Farmer Brothers Coffee Company
Under commodity price risk (see footnotes), Farmer
Brothers Mentioned that “from to time, it holds a mixture of
futures contracts and options to hedge against volatility in green
coffee prices.” How would Farmers use these financial products to
hedge price risk?
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Company Background Farmer Brothers Company was a manufacturer, wholesaler, and distributor of coffee, tea, and culinary products. The company distributed coffee to restaurants, hotels, casinos, hospitals, and other food service providers, and were nationwide providers of private-brand coffee programs to grocery retailers, restaurant chains, convenience stores, and independent coffee houses. The company's mission was to "sell great coffee, tea, and culinary products and provide superior service-one customer at a time." Farmers reached its customers in two ways: through its nationwide Direct-Store-Delivery (DSD) network of approximately 500 delivery routes, 114 branch locations, and 6 distribution centers; and by using the distribution channels of its national retail and institutional customers. Farmers differentiated itself in the marketplace through its customer service model offering value-added services including beverage equipment service, menu solutions, in which it recommended products, how these products were prepared in the kitchen and presented on the menu, and hassle-free inventory and product procurement management to its food service customers. These services were conducted primarily in person through Regional Sales Representatives, or RSRs, who developed personal relationships with chefs, restaurant owners, and food buyers at their drop-off locations. The company also provided comprehensive coffee programs, including private brand development, green coffee procurement, category management, and supply chain management to its national retail customers. Farmers manufactured and distributed products under its own brands, as well as under private labels on behalf of other customers. Branded products were sold primarily into food service channels, and comprised both national and regional brands. Leading national brands included the Farmer Brothers and Superior brands, as well as the Sierra, Metropolitan, Prebica, and Panache brands. It also marketed regional brands such as Cain's, McGarvey, and Ireland. Farmers' product line of over 2,800 SKUs included roasted coffee, liquid coffee, coffee-related products such as coffee filters, sugar and creamers, assorted teas and cappuccino, cocoa, spices, gelatins and puddings, soup, gravy and sauce mixes, pancake and biscuit mixes, and jellies and preserves. For the past three fiscal years, sales of roasted coffee products represented approximately 50% of total sales, and no single product other than roasted coffee accounted for more than 10% of total sales. Coffee purchasing, roasting, and packaging was con- ducted at its Torrance, California; Portland, Oregon; and Houston, Texas plants. Spice blending and packaging was conducted at the Torrance, California plant. In 2007, Farmer Brothers acquired Coffee Bean Holding Co., Inc., a specialty coffee manufacturer and wholesaler headquartered in Portland, Oregon, and in 2009 acquired from Sara Lee Corporation certain assets used in connection with their direct store delivery (DSD) coffee business in the United States. The DSD coffee business acquisition helped increase sales to $463.9 million in fiscal 2011 from $266.5 million in fiscal 2008, added over 2,000 new SKUs, and more than 60 trademarks, trade names, and service marks. In fiscal 2010, Farmers completed much of the post-acquisition integration of the DSD coffee business in an effort to realize the selling and operating efficiencies of the combined organization through consolidation of product offerings and SKUs. They also streamlined routes and distribution logistics, consolidated warehouses and distribution centers, and expanded their customer focus in the organization by adopting and implementing enhanced information management tools and training. Raw Materials The primary raw material was green coffee, which was mainly grown outside the United States and subject to volatile price fluctuations. Weather, real