn about the demand for our products and services as well as our capabilities on a broader scale as the site gets up and running. We will learn a lot through the startup phase, but are very excited to bring this new e-commerce platform to our customers. Next, supply chain optimization. As I mentioned in the last call, we continue to invest in supply chain optimization. The integration of our Portland manufacturing facility with our other operations, and as I mentioned earlier, completion of the ERP integration last spring, have allowed us to more effectively run our 3 manufacturing facilities as one system. We continue to simplify the supply chain through the winnowing of our product offerings and improvements in our equipment refurbishment process. Through our ongoing efforts to optimize and simplify our product portfolio, the number of SKUs has been reduced from approximately 4,500 a few years ago to approximately 2,500 now as of the end of fiscal 2014 with an additional 30% reduction targeted by the end of this current fiscal year. We believe this will allow us to lower costs and utilize excess capacity in our system. Additionally, we have completed transition of our equipment refurbishment operations to Oklahoma City. To build on these successes, we are now shifting our focus to logistics, planning and forecasting as part our commitment to bring our cost in line with best-in-class operations while maintaining high standards of quality for which we have always been known. Now let me turn the call over to Mark Nelson, our Treasurer and Chief Financial Officer, who will provide you with more details on our first quarter financial results. Mark?

Thanks, Mike. Hello, everyone. I'll spend the next few minutes discussing our financial performance for the first quarter of our fiscal year 2015. As Mike mentioned, we have continued to make positive financial progress over the last few years and we had a good quarter in terms of net sales growth, generating a 5% increase in revenues over our prior fiscal first quarter. Our results, however, reflect the effects of some of the large mark-to-market hedging gains recorded in our third fiscal quarter last year. But despite this, we achieved a solid 39% growth in net income over the prior period. Now let me get right into some of those details. On the income statement, net sales in the first quarter of fiscal 2015 were $136 million, representing a 5% increase from sales recorded in the first quarter of fiscal 2014. This increase was primarily due to increases and sales of products in our roast and ground coffee and other beverage categories. The increase of $6.4 million over the prior year period reflected balanced growth from both national accounts and independent customers. Although we have been experiencing increases in our green coffee commodity input costs, this did not materially impact our sales during the quarter to customers utilizing commodity-based pricing arrangements, where the changes in green coffee commodities are passed on to the customer. Most of these customers have directed us to enter into exchange-traded coffee derivative instruments on their behalf to effectively lock in the purchase price of green coffee. Their resulting pricing, based on their hedged commodity price levels, was roughly equivalent in aggregate to that of the first quarter of last year. As Mike mentioned in the first quarter, we saw a 7% increase in the volume of green coffee we processed and sold over the prior year period. Cost of goods in the first quarter of fiscal 2015 increased by $6.3 million versus the first quarter of 2014. As a percentage of net sales, cost of goods sold increased 170 basis points to 64.6% in the first quarter versus 62.9% in the prior year period. As a result, gross margin for the first quarter of fiscal 2015 was 35.4% or 170 basis points below that of the first quarter of fiscal 2014. It is important to note that, in the first quarter, we worked through the remainder of the green coffee receipts where the corresponding hedging gains were previously marked-to-market in our third fiscal quarter of 2014. We measure that, that roughly drove 110 basis points erosion in gross margin, which can be traced directly to Q1 commodity deliveries where the corresponding hedging gains were already recorded in other income in our fiscal third quarter of 2014. Operating expenses in the first quarter increased by $529,000 as compared to the prior year period, primarily due to an increase in freight charges and insurance-related costs, partially offset by the absence of expenses related to restatement of prior year financial statements. As a percentage of net sales, operating expenses in the first quarter decreased 120 basis points to 33.5% versus 34.7% in the first quarter of fiscal 2014. As a result, income from operations in the first quarter of fiscal '15 were $2.6 million compared to income from operations of $3 million in the prior year period. Total other income was $112,000 in the first fiscal quarter as compared to total other expense of $902,000 in the prior year period. The difference was primarily due to net gains and losses from coffee-related derivatives. In the first quarter of fiscal 2015, we had net gains of $49,000 on these derivatives as compared to net losses of $848,000 in the prior year period. Since our adoption of hedge accounting in the fourth quarter of fiscal 2013, the majority of our derivative gains and losses are now being recorded as a component of cost of goods sold upon receipt of the commodity as opposed to being