Farmer Brothers Undervalued On Fundamentals With Bearish Technicals (NASDAQ:FARM)


Introduction

Farmer Bros. Co. (FARM) stock is down over 70% year-to-date. The stock being down this much while the broader market has rebounded from the March sell-off is what attracted us to look into the company.

In our prior analysis, we suggested shorting the stock, with a price target of $4.47. The stock closed below this level on 10/15 with a closing price of $4.44. The current stock price is still below the $4.47 level and all outstanding shorts should be closed.

For the current analysis, six years of historical company financials was used to perform a fundamental discounted cash flow analysis. The company has not generated a high rate of sales growth in recent years and the company’s main input – green coffee – suggests higher prices in the future, creating a headwind for the company.

Despite this, the fundamental analysis suggests a price target of $4.66, which is 14% higher than the 11/2 closing price of $4.09. The technicals, however, suggest that it is not a good time to get into the stock. The 11/2 close of $4.09 is about 18% below the 50-day moving average of $4.98 and about 47% below the 200-day moving average of $7.68.

As such, we have a neutral stance on the stock. Again, any shorts should be closed, but any longs can hold. This is definitely a worthwhile stock to watch. If the company is able to successfully execute on its cost-cutting measures, or the economy rebounds quickly, this stock has a lot of space to run, as it is down over 70% from the 12/31/19 close of $15.06

(All graphs and tables in this report were compiled by the author. Source of data: company financials, unless stated otherwise)

Stock Price Update

In our last article, we recommended going short the stock at $6.09, with a price target of $4.47 and a stop-loss of $7.98. Shortly after that article, the price dropped to $4.82, and then immediately climbed to $7.73. Those who held through this ride were rewarded when the stock closed below our price target on 10/15 with a closing price of $4.44. The stock continued dropping, closing on 10/31 at $3.47.

With the stock now below our previous price target, it’s worth asking if now is the time to buy.

Company Data

FY2020 10-K

The company released its FY2020 10-K on 9/11. Net income for the year was negative $37 million, which is worse than the negative $30 million we estimated in our last report. Most of this difference was driven by much higher than expected operating expenses.

Even though our last estimate for NI turned out to be off by 7 million, it was still close enough to give us confidence that our process for developing our last price target was sufficient and should be used again to determine a new price target.

In the Management’s Discussion and Analysis section in the 10-K, the company stated that their cost-cutting measures “have already resulted in significant monthly costs savings, improved our cost structure, and helped to mitigate the impact of the COVID-19 pandemic on our operating results.”

(The various cost-cutting measures can be seen in our last report or directly from the 10-K.)

Management also stated, however, that as of 6/30, revenues were “still down by approximately 45% from the pre COVID-19 pandemic weeks.”

With seemingly no end to the pandemic in sight, this leads us to believe that we need to continue to be conservative in future estimates for FARM.

Let’s look at the updated sales breakdown from the 10-K data.

Sales

The company groups sales into six categories:

  1. Coffee (Roasted)
  2. Coffee (Frozen Liquid)
  3. Tea (Iced and Hot)
  4. Culinary, which includes gelatins and puddings, soup bases, dressings, gravy and sauce mixes, pancake and biscuit mixes, jellies and preserves, and coffee-related products such as coffee filters, sugar and creamers
  5. Spices
  6. Other, which includes cappuccino, cocoa, granitas, and concentrated and ready-to-drink cold brew and iced coffee

Coffee products continue to account for about 70% of sales, which continues to mean that green coffee prices are the main driver of COGS. (Note: The large increase in sales from FY2017-FY2018 is attributed to an acquisition.)

Green Coffee Overview

Green coffee is a commodity that is exchange-traded on the futures “C” market. In addition to the futures market, FARM also purchases through coffee brokers, exporters, and growers, such as Direct Trade and Fair Trade Certified. These contracts are negotiated directly, rather than on the futures market. Direct contract prices can vary from those quoted on the future market, but the futures prices reflect the general price level of the entire green coffee market.