or perceived supply shortages, political unrest, labor actions, currency fluctuations, armed conflict in coffee-producing nations, speculative investment, and government actions, includ- ing treaties and trade controls between the U.S. and coffee-producing nations, affected the price of green coffee. Green specialty coffees sold at a premium compared to other green coffees due to the inability of producers to increase supply in the short run to meet rising demand. As a result, the price spread between specialty coffee and non-specialty coffee could widen as demand for specialty coffee continued to increase. Other raw materials > Farmer Brothers Company, 10-K, 2011. 2 A01-14-0009
used in the manufacture of the company's tea and culinary products included a wide variety of spices, such as pepper, chilies, oregano, and thyme, as well as cocoa, dehydrated milk products, salt, and sugar. In fiscal 2011, fluctuations in commodity prices had a material effect on the company's operating results. Fiscal 2011 was a period of rapid commodity inflation, which impacted the cost of green coffee, sugar, and cocoa, and freight expense. Green coffee costs increased 80% in fiscal 2011 compared to the prior fiscal year. Since Farmers valued its inventory on a last-in-first-out (LIFO) method of valuation rather than on a first-in-first-out (FIFO) basis, the escalating coffee prices had a significant negative impact on cost of goods sold and the resulting gross profit (see Exhibit 4 for the selected financial statement information, and Exhibit 5 for footnote informa- tion about inventory valuation). To mitigate the increase in freight and fuel expense, the company instituted a fuel surcharge in fiscal 2011 and increased product prices several times in fiscal 2011. Competition Farmers faced competition from many sources, including the institutional food service divisions of multinational manufacturers of retail products such as The J.M. Smucker Company (Folgers Coffee), Kraft Foods Inc. (Maxwell House Coffee), and Sara Lee Corporation; wholesale grocery distributors such as Sysco Corporation and U.S. Foodservice; regional institutional coffee roasters such as S & D Coffee, Inc., and Boyd Coffee Company; and specialty coffee suppliers such as Green Mountain Coffee Roasters, Inc. (see Exhibit 6 for selected financial data). Green Mountain Coffee Roasters, Inc. was a leader in the specialty coffee and coffeemaker businesses. The company roasted high-quality Arabica bean coffees including single-origin, Fair Trade Certified ™, certi- fied organic, flavored, limited edition, and proprietary blends offered in K-Cup portion packs, whole bean and ground coffee selections, as well as other specialty beverages including tea, hot apple cider, and hot cocoa, also offered in K-Cup portion packs. Green Mountain manufactured and sold the Keurig single-cup brewing system for use with K-Cup portion packs and was an emerging leader in sales of coffee makers and single-cup brewing systems. Over the last several years, the primary growth in the coffee industry came from the specialty coffee category, including demand for single-cup specialty coffee. This growth was driven by the wider availability of high-quality coffee, the emergence of upscale coffee shops throughout the country, and the general level of con- sumer knowledge of, and appreciation for, coffee quality and variety. The company's growth strategy involved developing and managing marketing programs to drive Keurig single-cup brewer adoption in North American households and offices in order to generate ongoing demand for K-Cup portion packs. The company used FIFO to value inventory. Farmer Brothers' Future Amphlett knew that understanding Farmer Brothers' business and charting the company's future would be a difficult task. In addition to financial statement information, he also gathered capital markets data (see Exhibit 7). A recent article suggested that coffee prices surged after heavy rains, and flooding in Latin America and Asia were expected to reduce near-term coffee supplies. He wondered whether LIFO could result in a sharp drop in the company's earning if coffee prices surged again. Would Farmers' stock price hit the price target of $11 per share, as predicted by Sinclair?
