Background
Farmer Brothers coffee (FARM) was founded in 1912 by Roy E Farmer. The company is headquartered in Torrance, CA, which location also serves as a manufacturing and distribution hub.
The company became publicly traded in 1951 and for a while was profitable and paid a dividend. Yet the company has now failed to generate any annual profit since 2007. In 2011, the company cancelled its dividend, citing ongoing financial circumstances.
The company is not widely covered on the research side, while much of the institutional holdings consist of passive index funds. As a result, the share price has gradually crept up from a low of around $7 in 2012 to over $24 by late 2013. Much is this has been due to strong performance by other stocks in the coffee space such as Starbucks (SBUX) and Green Mountain Coffee (GMCR).
Farmer Brothers typically trades up gradually on very light volume and there have been almost no large, event-driven moves in it. There is virtually no short interest in the stock, with only 1-2% of the float being sold short. The market cap is currently just over $300 million.
The company has occasionally reported individual quarters of profitability. But as we saw last year, this was driven by one time gains, such as sales of real estate, and not due to sales of coffee.
This gradual rise in the share price has occurred despite a mounting series of problems at Farmer Brothers, including the following:
- recent forced restatement of 3 years of erroneous financials
- disclosure of a material weakness in internal controls
- significant speculation in coffee derivatives leading to large and consistent losses
- resignations from key members of the finance team
- an unfunded pension liability of $40 million
- short sighted financial practices such as “self insuring” to minimize near term insurance expenses
- inventory accounting which maximizes reported profit but which conflicts with the actual flow of goods
- significant involvement and influence from late generation members of Farmer family despite little to no business experience
- virtually no share ownership by any members of management
Key catalyst for a sharp decline at Farmer Brothers
The year 2013 saw two significant resignations from the finance team at Farmer Brothers. Also in 2013, the company was forced to restate 3 years of financials due to improper accounting for its very large pension obligations. The financials had all been previously signed off on by auditor E&Y as well as by management.
On December 30th, 2013, Farmer Brothers announced that it would be switching auditors from E&Y to Deloitte. The immediate impact of this announcement was largely muted due to the fact that it was released after the close of markets on the night before New Years Eve, along with the fact that the stock is not widely covered.
This new switch creates a tremendous risk that a new auditor will reevaluate current and past accounting treatment for items which may be considered aggressive and murky (including pension and derivative accounting) and will therefore require another (and potentially larger) financial restatement. Additional items such as the debatable use of LIFO accounting (which helps the company boost gross margins) should be more clear cut in the eyes of a new auditor. As most investors know, the use of LIFO in an environment of falling prices will always boost margins. Yet companies who sell perishable goods must always sell these goods as close to First In First Out in order to avoid unnecessary spoilage. In any event, this treatment is not consistent with major competitors. This will be demonstrated below.
Any time that a firm with a history of financial troubles and aggressive accounting switches auditors, it should be considered a greatly heightened risk factor for the share price. Initial audits by new auditors are generally considered to be the most thorough and stringent. The items detailed below should be evaluated in the context of how they will be viewed upon an initial audit by new auditor Deloitte.
Overview of financial concerns
Each of the concerns shown above is explained in detail below. However, the big picture can be summarized as follows:
It has now been an ongoing problem for years that the true net income (loss) being experienced at Farmer Brothers is more substantially influenced by things like pension and derivative accounting treatment than it is on the actual business of selling coffee itself.
Much of this has been missed by the very passive investor base because the impact of these items on Farmer Brothers is taken “below the line”. It is buried in “other comprehensive income” and not treated as a part of the “net income (loss)” line item.
As we will see below, these accounting items significantly outweigh the overall effect of what Farmer Brothers is supposed to be doing – ie. simply selling coffee.
Forced restatement of 3 years of financials
On September 11th, 2013, Farmer Brothers announced that its past 3 years of financials should no longer be relied upon due to significant errors in is reporting for post retirement benefits. Farmer Brothers has been in business for over 100 years and continues to employ nearly 2,000 people, such that its pension obligations are meaningful, standing at over $130 million.
