Westrock Coffee Stock: A Troubling Business Model (NASDAQ:WEST)

When first learning of Westrock Coffee Company, LLC (NASDAQ:WEST), it is tempting to get onboard with its “dual purpose organization,” which was formed in 2009 for the purpose of helping “ensure small holder farmers in the developing world are paid a fair price for their coffee crop.”

Interestingly, in its first-ever earnings report after going public via a SPAC merger with Riverside Acquisition Corp., management, after pointing out the company was formed for the purpose noted above, went on to say it was “first and foremost a commercial enterprise.”

While the company seems to be trying to have it both ways, I think it’s going to struggle immensely from the attempt to pay undefinable “fair” prices while at the same time improving the bottom line, especially since it added that its business model isn’t predicated upon “charging our customers premium prices.”

The company has definitely shown it can generate revenue since it launched, but doing so at a profit or at historical industry margins is another story.

In this article, we’ll look at its first earnings report, some of the initiatives it’s undertaking, and why I think it needs to change its business model if it’s going to succeed in the long term and create shareholder value.

Some of the numbers

Westrock Coffee Company, LLC revenue in the third quarter was $230 million, compared to revenue of $181 million in the third quarter of 2021. Revenue in the first nine months of 2022 was $118 million, compared to revenue of $105.8 million in the first nine months of 2021.

Its Beverage Solutions segment accounted for $175.5 million in sales in the quarter, up 25 percent year-over-year. It also contributed $15.9 million in adjusted EBITDA in the third quarter of 2022.

Revenue from its SS&T segment was $56.8 million, up 34 percent year-over-year. The increase in revenue in the unit was attributed to higher green coffee prices.

Gross profit was $41 million in the quarter, compared to gross profit of $38 million in the third quarter of 2021. This is one of the obvious weaknesses of the company, as it means gross profit margin is approximately 18 percent, far below the industry average. The company noted that gross profit margins were down 310 basis points in the reporting period.

Adjusted EBITDA in the third quarter was $17.9 million, up 33 percent year-over-year.

Net loss in the quarter was $(20.2) million or negative $(0.41) per diluted share, compared to a net loss of $(10.1) million or negative $(0.29) per diluted share in the third quarter of 2021. Net loss in the first nine months of 2022 was $(44.7) million, or negative $(1.12) per diluted share, compared to a net loss of $(34.4) million, or negative $(1.00) per diluted share in the first nine months of 2021.

Cash and cash equivalents at the end of the third quarter of 2022 was $90.9 million, compared to cash and cash equivalents of $19.3 million at the end of calendar 2021. It also had a $175 million undrawn revolver.

Long-term debt was $165 million at the end of the reporting period.

Concerns over the business model

From the beginning of its first earnings report since going public, Westrock Coffee Company, LLC CEO Scott Ford was clear that the company was founded purpose of “ensure small holder farmers in the developing world are paid a fair price for their coffee crop.” as mentioned earlier.

There are a number of problems with that as a business model, with the first being that there is no way of knowing what a “fair price” is. The most accurate mechanism for price discovery is the free market, where people or companies via negotiations associated with supply and demand find out what the real price of a product or service is, based upon what they agree to.

The idea of paying for coffee, in the case of WEST, based upon an arbitrary idea of what a fair price is, results in paying above-market prices not determined by the market, but by a small number of individuals imposing what they consider “fair” to be.

Someone may ask this question then: Why does it matter? It matters because, as management revealed in the earnings report, coffee accounts for approximately 60 percent of the total cost of the end products of the company, adding that price inflation for green coffee acquisitions was up 45 percent on a year-over-year basis. Assuming the company actually adheres to the original idea of paying fair prices to coffee producers in developing nations, then I have to wonder why these prices are soaring so much. Is there little in the way of negotiations because the management believes they must continue to pay fair prices, even if they rise at exorbitant levels?

The point of all of this is to say that the fair price business model of the company could continue to weigh heavily on margins and earnings if there are few if any measures in place to restrain “fair prices” from becoming a huge headwind for the company.

Again, with coffee accounting for 60 percent of its input costs, and prices in other areas of business rising, the company is faced with a huge problem if it is committed to its fair price policy.