Exhibit 1. Robusta Coffee Prices over the 10-Year Period, November 2001-December 2011 (in cents per pound) 8 8 88 2 No-11 Sep11 J-11 Ma-117 Jan-11 No10 Sep 10 quer May-10 90-196 andas 90-85 80-a 80 Jan 08 20-40% mdas J-07 May 07 Mar-07 Jan-07 20-40% godag 30-06 Aly-06 Mar 06 9048 400-05 godas 90-85 90-day SHIBA go-ve Ma modal Mar -fox Mar-04 WHE m ondas mer Aly-03 Marco eurten con 30-44 20-40 20-Fr May-02 201m Jan-02 No-01 Coffee Price per Pound 1.2633 1.2129 0.7501 30, 2011 May 30, 2011 June 30, 2010 June
Exhibit 2. Historical Financial Data for Farmer Brothers Company In thousands Cash & cash equivalents Short term investments Accounts & notes receivable, net Inventories Total current assets Property, plant & equipment, net Total assets Accounts payable Short-term borrowings under revolving credit facility Total current liabilities Total shareholders' equity Net sales Cost of goods sold Gross profit Operating expenses Income (loss) from operations Income (loss) before taxes Net income (loss) Year-end shares outstanding Net income (loss) per share-basic Number of employees Net cash flows from operating activities Net cash flows from investing activities Net cash flows from financing activities Net increase (decrease) in cash & cash equivalents Cash & cash equivalents at beginning of year Cash & cash equivalents at end of year Cash paid for interest 06/30/2011 06/30/2010 06/30/2009 06/30/2008 06/30/2007 6,081 4,149 20,038 9,973 12,586 24,874 50,942 42,926 113,286 158,050 43,501 42,596 45,744 19,856 17,651 79,759 83,712 68,961 54,253 44,996 157,410 189,956 186,546 217,750 239,362 114,107 120,372 112,063 69,065 52,667 290,053 339,121 330,017 312,984 337,609 42,473 34,053 34,627 12,169 8,702 31,362 37,163 16,182 103,462 98,546 76,457 28,909 27,096 128,115 165,595 196,489 266,455 266,216 463,945 450,318 341,724 266,485 216,259 306.771 252.754 181.508 147,073 89.492 157,174 197,564 160,216 119,412 126,767 225,596 236,756 175,419 130,056 130,843 (68,422) (39,192) (15,203) (10,644) (4,076) (63,484) (26,482) (18,987) (15,323) 6,848 (54,317) (23,953) (33,270) (7,924) 6,815 16,186.372 16,164.179 16,078.111 16,075.08 16,075.08 (3.61) (1.61) (2.29) (0.55) 0.48 1,820 2,030 2,218 1,256 1,233 33,937 (1,047) 87,244 27,496 48,791 (17,395) (28,047) (86,583) (23,439) (35,396) (14,610) 13,205 9.404 (6,670) (6.142) 1.932 (15.889) 10.065 (2.613) 7.253 4,149 20,038 9,973 12,586 5,333 6,081 4,149 20,038 9,973 12,586 1,339 890 812
12/29/2006 129/2007 20000 381.2007 480.0007 581.2007 6800007 781.2007 8.1.2007 9.480./2007 1091.2007 11002007 1201.2007 181.2008 2290000 481009 381.2008 www 4202008 541.2000 680.2008 www 781.2008 81.2008 9.80.2008 1001:2008 11002008 1231/2008 son 1019 1812000 2:28./2009 A 3812000 4800000 581.2009 STIONS 680/2009 781.2009 980./2009 10912009 11902009 1201.2009 1812010 sem 2282010 Am 3812010 10000 4800010 5810010 ARIMID 6402010 1010010 781/2010 w 801.2010 enero 9800010 1031.2010 11000010 12010010 181/2011 pro 2012011 A 381.2011 *** 480/2011 581/2011 6800011 7810011 881.2011 980./2011 1031/2011 11302011 2500 3000 (vs. NASDAQ) Exhibit 3. Stock Price Performance for Farmer Brothers Company, December 2006-December 2011 Farmer Brothers
Exhibit 4. Selected Financial Statement Information for Farmer Brothers Company FARMER BROS. CO. CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except share and per share data) June 30, ASSETS Current assets: Cash and cash equivalents Short-term investments Accounts and notes receivable, net of allowance for doubtful accounts of $2,852 and $3,293, respectively Inventories Income tax receivable Deferred income taxes Prepaid expenses Total current assets Property, plant and equipment, net Goodwill and other intangible assets, net Other assets Deferred income taxes Total assets LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable Accrued payroll expenses Short-term borrowings under revolving credit facility Short-term obligations under capital leases Deferred income taxes Other current liabilities Total current liabilities. Accrued postretirement benefits Other long term liabilities-capital leases Accrued pension liabilities