The following graph has daily closing coffee prices from 7/1/2019 to 10/30/2020. FY2019 average is calculated using 7/2/2018 to 6/28/2019 prices, and the FY2020 average is calculated using 7/1/2019 to 6/30/2020 prices. The FY2021 average is from 7/1/2020 to 10/30/2020. These dates correspond to the market dates that reflect FARM’s fiscal year. (These prices are found here.)

(Data from MacroTrends.net)

This chart shows that coffee prices have been higher in the first couple months of FY2021 but have decreased recently. In order to get a gauge of what prices may be a little farther out in the future we need to take a look at coffee futures. Below is a chart of coffee futures, as of 10/30/2020 close, compared with the same futures contract as of the 7/2/2020 close. (These prices are found here.)

(Data from BarChart.com)

The December 2020 contract is now the front month contract, so it must be compared to the 7/2 front month contracts, which were the July and September contracts. The reason we are comparing to both July and September contracts is because both contracts were the most actively traded on 7/2, with some trading the July contract but many moving on to the September contract. Right now, the December contract is the most actively traded, with very little activity in future month contracts.

What we see is that the December contract is above where the equivalent front month contracts were being traded on 7/2, which is reflected in the higher average coffee prices in FY2021. The rest of the futures curve is similar to what is was on 7/2, indicating the expectations for future coffee prices has not changed.

Macroeconomic Environment

In order to provide a sales estimate for the next fiscal year, which ends on 6/30/2021, we wanted to look at the general economic environment. Since some of FARM sales come from hotels and casinos, which rely on tourism and travel, we looked at weekly TSA data from statista.com.

(Data from Statista.com)

What is clear from these data, is that air travel in the U.S. is still less than half of 2019 levels. With no data to suggest that travel will pick up in the near term, this is a clear headwind for FARM.

On the GDP front, the Federal Reserve Bank of Chicago recently introduced their new U.S. GDP forecast model named ALEX. In the most recent forecast, the model predicts that U.S. real GDP will likely not be “fully back to its pre-pandemic levels by 2021:Q3.”

We will use these two data points for our revenue estimate over the next fiscal year.

Financial Analysis and Valuation

This section lays out the analysis used to determine a final valuation, which shows that the current stock price is undervalued. These estimates were determined by analyzing the financial statements for the last six fiscal years. The logic used to determine the fundamental analysis will be laid out in the following sections.

The estimates needed for the valuation:

  1. Revenue
  2. Cost of Goods Sold
  3. Operating expenses
  4. Other items needed for Net Income
  5. Net Income
  6. Activity Ratios
  7. Other assets and liabilities
  8. Capital expenditures
  9. Unlevered free cash flow
  10. Weighted average cost of capital
  11. Terminal growth rate
  12. Discounted cash flow analysis
  13. Comparable transaction analysis
  14. Final Valuation

There are assumptions laid out for three DCF estimates – base, optimistic, and worst estimates. The forecast period is from FY2021-FY2025.

Revenue

As previously stated, we used the TSA travel data and the Chicago FED’s GDP forecast to estimate FARM’s revenue of the next fiscal year. Since GDP is not expected to reach pre-pandemic levels before FARM’s FY2021 ends on 6/30/2021, and because travel in the U.S. has been depressed over the first couple months of this fiscal year, we think a 1% sales growth base assumption is sufficient. For the optimistic assumption, we will use a 3% increase and assume sales will be flat (0% growth) in the worst scenario.

For the forecast after FY2021, we will use the FY2019 sales as a guide. For the base scenario, sales reach back to the FY2019 level in FY2024, with the optimistic scenario having sales reach the FY2019 level in FY2023 and the worst scenario reaching the FY2019 level in FY2025.

The growth in sales that return the sales number to FY2019 can be thought of as a “catch-up” growth amount, meaning that this amount is not sustainable in the long-run. Our projection goes until 6/30/2025, meaning that the worst scenario does not needed a long-run growth rate, but a long-run growth rate is needed for both the optimistic and base scenarios. In the four years from the end of FY2015 to the end of FY2019, the CAGR was 2.2%. With this as a guide, we will use a 2% long-run growth rate for the base scenario and a 3% rate for the optimistic scenario.