As part of the restatement it was forced to disclose a material weakness in its internal controls. It was also disclosed that there were certain additional errors found in its reporting, but they deemed that these errors were “immaterial”.
It should be noted that auditor E&Y had previously signed off on all of these erroneous financials. Investors now have adequate reason to be concerned that a fresh look by Deloitte will uncover additional items that had slipped by under the watch of E&Y for whatever reason.
The items which had been determined by management and E&Y to be “immaterial” could certainly be considered to be quite “material” for anyone who owns stock in Farmer Brothers. The Net Income (Loss) was restated by as much as $3 million, Liabilities were off by as much as $13 million, Total Comprehensive Loss was off by as much as $9 million, while Total Equity was off by as much as $15 million.
These amounts would certainly appear to be substantial for a company which had a market cap of around $120 million last year. The current market cap has risen to over $300 million.
The notice of this restatement came at the very last minute for Farmer Brothers, with just 2 days left before it was required to file its 10K in September. As a result, the company filed Form12b-25 to get an extra 15 days to file its 10K.
As that date rolled around, the company missed the new deadline once again, with the result that it received a NASDAQ delisting notice which triggered events of default with its banks. These were then modified by the lenders subject to remedying of the delisting.
When the 10K was finally released, it revealed that the process of restatement had had significantly negative impacts on the company. The magnitude of these impacts should be read carefully, because they will become highly relevant below.
As disclosed by Farmer Brothers:
THE RESTATEMENT OF OUR HISTORICAL FINANCIAL STATEMENTS HAS ALREADY CONSUMED, AND MAY CONTINUE TO CONSUME, A SIGNIFICANT AMOUNT OF OUR TIME AND RESOURCES AND MAY HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS AND STOCK PRICE.
We cannot be certain that the measures we have taken since we completed the restatement process will ensure that restatements will not occur in the future. The restatement may affect investor confidence in the accuracy of our financial disclosures, may raise reputational issues for our business and may result in a decline in share price and stockholder lawsuits related to the restatement. The restatement process was resource-intensive and involved a significant amount of internal resources, including attention from management, and significant accounting costs.
WE CANNOT ASSURE INVESTORS THAT WE WILL BE ABLE TO FULLY ADDRESS THE MATERIAL WEAKNESS IN OUR INTERNAL CONTROLS THAT LED TO OUR RESTATEMENT, OR THAT REMEDIATION EFFORTS WILL PREVENT MATERIAL WEAKNESSES IN THE FUTURE.
We have identified control deficiencies in our financial reporting process that constituted a material weakness in our controls over our accounting for and reporting of other postretirement benefit obligations, leading to the restatement of certain prior period financial statements. Specifically, our controls did not properly identify the failure to apply generally accepted accounting principles with respect to the accounting for death benefits and the related cash surrender value of life insurance, and did not properly detect when changes or amendments to other postretirement benefit plans occurred that should have resulted in changes to the related benefit plan obligations. As a result, material errors to the recorded postretirement benefit liability, postretirement death benefit liability and cash surrender value of life insurance purchased to fund the postretirement death benefit occurred and were not timely detected.
The restatement was obviously a bad thing. It was embarrassing. It was unprofessional. It was expensive. It created a significant drain on internal resources away from managing the business and trying to make money by selling coffee.
But here is the real point of concern:
The delisting notice was received on October 3rd. As a result, most shareholders should be outraged that just 5 days later, the company awarded record bonuses to all members of management, which in each case were in excess of 100% of their target amounts as set in their incentive plans. Again, this was almost immediately after the public disclosure of the significant impact of their erroneous accounting and management decisions.
| Officer | Maximum target bonus | Actual bonus (2013) | % |
|
Michael H. Keown
|
$ 475,000 | 536,274 | 113% |
|
Mark A. Harding(2)
|
$ 128,250 | 142,908 | 111% |
| Thomas W. Mortensen(2) | $ 128,250 | 142,908 | 111% |
| Hortensia R. Gómez | $ 60,000 | 66,029 | 110% |
In addition to the amounts above, CFO Mark Nelson was also paid a bonus of over $36,000 as a partial year bonus even though he had only been employed at the company for a few months prior to the June 30th Fiscal Year end. This was 112% of his target pro rata bonus.