Accrued workers' compensation liabilities Deferred income taxes Total liabilities Commitments and contingencies Stockholders' equity: Preferred stock, $1.00 par value, 500,000 shares authorized and none issued Common stock, $1.00 par value, 25,000,000 shares authorized; 16,186,372 and 16,164,179 issued and outstanding at June 30, 2011 and 2010, respectively Additional paid-in capital Retained earnings Unearned ESOP shares Less accumulated other comprehensive loss Total stockholders' equity Total liabilities and stockholders' equity 2011 2010 4,149 6,081 24,874 50,942 43,501 42,596 79,759 83,712 448 5,840 4 -2.747 2.713 157,410 189,956 114,107 121,710 14,639 23,904 2,892 2,492 1.005 1.059 290.053 339.121 42,473 34,053 15,675 14,661 31,362 37,163 1,570 724 500 264 11,882 11,681 103,462 98,546 23,585 22,185 3,137 22,371 43,497 3,639 4,388 1.815 1.773 161,938 173,526 16,186 16,164 36,470 37,468 129,784 186,900 (30,437) (35,238) (23.888) (39,699) 128.115 165.595 290.053 339.121
FARMER BROS. CO. CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except share and per share data) For the year ended June 30, Net sales Cost of goods sold Gross profit Selling expenses Intangible assets impairment losses General and administrative expenses Operating expenses Loss from operations Other income (expense): Dividend income Interest income Interest expense Other, net Total other income (expense) Loss before taxes Income tax (benefit) expense Net loss Net loss per common share, basic and diluted Weighted average common shares outstanding-basic and diluted Cash dividends declared per common share 2011 2010 2009 463.945 450,318 341,724 306.771 252.754 181,508 157,174 197,564 160,216 170,670 187,685 138,876 7,805 47.121 49,071 36.543 225.596 236.756 175.419 (68,422) (39,192) (15,203) 2,534 3,224 3,563 178 303 1,236 (1,965) (986) (335 4.191 10.169 (8.248 4.938 12,710 (3.784) (63,484) (26,482) (18,987) (9.167) (2.529) 14.283 (54.317) (23.953) (33.270) (3.61) (1.61) (2.29) 15,066,663 14,866,306 14,508,320 0.18 0.46 0.46
FARMER BROS. CO. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) For the year ended June 30, Cash flows from operating activities: Net loss Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization Provision for doubtful accounts Deferred income taxes Intangible assets impairment losses Loss (gain) on sales of assets Share-based compensation expense Net (gain) loss on investments Change in operating assets and liabilities: Short-term investments Accounts and notes receivable Inventories Income tax receivable Prepaid expenses and other assets Accounts payable Accrued payroll, expenses and other liabilities Accrued postretirement benefits Other long-term liabilities Net cash provided by (used in) operating activities Cash flows from investing activities: Acquisition of businesses, net of cash acquired Purchases of property, plant and equipment Proceeds from sales of property, plant and equipment Net cash used in investing activities Cash flows from financing activities: Proceeds from revolving line of credit Repayments on revolving line of credit Payments of capital lease obligations Dividends paid Net cash (used in) provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Supplemental disclosure of cash flow information: Cash paid for interest Cash paid for income taxes Non-cash financing and investing activities: Equipment acquired under capital leases Dividends accrued, but not paid 2011 2010 2009 (54,317) (23,953) (33,270) 31,758 26,778 18,292 2,024 3,188 810 336 758 15,556 7,805 358 430 (46) 3,825 4,784 5,452 (1,387) (9,382) 8,989 27,456 1,365 61,371 (2,929) (40) (26,698) 3,952 (14,751) 1,730 5,392 (1,677) (1,283) (434) 179 6,518 12,997 (738) 22,457 2,112 2,904 3,776 1,399 3,926 638 (6.410) 5.182 2.952 33.937 (1,047) 87,244 (48,287) (19,416) (28,484) (38,901) 2,021 437 605 (17,395) (28,047) (86,583) 35,450 33,737 29,500 (43,970) (12,756) (13,318) (1,433) (837) (147) (4,657) (6,939) (6,631) (14.610) 13.205 9.404 1932 (15.889) 10.065 4,149 20,038 9,973 6,081 4,149 20,038 1,339 890 812 136 5,659 3,954 1,252 1,849 1,849