marked-to-market through other income and expense periodically. Now let me provide you with an update on coffee prices. The green coffee commodity market experienced a sharp increase during our third fiscal quarter of 2014, spiking to over $2 a pound for Arabica seed coffee. Coffee prices have varied within a range since that time, but have generally remained at an elevated level, creating some potential headwinds for our material input costs. In recent weeks, reports of rainfall in Brazil have eased these cost pressures a bit, reducing uncertainty about the potential drought impact on future harvests. Additionally, we continue to find ample supply of green coffee on offer, leading us to believe that a lighter position and shorter duration in our coffee-related derivative instruments is warranted. As of September 30, 2014, we held coffee-related derivative instruments covering 20.7 million pounds of green coffee compared to 53.2 million pounds of green coffee covered as of September 30, 2013. In addition to these coffee futures, we believe we have sufficient coffee, either price-fixed with our vendors or already in inventory to provide for the majority of our fiscal year 2015 forecasted demand for those DSD or street business customers, not on a commodity-based pricing arrangement. In general, our hedging program is designed to reduce the impact of variability in green coffee commodity prices, creating stability in our pricing model and allowing us to plan for pricing actions in the future. As a result of all the factors I mentioned, net income was $2.5 million in the first quarter of fiscal 2015 compared to net income of $1.8 million in the first quarter of fiscal 2014. Weighted average common shares diluted in the first quarter of fiscal 2015 were 16.1 million shares versus weighted average common shares outstanding diluted in the first quarter of fiscal '14 of 15.8 million shares. Diluted earnings per share for the first quarter of 2015 were $0.16 versus diluted earnings per share of $0.11 in the prior year period. Okay. Now let's turn to the balance sheet. As of September 30, 2014, we had $4.8 million in cash and cash equivalents. Additionally, we had $22.1 million in short-term investments and we had no restricted cash. In our fiscal first quarters, we typically see higher cash outflows associated with accrued payroll and payables reductions. As a result, we had $2 million borrowed and outstanding on our revolving credit facility as of September 30, 2014. For the first quarter of fiscal 2015, our capital expenditures were $4.9 million as compared to $4.8 million in the first quarter of the prior fiscal year. Our CapEx during the quarter included funds spent on coffee brewing equipment, expenditures for vehicles, machinery and equipment, building and facility improvements, and IT-related expenditures. Depreciation and amortization expense in the first quarter of fiscal '15 was $6.3 million versus $7.4 million in the first quarter of fiscal '14. Finally, we used certain non-GAAP financial measures including adjusted EBITDA and adjusted EBITDA margin in assessing our operating performance. We define adjusted EBITDA as net income excluding the impact of income taxes, interest expense, depreciation and amortization expense, ESOP and share-based compensation expense, noncash impairment losses, noncash pension withdrawal expense and other similar noncash expenses. Adjusted EBITDA for the first quarter of fiscal '14 was $10.4 million as compared to $10.8 million in the first quarter of fiscal 2014. Overall, we had a strong first quarter, setting us up well for the year as we enter into our busy season and putting us in great position to execute towards our stated adjusted EBITDA margin goal of 10% of sales. And with that, I'll turn the call back over to Mike.

Thanks, Mark. In summary, the turnaround at Farmer Brothers continues. I'd like to say that we are in the second or third inning and we are very excited about the opportunity for growth. I don't believe most turnarounds are linear in progression, but if you step back, you can see that we are clearly improving and, of course, we plan to continue that trend. And with that, I'd like to open the call up to a few questions.

[Operator Instructions] Our first question comes from Tony Brenner of Roth Capital Partners.

A couple of questions. As coffee prices have increased and your coverage length has declined, is it fair to assume that as we go forward to the second, third and fourth quarters, more of the increase in green coffee costs will be reflected and therefore the percent sales increase should accelerate without making any change to assumptions about volumes?

So I think you're referencing the cost plus pricing customers, those that have a commodity...

Primarily, yes.

So those -- what we saw in the first quarter of fiscal '15 as we looked across that balance of customers, their pricing was roughly equivalent to the first quarter of fiscal '14. We know in the last quarter, we were still seeing the declines in a year-over-year sense from those cost-plus arrangements. And so this quarter represents kind of the crossing point where we're starting now to see those increases. The national account customers are hedged somewhere between 6 to 12 months on average. So you would expect to see that lag as coffee prices are now coming through their hedged costs and we are starting to see that lift in our revenue numbers going forward. It was essentially flat, though, this quarter first '15 versus the prior year first quarter of fiscal '14.

