Farmer Bros.: It’s Make Or Break Time For The Company (NASDAQ:FARM)

Farmer Bros. Co. (NASDAQ:FARM) is coming off a terrible quarter, where gross margins collapsed even as sales were up; primarily from raising prices as volume dropped by 13 percent.

Surprisingly to me, the share price of the company has held up better than I thought after such a weak performance. Right before the earnings report the share price was trading at approximately $6.80 per share, and immediately afterwards dropped briefly to about $4.90 per share before rebounding to a little over $6.00 per share on November 11, 2022, before finding a temporary bottom at around $5.13.

It held there until November 21, 2022, before beginning a run-up to just under $6.00 per share before finally beginning a descent that better reflected the reality of the performance of the company, eventually falling to its 52-week low of $4.33 per share on December 22, 2022. Since then, it has traded in a tight range of approximately $4.50 to $4.75, before resuming an upward trajectory on January 6, 2023, now trading at slightly above $5.00 per share as I write.

My major reason for going into the detail of its price movement is, I believe the share price has held up better than I thought it would, even though it did come down from about $6.80 per share to where it is today. I think it is doing better than expected because of management commentary on the contracting margin being transitory and will significantly rebound in the second fiscal quarter of 2023.

In this article we’ll look at some of its latest numbers, contracting margins, and why, with the economy likely to get worse before it gets better, the company is far from out of the woods yet.

Some of the numbers

Revenue in the first fiscal quarter of 2023 was $121 million, up $13 million or 12 percent from the $108 million revenue generated in the first fiscal quarter of 2022. Its DSD and Direct Ship sales were both up by 12 percent year-over-year.

The increase in sales came from an increase in prices, as volumes in the reporting period were down 13 percent. The main question to me is, how much more pricing power the company has in an increasingly uncertain economic environment that will probably get worse before it gets better? I’ll talk more about that later in the article.

Concerning the decline in volume, over two-thirds of that was attributed to a drop on the Direct Ship side of the business, and two-thirds of that came from customers it retained, and the remaining one-third from customers that exited.

The obvious meaning of that is lower demand from existing customers was the major reason for the decline in volume. Reasons for that were a drop in consumption by customers associated with the recession, normal weaker summer demand, and probably most important, the inventory drawdowns at several of its major accounts. How long those inventory drawdowns continue will be a factor in the company’s performance over the next couple of quarters.

Gross profit in the reporting period was $26.6 million, compared to $31.5 million in gross profit in the first fiscal quarter of 2022. Gross margin in the quarter was 21.9 percent, plunging from gross margin of 29 percent last year in the same quarter.

Adjusted EBITDA in the quarter was negative $(4.9) million, compared to $3.5 million in the first fiscal quarter of 2022. Adjusted EBITDA margin was negative 4 percent in the first quarter of fiscal 2023, compared to 3.2 percent in the first fiscal quarter of 2022.

Cash and cash equivalents at the end of the first fiscal quarter of 2023 was $7.6 million, compared to $9.8 million as of June 30, 2022. The company attributed the decline in liquidity to the impact of higher operating and product costs in the reporting period.

During the quarter, the company refinanced its ABL credit facility, which will save approximately $2 million annually in savings.

Margin recovery

The most important part of FARM’s performance at this time will be how effectively it’ll be able to mitigate the decline in margins going forward.

The first thing I want to cover here is some of its large national accounts working through their inventory in the quarter. As with many companies in a variety of sectors, the lack of certainty concerning supply chains has resulted in them buying more inventory in order to reduce risk in relationship to meeting demand.

In the case of FARM’s large customers, apparently, the decline in volume connected to lower demand ended up with them working down excess inventory before making purchases in large quantities. The company said much of that didn’t start coming back until the end of the reporting period. It remains to be seen how much has actually come back in the second fiscal quarter, and further out.

Management said the drop in orders surprised them and will have to rethink how to respond if the practice continues on.

As it relates to margin, it means its customers are working through lower-cost inventory while not buying higher-margin inventory, which of course would widen FARM’s margin. If this continues on, there’s nothing the company can do on the pricing side if its products aren’t bought at levels they expected.

The other factor connected to inventory drawdowns is the underutilization of its production facilities, where fixed costs remain in place.

And speaking of pricing, I’m not sure how much more pricing power the company has in light of a frail economy, and by extension, labor market. Consumers are starting to reprioritize their spending, which the 13 percent drop in volume confirms. The good news so far is there is a customer base that’s willing to, at this time, pay higher prices for coffee and other drinks. On the other hand, as layoffs and terminations accelerate, the volume levels are likely to drop further in the quarters ahead, which will limit how much the company could increase prices, which means one of the means of improving margins would be, for the most part, removed from it.

Several other factors having an impact on margin in the quarter were an increase in the price of coffee, higher production costs, hedges rolling off, and price increases in DSD in particular not keeping up with inflation.

The key thing to consider in margin recovery, in my opinion, is the ability of the company to offset higher costs that it has no control over, with higher prices. As already mentioned, demand has been dropping because of inflationary pressures, as consumers cut back on consumption. I’m not sure how much higher FARM can raise prices before it further cuts into demand.

Combined with the rising concerns in relationship to the labor market, I see consumers getting tighter with their spending in the quarters ahead, and I don’t see how increasing prices won’t result in volumes continuing to drop.

That doesn’t mean margin won’t expand, but it would mean it would probably be at the expense of revenue. Along with the above-mentioned inflationary impacts, another key factor concerning margins in the reporting period was contract delays connected to price increases from national accounts. The company says once they come through, it should increase margin by a minimum of 200 to 300 basis points in December 2022 and expects it to continue to improve in the second half of the current fiscal year.

Another reason management believes margin will improve, it has started to see coffee prices start to fall. If coffee prices continue to soften that would be a nice tailwind for the company, as it would likely also trigger more demand for increasingly price-conscious consumers. That said, there’s no guarantee coffee prices will remain subdued in the months ahead.

Last, if commodity prices continue to fall, its hedging program won’t have the positive impact that would come from a higher-price environment, as hedges mature at higher price levels on a monthly basis.

Conclusion

The most important thing to watch with FARM in the near term is recapturing margin. If it’s able to do so while increasing sales, the company would get a boost in its share price that would probably raise the floor and ceiling of its share price in calendar 2023.

With management confidently asserting the near-term recovery of a significant amount of margin, it’s now on them to execute on that optimism.

While there is some visibility on how margin could improve, specifically with the impact of lag on its price increases and softer coffee prices, it remains to be seen to what level that will widen margin, especially in regard to coffee prices.

The company taking short hedge positions could also have a positive impact on margin in calendar 2023.

Taken together, the drop in coffee demand from inflationary pressure, concerns over the labor market, and a macroeconomic environment that seems like it’ll get worse before it gets better, all strong headwinds that could play a big part in disrupting the optimistic outlook the company has in recovering margin.

I think it’s highly probable that gross margin will improve in the quarter, but I’m not convinced it will be in a sustainable manner. There are far too many variables that could suppress margin in the year ahead, and the offsetting factors could result in it either staying level and even possibly contracting further if demand continues to erode in response to higher prices in a market where consumers are tightening up on spending.

In the end, I think FARM could go either way, and there’s no way of knowing at this time whether it’ll be up or down.

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