Exhibit 5. Selected Footnote Information for Farmer Brothers Company Inventories Inventories are valued at the lower of cost or market. Costs of coffee, tea, and culinary products for the Company are determined on the last-in-first-out (LIFO) basis. Costs of coffee-brewing equipment manufactured are accounted for on the first-in-first-out (FIFO) basis. The Company regularly evaluates these inventories to determine whether market conditions are correctly reflected in the recorded carrying value. Note 4. Inventories June 30, 2011 Processed Unprocessed Total (In thousands) Coffee $22,464 $17,220 $39,684 Tea and culinary products 25,469 4,100 29,569 Coffee brewing equipment 3.930 6,576 10,506 $51,863 $27,896 $79,759 June 30, 2010 Processed Unprocessed Total (In thousands) Coffee $22,230 $16,765 $38,995 Tea and culinary products 28,833 3,145 31,978 Coffee brewing equipment 5.849 6.890 12.739 $56,912 $26,800 $83,712 Current cost of coffee, tea, and culinary inventories exceeds the LIFO cost by (in thousands): June 30, 2011 2008 Coffee $62,870 $22,932 Tea and culinary products Total 2010 2009 $24,432 $22,094 4.816 5,064 $29,248 $27,158 6.695 4.239 $69,565 $27,171 The change in the Company's green coffee, tea, and culinary product inventories during fiscal 2011, 2010, and 2009 resulted in LIFO (increments) decrements which resulted in a net increase (decrease) in gross profit for those years by $(40.3) million, $(0.7) million, and $(1.5) million, respectively. At times, the Company enters into specialized hedging transactions to purchase future coffee contracts to enable the Company to lock in green coffee prices within a pre-established range. For the year ended June 30, 2011, the Company recorded $1.6 million in net unrealized losses related to hedging transactions. From time to time, the Company may hold a mix of futures contracts and options to help hedge against volatility in green coffee prices. Gains and losses on these derivative instruments are realized immediately in "Other income (expense)." In fiscal 2011 and 2010, certain inventory quantities were reduced. This reduction resulted in a liquidation of LIFO inventory quantities carried at lower costs prevailing in prior years as compared with the current year cost in fiscal 2011. The effect of this liquidation was to reduce net loss for fiscal 2011 and 2010 by $1.1 million and $0.8 million, respectively. There was no liquidation of LIFO quantities in fiscal 2009.
Note 15. Quarterly Financial Data (Unaudited) September 30, December 31, March 31, June 30, 2011 2010 2010 2011 (In thousands, except share data) Net sales $108,743 $119,227 $116,732 $119,243 Gross profit $43,945 $5,016 $41,861 $26,352 $(12,019) Loss from operations Net loss $(10,543) $(14,463) $(31,397) $(9,873) $(8,912) $(13,196) $(22,336) Net loss per common share $(0.66) $(0.59) $(0.87) $(1.47) September 30, December 31, March 31, 2010 June 30, 2009 2009 2010 (In thousands, except share data) $112,127 $120,225 $111,002 $106,964 Net sales Gross profit $54,304 $51,092 $49,261 $42,907 Loss from operations $(2,499) $(5,102) $(9,288) $(22,303) Net income (loss) $2,199 $1,417 $(6,575) $(20,994) Net income (loss) per common share $0.15 $0.10 $(0.44) $(1.40) During the fourth quarter and for the fiscal year ended June 30, 2011, the Company recorded $40.3 million in LIFO charge in cost of goods sold and an impairment loss of $7.8 million related to the write-off of definite-lived intangible assets that the Company acquired or entered into during the DSD Coffee Business acquisition. During the fourth quarter of fiscal 2011, the Company also recorded $9.2 million in income tax benefit. Commodity Price Risk We are exposed to commodity price risk arising from changes in the market price of green coffee. We price green coffee inventory on the last-in-first-out (LIFO) basis. In the normal course of business, we hold a large green coffee inventory and enter into forward commodity purchase agreements with suppliers. We are subject to price risk resulting from the volatility of green coffee prices. Due to competition and market conditions, volatile price increases cannot always be passed