In any ordinary public company, the substantial multi year restatement would have likely been a reason for members of management to feel lucky to keep their jobs and simply receive a zero bonus as a warning. This is particularly true given that 2013 was the 7th consecutive year of net losses for Farmer Brothers. As we saw from the disclosure above, the impact of these restatements was very substantial.
When management consistently fails at their jobs, they are supposed to be sent a strong message to change or else they are replaced.
But at Farmer Brothers, the company continues to receive strong influence from the family descendents of Roy Farmer, who founded the company over 100 years ago. It is not really run much like an independent public company which is supposed to serve the interests of shareholders.
Roy Farmer’s son (also named Roy) had previously served as chairman. His two daughters (Jeanne Farmer Grossman and Carol Farmer Waite) have more recently served on the board of directors. Ms. Farmer-Waite’s son currently holds the somewhat ambiguous title of “Vice President of Coffee” and earns $270,000 per year.
As shown below,these later generation members of the Farmer family have demonstrated no qualifications to run this company. Had they not been born with the last name “Farmer” there is clearly no conceivable way they would be in any position to be managing any public company.
Ms. Farmer-Grossman is Chairman of the Compensation Committee and would therefore have been responsible for setting the record bonuses following the restatement of 3 years of erroneous financials and the NASDAQ delisting notice. She would also be responsible for signing off on the $270,000 compensation awarded to her nephew who serves as “Vice President of Coffee”. Ms. Farmer-Grossman also sits on the Nominations Committee of the board.
In justifying her significant board roles and decision making authority, the latest proxy notes that her experience is as a “retired teacher and homemaker” age 63, who received her undergraduate degree in education. If she has any business experience, none is cited in these credentials. Likewise, her sister Carol Farmer Waite is also a retired school teacher.
In clarifying qualifications, the proxy states that “Ms. Grossman’s qualifications to sit on our Board include her extensive knowledge of the Company‘s culture and sensitivity for Company core values…”
By being born into the Farmer family, and by virtue of owning roughly $20 million in stock, Ms. Farmer-Grossman has been granted a position of authority and responsibility on two board committees. The ongoing management of Farmer Brothers as a family fiefdom by those with zero business experience is what has led to consecutive years of ongoing net losses and cancellation of the dividend as well as a massive and amateurish financial restatement due to poor supervision of the finance team.
In fact, as we will see below, there are much larger problems brewing at Farmer Brothers which have also likely been swept under the rug. Although these have been given scant attention by management and the board, they will certainly be closely evaluated during the first audit by new auditor Deloitte.
Speculation in coffee derivatives leading to large consistent losses
Farmer Brothers frequently refers to its large purchases of coffee derivatives as being for “hedging” purposes. There are several obvious signs that these purchases have more to due with speculative bets on coffee prices than they do with hedging sales of coffee products.
Farmer Brothers should not be in the business of gambling on the direction of commodity markets. Even professional commodities traders find it hard to do well in these volatile markets. Moreover, it is clear that Farmer Brothers has demonstrated a consistent habit of placing bets which are very large and very wrong and which have repeatedly cost the company tens of millions of dollars.
Rather than just running the business, Farmer Brothers has tried to “call the bottom” on coffee prices and has hoped to profit by loading up on large amounts of coffee derivatives. The problem is that the price of coffee has seen a continuing slide for 3 years running and there does not appear to be any end in sight in the near term.
The Wall Street Journal recently ran an article entitled “As Coffee Prices Decline, Investors Brace for More”
It noted that:
Coffee prices have tumbled 20% this year, capping the biggest two-year plunge in a decade and highlighting commodity markets’ struggle with a supply deluge.
Coffee prices haven’t fallen for three consecutive years since the early 1990s. Since 2011, coffee prices are down 49%. That is the largest two-year decline since 2000-2001, when prices fell 63%.