Cost of Goods Sold

Over the six-year historical period analyzed, the COGS margin for FARM was the highest in FY2019 and FY2020. As we previously laid out, coffee prices are expected to continue to be elevated for the foreseeable future. The FY2019 and FY2020 COGS margin average of about 71% will be used for the base estimate forecast. The optimistic and worst estimates will be a decrease or increase of 2% of the base estimate.

Operating Expenses (Op ex.)

During the six-year historical period used for this analysis, FARM has restructured by moving headquarters and selling off assets (mainly buildings). This has resulted in many non-reoccurring items being reflected in the op ex. amounts on the financial statements. In order to get a long-run estimate for op ex., historical op ex. was normalized by removing these non-reoccurring items. After normalizing the op ex. amounts, the historical average op ex. margin is about 28%.

With FARM’s focus on cost-cutting measures for the immediate future, the 28% average will be used for the worst estimate. The base estimate will be 2.5% better than the 28% average, and the optimistic estimate will be 5% better than the average.

(One note: On the income statement, FARM includes depreciation and amortization (D&A) in operating expenses; it is not its own line item. In order to back out D&A from op ex., the D&A from the statement of cash flows was backed out of the op ex. amounts on the income statement.)

Other items for Net Income

The other items needed for net income are D&A, interest expense, extraordinary items, and taxes.

The D&A margin has generally been increasing for FARM. FY2016 had a D&A margin of 3.8%, while FY2020 had a D&A margin of 6%. For FY2021, we used an average margin over the six-year historical period, which leads to a D&A margin of 5.1% for the base estimate. For remaining years of the projection, we reflected a decreasing D&A margin to reflect the restructuring that has occurred in the last few years. The base D&A estimate will decrease by 25 basis points per year, which leads to a 4.1% margin in FY2025. This margin is similar to the 4.2% margin for FY2017, so we are comfortable with this assumption. The optimistic and worst scenarios will have margins that are 2% better and worse from the base.

At this point, the company does not plan on needing to borrow any more money, so the interest expense amount was set equal to the amount paid in FY2020 for all three scenarios. Since interest expense has generally not been a very large percentage of revenue, we are comfortable with this assumption.

Extraordinary items is difficult to predict, and the average extraordinary items margin over the historical period is close to zero. We will assume these items will average out over the forecast; therefore, we will not forecast any extraordinary items in any scenario.

The company has had a negative tax rate in four years out of the six in the historical period. We feel it is not prudent to forecast a negative tax rate, so the forecasted taxes are zero for all scenarios.

Net Income

The base estimate has negative NI for the entire forecast period, which is consistent with the company’s $50 million valuation allowance they took in FY2019 to write their deferred tax asset down to zero. We are comfortable with the assumptions used to derive this forecast because forecasted margins are in-line with historical margins.

(Base estimate)

(Base estimate)

(Optimistic estimate)

(Optimistic estimate)

(Worst estimate)

(Worst estimate)

Activity Ratios

The next items to forecast are those needed for working capital, namely: accounts receivable, inventory, and accounts payable. These forecasts will be driven by historical activity ratios. The activity ratios are days of sales outstanding, days of inventory outstanding, and days payable outstanding.

These three ratios make up what is known as the cash conversion cycle. From a high level, the cash conversion cycle is the amount of time needed for a company to turn inventory into cash. It is calculated as (DSO + DIO – DPO). (A more thorough explanation of the cash conversion cycle and these ratios can be found here.)

As seen in the table below, the cash conversion cycle for FARM has been trending in the wrong direction – it has been taking FARM longer and longer to turn inventory into cash. Even though management will be focused on preserving cash, we feel it will be difficult in the COVID business environment for FARM to improve on their activity ratios, especially considering FY2020 ratios were already a reversal of the historical ratios.

FARM will attempt to improve DSO by collecting sales invoices as soon as possible, but some of FARM’s customer will not be able to increase payment frequency, think hotels and casinos. On the other end, FARM will attempt to push off their accounts payables. FARM suppliers will be in the same situation as FARM, though, so we do not think they will be able to improve on FY2020 numbers. The one area they will have more control is DIO, which we believe they will be able to marginally improve in FY2021 but make no further improvement after that.