Got it. As I recall, when you raised prices or notified DSD accounts that you were raising prices, green coffee costs at the time had risen to about $1.60, probably not more than that, and prices are $0.20 to $0.30 higher than that now. Does that indicate that you will be raising Street account prices again during the year?

Tony, it's Mike, I'll take that. Yes, we did implement an across-the-board price increase in the fourth quarter of fiscal 2014 and the first quarter of fiscal 2015. And we did so while working closely with our customers using the opportunity to penetrate these accounts, sometimes with a better product as well. Going back to the idea of upselling our customers to specialty coffee and iced coffee, we approach this price increase as a chance to help our customers introduce new products, and at the same time, price in advance of the increase in the market. So it's a little bit challenging to give you one answer, but directionally, we are pricing. The reason it's complicated is we have different terms with different customers and so forth, but the answer to your question directionally is yes.

Okay. Last question then. Assuming that $1.80 or $1.90 a pound or $2 a pound is the new normal for green coffee and we don't -- you don't get a chance to see another $0.60 decline, is a -- is the current forward hedging roughly where you want to be going forward? I mean, is there any reason to double or triple the amount that's hedged again given stable prices?

Tony, this is Mark. Two parts to that question. I think where the coffee prices, call it, started in that $1.20, $1.30 range to where they're sitting down in this kind of $1.80, $1.90 range, that increase, we believe, we have effectively covered in the form of price increases. And now as you look forward, we burnt through some of our hedge position. So we reduced our hedging position, we effectively got shorter. But what we don't disclose, except for annually and we're looking at is also disclosing the amount of coffee that we have fixed with vendors. And once we price-fix, either by applying a future or by fixing with the vendor directly, it locks that price into us. So the other piece is we do have greater position of fixed pounds with our vendors, and in addition, we have more green coffee in-house. So it's really 3 buckets which represent the amount of coverage we have. And if we look at that and we look at how far that coverage is, we believe it will cover the majority of our fiscal '15 period on our DSD, non-commodity plus pricing customers.

[Operator Instructions] Our next question in queue comes from Carter Dunlap of Dunlap Equity Management.

[indiscernible] on the continued goal of SKU reduction, can you talk about what impact you hope -- you've had a goal of reducing your inventory levels on a churn basis and now you're talking about a goal of another 750 or so SKUs. Is that going to have a proportional impact on the dollar inventory or more or less? And is there anything else in the optimization that can bring that dollar number down besides just the SKU count drop?

Carter, it's Mike. The SKU reduction initiative is really around simplifying the supply chain so our manufacturing facilities run more efficiently. When we do it well and we seem to be having some pretty considerable success, we simply move that volume to other customers. So the impact on overall inventory, at this point, I would say, is fairly small. It does help us plan more efficiently. And as I mentioned, we're still getting our arms around the supply chain in totality through one ERP system. So there may be some potential, it's just very early for us to make any kind of forward call on that for now.

So any further progress will come from the optimization tools. But are you happy where that is? Or do you think there' still -- what type of percentage is left?

Yes, Carter, it's Mike again. I think it's -- we have a lot of opportunity there. As I mentioned, building the tool is merely the first step. We have a number of other initiatives to improve how we plan, forecast and so forth. So I think we're making progress in terms of getting the tool up and running. But in terms of really appreciating the future potential of it, we're probably in a relative infancy.

[Operator Instructions] As there appear to be no further questions in queue, at this time, I'd like to turn the call back over to Mr. Keown for any closing remarks.

Thank you. And thank you for being part of Farmer Brothers' First Quarter Fiscal 2015 Earnings Conference Call. We appreciate your interest in our story and are excited about the future. We look forward to continuing the progress we've made in the past few years and telling you more about our accomplishments at our Annual Stockholders Meeting on December 4 at our headquarters in Torrance, California. Thanks again and have a great day.

Thank you, sir, and thank you, ladies and gentlemen, for your participation. That does conclude Farmer Brothers' Q1 2015 Earnings Conference Call. You may disconnect your lines at this time. Have a great day.