Investors have bailed out of bullish bets and as a group are betting for prices to keep falling, according to Commodity Futures Trading Commission data.
The following is a graph which illustrates the magnitude of the 3 year continuous decline in coffee prices:
Were it not for poor speculation, this type of decline should have actually been a major boon to Farmer Brothers. The WSJ noted that:
Meanwhile, retail prices for bagged coffee and lattes have stayed relatively steady, a boon for roasters and food companies that are able to capitalize on lower coffee costs.
So just how bad has the impact been from wrong way derivative bets by Farmer Brothers management ? Here are a few examples.
In May, the company released 9 month results in which it proudly noted that its gross margin had improved by 4%. However this was during a time in which coffee prices (as disclosed by the company) had declined by more than 30%. Even if Farmer Brothers had passed on the majority of the real market savings to its customers, it still should have shown a dramatic surge in margin, but the company enjoyed almost no benefit at all.
It also announced that losses on coffee derivatives for the 9 months had already exceeded $10 million, an even larger loss than the $8 million in the 9 months from the preceding year.
The size of this loss was attributed to a “four fold increase” in the number of coffee related derivative contracts purchased covering 34.8 million pounds of coffee vs. 9.4 million pounds of coffee in the prior year. Yet revenues had increased by less than 2%.
When coffee purchases increase by 300% to cover a 2% increase in sales, this is called speculation, not hedging.
Beyond the past losses, it is disclosed that it expects to continue losing more on the derivatives:
Based on recorded values at September 30, 2013, $8.2 million of net losses are expected to be reclassified into earnings within the next twelve months.
As of April 1st, 2013, the company began implementing procedures to apply ASC 815 for its “derivatives and hedging”. The stated goal of this is to
minimize the volatility created in the Company’s quarterly results from utilizing these derivative contracts and to improve comparability between reporting periods
Investors who are interested can click here to read the accounting guide from PWC on this subject. Those who choose to click the link will see that the summary guidance is over 500 pages long.
There are several points from this. First off, the goal of these accounting treatments as implemented by the company should arguably not be to “minimize the volatility created in the quarterly results”. Instead, it should be to present the fair value of the derivatives activity in which the company is engaging. That way there will be no sudden and dramatic “mark to market” surprises in coming quarters.
Perhaps of greater importance is the fact that this 100 year old company is now engaging in more sophisticated and risky activities which were likely never envisioned by its founder. When the founder had been running this company in simpler times, Farmer Brothers was consistently profitable and paid a healthy dividend. The diversion into derivatives speculation has coincided with the company canceling its dividend as it continues to lose money each year.
The current installment of Farmer family descendents into roles of responsibility does not help matters. Based on any disclosure of their educational and professional backgrounds, most investors would find it highly unlikely that either of the retired Farmer homemakers and school teachers would be able to navigate and explain the nuances of derivatives speculation and the appropriateness of the resulting accounting issues for transparency to investors. The same could likely be said for the Farmer who serves as “Vice President of Coffee”, but whose background is not disclosed.
As we saw in October, when there were suddenly large losses and restatements, these individuals were, not surprisingly, caught 100% off guard.
These observations should in no way be construed as personal aspersions against the current members of the Farmer family. The point is simply that as a public company, these family members should not be entitled to oversee the business when they have not demonstrated any relevant qualifications. The results of their oversight have been ongoing losses, financial restatements and risky derivatives speculation by management which have then been rewarded with excessive compensation.
Perhaps of greatest importance is the fact that many investors seem entirely unaware of the derivative losses. For 2013, Farmer Brothers reported an accounting net loss of $8.4 million. But this entirely ignoresadditional “Deferred losses on derivatives designated as cash flow hedges” which totaled an additional $7.9 million.
The additional losses incurred from derivatives was nearly as large as the total loss from selling coffee in the operating business. But this is only disclosed “below the line” in Other Comprehensive Income (Loss) and can be found on page 38 of the 10K.