Other assets and liabilities

Other assets includes the balance sheet items prepaid expenses and other assets. Other liabilities includes the balance sheet items accrued payroll expenses, current portion of operating leases, and other liabilities. These items are forecast as a percentage of revenue. This percentage was determined using the average over the six-year historical period and is kept constant for the projection period.

(Base estimate)

(Optimistic estimate)

(Worst estimate)

Capital Expenditures

Capital expenditures is the last item needed for the unlevered free cash flow forecast. There are two drivers of the CAPEX forecast: property, plant, and equipment and depreciation and amortization. CAPEX is forecast using the change in PPE plus any D&A. The D&A assumption was covered in the net income forecast.

The PPE margin for FARM was much higher over the last four fiscal years than the first two fiscal years in the historical period (FY2015 and FY2016). In order the reflect this higher margin, the base estimate will use the average of the last four years as a starting point for FY2021. We believe that FARM will have a low PPE growth rate over the forecast period, due to restructuring, so the PPE margin will decrease by 1% each year of the forecast. The amount of PPE will continue to increase, but it will decrease as a percentage of revenue.

(Base estimate)

(Optimistic estimate)

(Worst estimate)

Unlevered Free Cash Flow

The table below lays out the FCF forecast for the base estimate. FY2017, FY2018, FY2019, and FY2020 all had negative unlevered FCF. This make us comfortable with the base estimate having negative FCF in all years expect FY2021 and FY2025. This is reasonable because FY2021 will be the year where FARM is most focused on retaining cash.

(Base estimate)

The optimistic estimate makes sense to us. The increasing accounts payable over the forecast period is the main driver of unlevered FCF in this scenario. As we pointed out in the activity ratios estimates, the days payable does not increase over the forecast period, but as revenue grows, the level of accounts payable also grows.

(Optimistic estimate)

Given the assumptions in the worst estimate, it makes sense that there would be no positive FCF over the forecast period.

(Worst estimate)

Weighted Average Cost of Capital

There are four parts that go into the WACC for FARM: cost of equity, cost of debt (two forms), and cost of preferred shares. For a reference on FARM’s WACC, we relied on data from NYU professor Aswath Damodaran (Homepage). (Any misuse use of his numbers is the responsibility of this report’s author.)

The calculated WACC for FARM came out to 5.50%. Damodaran has FARM in the food processing category. The WACC he gives for this category is 5.38%, so 5.50% is a reasonable WACC to use for the DCF.

Cost of Debt

FARM’s two sources of debt are a credit revolver and an interest rate swap. The interest rate swap was entered to offset a portion of the variable rate on the credit revolver. As of 6/30, the outstanding amount on the credit revolver was $122 million and the offsetting notional of the IRS was $65 million, leaving $57 million subject to a variable interest rate, which was 4.91%. The IRS has an interest rate of 2.1957% and had a fair value of $3.84 million as of 6/30. These numbers will be used in the WACC calculation. Only the variable portion of debt under the credit revolver will be adjusted for the company’s tax rate of 21%.

Cost of Preferred Shares

The dividend on the preferred stock is 3.5%. The disclosed carrying value on the 6/30 10-K was about $11.76 million.

Cost of Equity

The cost of equity was calculated using the capital asset pricing model (CAPM). The equity premium and risk-free rate needed will come from Professor Damodaran. His equity premium is 5.2% and risk-free is 1.9%.

The weight of equity is calculated using the shares outstanding as reported in the 6/30 10-K – 17.4 million – and the 10/31/20 closing share price – $3.47. Using this weight for equity and the weights calculated for cost of debt and cost of preferred shares, the final equity weighting is about 54% and the final debt weighting is about 46%. These levels will be used for the beta calculation.

Damodaran’s calculated “unlevered beta corrected for cash” for the food processing beta is about 0.69. This beta was relevered to arrive at a beta of about 1.15. After applying Blume’s adjustment, the final beta is about 1.1.

Using an equity premium of 5.2%, a risk-free rate of 1.9%, and a beta of 0.95, the CAPM formula arrives at a final cost of equity of about 7.6%.

Final WACC

Using the numbers outlined above, the final WACC is 5.50%.