I’ve seen many entrepreneurs in different areas of business have similar ideas, but they rarely work because it combines business practices with the idea of fairness, which is usually associated with governments and how they distribute money to citizens. What I mean by that is buying coffee at above-market prices is a form of underwriting the coffee farmers. Governments do this across many industries, but they have the resources, for the most part, to do so.

In my opinion, that’s the negative side of its business model. The reason I draw that conclusion is because the practice isn’t sustainable. I think WEST management is finding that out the hard way under the current macroeconomic environment.

On the other hand, a potential strength of another part of its business model is it integrated supply chain, where, after buying the coffee, the company has its hands directly on every aspect of the process that leads to the end-user.

This probably results in a streamlined experience for its customers that could be a differentiator if it executes well on it.

With the company pulling forward its manufacturing operations in Conway, Arkansas, it needs to find a way to widen margins. Under its current business model, it’s going to be tough to do, even if it scales nicely.

Conway, Arkansas facility

According to management, strong demand for its products has resulted in it deciding to bring forward its manufacturing and packaging capabilities at its expansion in Conway, Arkansas to Phase 2.

Phase 1 of the expansion was for the purpose developing “basic extraction capabilities and high speed can and glass bottle lines,” which will now include accelerating its process of adding “enhanced extraction and soluble capabilities, a multi serve bottling line and several bag in a box lines.”

The company noted that prior guidance was based only upon the completion of Phase 1 of the project. The original thought was bringing Phase 1 online would have little impact on EBITDA in 2024. With Phase 2 being accelerated, the company expects it to improve its adjusted EBITDA into 2025 and further out. If it can do so while lowering coffee costs while increasing revenue, the company could surprise to the upside within two or three years.

Acquisition of Kohana Coffee

The company recently closed on its acquisition of Kohana Coffee based in Richmond, California, which is owned by former PepsiCo CEO Steve Reinemund and his son Jonathan. The immediate benefits of the deal are it brings some significant national customers to the company, as well as two “ready-to-drink extract packaging formats.”

With the rapid progress of its expansion in Arkansas and the acquisition of Kohana Coffee, management believes it can accelerate its product to market based upon its CPG customers that are ramping up their own marketing of RTD beverages in response to growing demand.

Conclusion

WEST is having some success boosting revenue, but it continues to struggle to widen margins, not only because of rising material and labor costs, along with slowing demand in convenience stores and restaurants, but also from the cost of coffee, which accounts for approximately 60 percent of cost input. I think the company will be forced to make a decision soon, and that is it’s going to have to rethink the major reason for launching the business in the first place in regard to paying coffee farmers in developing countries a “fair price” for their product and start moving in the direction of paying market prices. I tend to think Westrock Coffee Company, LLC is already moving in that direction, and if not, will in the near future.

If it doesn’t, and as its discovered by more investors digging deeper into its business practices that it is found it’s paying above-market prices for coffee that are having a strong impact on margin and earnings, they will either ignore the stock or put pressure on management to change its strategy.

After all, paying higher coffee prices, while stating you’re not going to charge premium prices to customers, means there’s going to be a consistent underperformance on the bottom line going forward that will eventually have to be dealt with.

I know the idea of scaling the business would suggest improved margins, and to a degree that may be true, but again, if coffee remains about 60 percent of total input costs, it’s going to continue to hinder the performance of the company.

If there is a large enough customer base that supports the business model of WEST, then it isn’t going to have near the problems it could have if shareholders not so sympathetic to the cause, start generating noise concerning making changes.

As for the near term, I think Westrock Coffee Company, LLC is overvalued and needs to pull back to below $8.00 per share or lower in order to make it a better risk-reward holding. However the company manages to do it, if it indeed can, it will have to deal with margin in order to make it attractive and sustainably profitable in the future.

Until it does, I think Westrock Coffee Company, LLC is going to turn into a very volatile stock that is more of a trading vehicle than a long-term holding. In the end, investors want a business, not a charity, and the company, in my opinion, must change that perception if Westrock Coffee Company, LLC wants to attract serious investors.