How concerning is the pension benefit restatement ?
Companies which employ many people and which have been in business for an extended period of time typically suffer disproportionately from the burden of post retirement benefits. The most widely recognized example of this would be General Motors.
Farmer Brothers currently employs around 1,800 people. But having been in business for over 100 years (more than 60 years as a public company), the company has a fairly large built up obligation from post retirement benefits.
As of its fiscal year end, Farmer Brothers had a Projected Benefit Obligation(“PBO”) of $132.2 million while the Fair Value (“FV”) of its plan was just $92.4 million.
As a result, its plan is under funded by about $40 million.
The company disclosed that
We expect to make approximately $1.3 million in contributions to our single employer defined benefit pension plans in fiscal 2014 and accrue expense of approximately $0.7 million per year beginning in fiscal 2014. These pension payments are expected to continue at this level for several years, and the current economic environment increases the risk that we may be required to make even larger contributions in the future.
The accounting for post retirement benefits is complicated and is subject to many management assumptions. As a result, many investors find themselves completely befuddled by it and find it easier to simply ignore these liabilities and expenses, focusing instead on the operating business which is easy to understand.
But for companies with obligations which are very large relative to their balance sheet, these expenses and liabilities can entirely outweigh the results of the operating business. This is what we ultimately saw with GM (although obviously GM is a very extreme example).
Point #1 – the pension obligations are very large relative to equity in the company
For Farmer Brothers, the size of the PBO liability (using current assumptions) is $132 million. Total equity for Farmer Brothers is just $84 million. The point is that this $132 million obligation is very large relative to its equity.
Point #2 – the obligations and underfunded status are simply management’sestimates
The second point to be made is that this already large obligation is simply anestimate of what the company will actually owe and is subject to assumptions which are being put forth by Farmer Brothers management. The biggest point of sensitivity for the PBO is the assumed discount rate. The lower the rate, the higher the obligation becomes. We are currently still in an environment of extremely low interest rates. Yet the company assumes rather high discount rates of 4-5%. This results in a projected benefit obligation which is lower than should really be the case.
In looking at the largest one of the pension plans (the “Farmer Brothers Plan”), each 0.5% decrease in the discount rate increases the PBO by $8 million. (See page 24 of the 2013 10K) So if the company were to instead assume a 3% discount rate, the PBO would rise to around $150 million. A 2% discount rate would cause it to rise to around $166 million. This then comes to double the shareholders equity in the entire company.
For reference, 10 year treasuries are currently sitting at around 3%, which are still at 3 year highs. One year ago (including the reference period for the current 10K which assumes 4-5%) treasuries were at just 1.76%.
The level of underfunding can be analyzed the same way. With a Fair Value of $92 million, the pension plan appears to be underfunded by $40 million using current management assumptions. But with a 2% discount rate, the level of underfunding alone would be around $75 million (almost equal to the total shareholders equity for the entire company).
Investors should also note that there are multiple plans to consider: the “Farmer Brothers Plan”, the “Brewmatic Plan” and the “Hourly Employees Plan”. For simplicity, the numbers above refer only to the Farmer Brothers Plan because it is notably the largest.
So investors need to ask themselves how large is Farmer Brothers actual pension benefit obligation and how large is the actual shortfall? Investors also need to handicap how and when Farmer Brothers will end up funding the shortfall. Given that the company has failed to generate a real profit since 2007, it seems more likely that the company may be forced to issue a substantial amount of equity in order to remedy this shortfall.
Point #3 – Fluctuations in pension obligations outweigh the total income / loss for Farmer Brothers
As with the deferred losses on derivatives, the changes in the funded status of the pension plan are treated as “Other Comprehensive Income (Loss)” and can be found on page 38 of the 10K.
In 2013, the fluctuation in the underfunded status of the pension plan amounted to an improvement of $10.9 million. This is greater than the magnitude of the entire reported net loss ($8.5 million) for all of the company’s operating business of selling coffee. But because this is reported “below the line”, most investors are entirely unaware of the magnitude of these swings.