Terminal Growth Rate

We performed an analysis of FARM’s pricing power to determine a terminal growth rate of 0.5%. To get a gauge for pricing power, we looked at the three largest sales groups – coffee (roasted), culinary, and other. (See the Sales section above for a description of these groups)

In the tables below, unit price is on the x-axis and units sold is on the y-axis. What is evident is that units sold decreases at higher price points. This implies that FARM is not able to pass along costs to customers. What really stands out is the pressure FARM faced in its largest selling segment – coffee (roasted). For FY2020, unit price decreased and unit sales were much lower than what would be expected based on the prior three fiscal years.

Discounted Cash Flow Analysis

Three scenarios were used for the DCF analysis – base, optimistic, and worst. The financial liabilities in the DCF analysis will include the $69 million in retirement obligations and the $122 million outstanding credit revolver amount on the 6/30 balance sheet.

Base Estimate

With the base assumptions, the forecasted present value of invested capital and cash are not enough to cover the company’s outstanding credit revolver and retirement obligations. This suggests the stock is worthless under the base assumptions. This estimate will be given a weight of 55% for the final valuation.

Optimistic Estimate

The optimistic assumptions arrive at a price target of $17.95. Compared to the base estimate, this estimate has improved sales and expense assumptions. In our view, these numbers are achievable, but the company has not demonstrated operating efficiency in the past. This estimate will be given a weighting of 15%.

Worst Estimate

Like the base estimate, the worst estimate suggests the stock is worthless. This estimate will be given a weighting of 15% in the final valuation.

Comparable Transaction

The public companies in the coffee business are either part of a conglomerate, like Keurig Dr. Pepper (NYSE:KDP), or are too large for comparison, like Starbucks (NASDAQ:SBUX), so using a multiples approach is not appropriate.

For a comparable transaction analysis, we will use the Westrock Coffee Company acquisition of S&D Coffee & Tea in February of this year (2020). (Link) S&D is a reasonable comparison to FARM. They both roast and sell coffee, while also selling tea and other items. The business models are similar, with sales teams, direct store delivery, and national distribution. They both supply equipment and have similar customer bases, such as convenience stores, national chains, offices.

The debt and cash-free price for S&D was $405 million. Using this acquisition price with FARM’s financials arrives at a price target of $13.10. This estimate will have a weighting of 15% in the final valuation.

Final Valuation

When the three DCF estimates and comparable transaction estimate are combined, the final price target is $4.66. This is about 14% higher than the 11/2 closing price of $4.09.

Technical Analysis

Based on fundamentals, the stock price is undervalued; however, the technicals for FARM are very bearish. The stock price has been below the 50-day moving average since mid-September. The 11/2 stock price of $4.09 is about 18% below the 50-day moving average of $4.98 and about 47% below the 200-day moving average of $7.68. With the current price well below the 50-day, we would hope it might be oversold. As you can see at the bottom of the graph, the 14-day RSI indicator is not signaling that the stock is oversold. This analysis is contradictory to the fundamental analysis.

Risks

What could go wrong with this estimate? The Q1 FY2021 10-Q should be released shortly. We will be mainly focused on costs. In the current environment, increasing sales is a tall order, but the company has more control of decreasing costs. This will be key to the long-term prospects for FARM. If the company can cut costs, it might be worth beginning to build a position in the stock.

If they are not able to control costs in this environment, bankruptcy is not out of the question. The company had about $60 million in cash on the 6/30 balance sheet and $122 million outstanding on the credit revolver. A large cash burn would seriously question FARM’s ability to continue as a going concern.

Summary

The conclusion of the fundamental valuation is that FARM stock is undervalued at current levels. This analyze suggests a price target of $4.66, about 14% above the 11/2/20 closing of $4.09. The technicals, however, suggest that now is not the time to enter the stock, as it is well below both the 50-day and 200-day moving average.

This stock is worth watching. With the current stock price down over 70% year-to-date, there is plenty of upside available. If the company can execute on its cost-cutting measures or the economy rebounds quicker than expected, the stock could be a big winner. If the company is not able to control costs and sale do not rebound, bankruptcy is not out of the question.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

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