on to our customers. At times, we also enter into specialized hedging transactions to purchase future coffee contracts to enable us to lock in green coffee prices within a pre-established range. For the year ended June 30, 2011, we recorded $1.6 million in net unrealized losses related to hedging transactions. From time to time, we may hold a mix of futures contracts and options to help hedge against volatility in green coffee prices. Gains and losses on these derivative instruments are realized immediately in "Other income (expense)." The following table demonstrates the impact of changes in market value of coffee cost on market value of coffee forward purchase contracts: Market Value (in thousands) Coffee Cost (Decrease) Increase Coffee Inventory Futures & Options -10% Total $35,983 (Decrease) Increase in Market Value Derivatives Inventory $(17) $36,000 $(17) $(3,684) $39,684 $1,316 $41,000 Unchanged 10% $44,000 $17 $44,017 $7 $4,316
Exhibit 6. Selected Historical Financial Data for Green Mountain Coffee Roasters, Inc. In thousands Cash & cash equivalents Restricted cash & cash equivalents Receivables, net Inventories Total current assets Fixed assets, net Total assets Accounts payable Total current liabilities Revolving credit facility Total long-term debt Total stockholders' equity Net sales Cost of sales Gross profit Selling & operating expenses General & administrative expenses Patent litigation (settlement) expense Operating income (loss) Interest expense Income (loss) before income taxes Income tax expense (benefit) Net income (loss) Year-end shares outstanding Net income (loss) per share--basic Total number of employees Net cash flows from operating activities Net cash flows from investing activities Net cash flows from financing activities Change in cash balances included in current assets held for sale Effect of exchange rate changes on cash & cash equivalents Net increase (decrease) in cash & cash equivalents Cash & cash equivalents at beginning of period Cash & cash equivalents at end of period Cash paid for interest Cash paid for income taxes 09/24/2011 09/25/2010 09/26/2009 09/27/2008 09/29/2007 12,989 4,401 804 2,818 241,811 280 27,523 355 161 354 310,321 172,200 91,559 54,782 39,373 672,248 262,478 137,294 85,311 38,909 1,131,527 495,269 537,801 152,090 87,823 579,219 258,923 135,981 97,678 65,692 3,197,887 1,370,574 813,839 357,648 264,527 265,511 139,220 76,961 43,821 37,778 471,374 238,055 124,053 72,920 57,048 331,202 173,000 582,638 354,513 78,043 123,550 90,113 1,912,215 699,245 590,174 139,520 99,099 2,650,899 1,356,775 803,045 500,277 341,651 1.746,274 931,017 553,281 323.372 210,530 904,625 425,758 249,764 176,905 131,121 348,696 186,418 123,948 92,182 72,641 187,016 100,568 47,103 42,311 30,781 (17.000) 368,913 138,772 95,713 42,412 27,699 57.657 5.294 4.693 5.705 6.176 302,747 133,209 90.358 36,472 21,577 101,699 53.703 34.476 14,173 8,734 201.048 79.506 55.882 22,299 12,843 154,466.463 132,823.585 130,811.052 109,444.419 105,927.543 1.36 0.6 0.49 0.207 0.122 5,600 2,380 1,517 1,220 995 (10,535) 38,498 1,946 29,834 785 (1,187,672) (525,197) (139,497) (48,311) 1,199,845 298,322 342,006 (21,657) 44,351 (6,425) (5,160) 790 8.588 (237.410) 241.007 (2,014) 1.752 4,401 241,811 804 2,818 1,066 12.989 4.401 241,811 33,452 6,486 5,118 58,182 42,313 20,368 L 804 6,087 6,701 2,818 6,654 3,184
Exhibit 7. Selected Capital Markets Information for Farmer Brothers Company Farmer Brothers' equity beta (from Value Line), October 21, 2011 Equity market risk premium (from Dimson, Marsh and Staunton) Common stock price per share (September 30, 2011) Shares outstanding (September 30, 2011): Yield to maturity on 10-year Treasury Notes, (March 30, 2011) Yield to maturity on Aaa Industrial Bonds (March 30, 2011) Yield to maturity on Aa Industrial Bonds (March 30, 2011) Yield to maturity on A Industrial Bonds (March 30, 2011) Yield to maturity on Baa Industrial Bonds (March 30, 2011) Sinclair Research (November 4, 2011) estimated sales (Sm) and EPS in 2012, 2013 ($) 1.50 5-6% per year $5.51 16,186,372 3.45% 5.13% 5.22% 5.48% 6.09% $477.8 $0.11 $492.2 $0.68