And by looking at the (now restated) numbers for 2012, we can see that the funded status in that year fell by $26.5 million, which was basically equal to the $26.5 million loss the company incurred for its entire operating business of selling coffee.
So again, the point here is that changes in the status of the pension plan (which are heavily dependent upon management assumptions) have been of equal or greater impact on Farmer Brothers than its entire business of selling coffee.
As a result, the fact that Farmer Brothers has been unable to properly estimate and account for its pension liabilities and was forced to restate 3 years of financials is of very extreme significance. In fact, it is of far more consequence than the issue of how much coffee is Farmer Brothers selling.
The fact that the company has now restated these financials with E&Y should be of very little comfort. E&Y missed all of these problems in the first place, blessing the 3 years of results. Shortly after E&Y reviewed and once again blessed the restated numbers, they were they replaced as the auditor for Farmer Brothers.
Given the huge impact on the financial health of Farmer Brothers, this will obviously be the first area which is subject to scrutiny by new auditor Deloitte.
Looking at past behavior of management and the board
As shown above, the restatement of 3 years of financials was announced in September. But there are very clear signs that management was well aware of these problems at a much earlier date.
As far back as May (4 months before the restatement was announced), the company had suddenly amended and restated the audit committee charterwithout any explanation for why these changes were suddenly deemed necessary.
Even a brief read of this document filed in May will strongly suggest that the board already knew that there were problems with the ongoing financial statements and was looking to shift blame to the auditor and towards management and away from its own members.
For example, the restated audit committee charter states that
Additionally, the Committee recognizes that the Company‘s management, as well as the Company‘s independent auditors, have more time, knowledge and more detailed information concerning the Company than do Committee members.
Consequently, in carrying out its oversight responsibilities, the Committee isnot providing any expert or special assurance as to the Company‘s financial statements or any professional certification as to the work or independence ofthe Company‘s independent auditors. In addition, auditing literature, particularly Statement of Auditing Standards No. 100, defines the term “review” to include a particular set of required procedures to be undertaken by independent auditors. The Committee members are not independent auditors, and the term “review”as applied to the Committee in this Charter is not intended to have that meaning and should not be interpreted to suggest that the Committee members can or should follow the procedures required of auditors performing reviews of financial statements. Furthermore, the Committee’s authority and oversight responsibility do not assure that the audits of the Company‘s financial statements have been carried out in accordance with GAAS.
Again, the timing of such a strange document is noteworthy.
This document was released just 4 weeks before the end of the fiscal year ended June 30th, 2013. This was the 10K which included the 3 years of restatements. It seems quite clear that the board had already been informed of problems with the previous financials.
Clearly all elements of the business (including the financial statements) fall under the responsibility of CEO Michael Keown. But the detailed day-to-day involvement would have largely been the responsibility of former CFO Jeffrey Wahba.
It should be noted that Mr. Wahba resigned from the company earlier in 2013, and continued on as a consulting CFO until May 22nd. One week after the end of the CFO’s employment (following 3 months of consulting by him) the company chose to issue the audit committee restatement.
As we can see, that restated audit committee charter clearly shifts blame towards management and the auditor. By the time the restated document was released, the CFO had already discontinued his employment. And now, by the end of the year, the auditor has already been replaced. The point is that in May, these actions indicate that the board was already aware of the problems. They had shifted the blame away from themselves and now they have completed the process by eliminating the CFO and the auditor.
But here is the kicker. Although management and the board certainly knew about these problems, investors were entirely in the dark. In May, the share price had been trading as low as $13. By the time the auditor was replaced, the share price had traded to over $24.
Despite impending problems, CFO Wahba reaped a large windfall upon his departure. Much of this would clearly require board approval from the compensation committee which is chaired by Ms. Farmer Grossman.
Technically, Mr. Wahba resigned his employment with the company effective February 28th, 2013. But he continued to provide his “consulting services” to the company as CFO into May at a rate of $285 per hour. For this few month period of service (which ended right as 3 years of his financials) were about to be restated, he received $795,000 in compensation. For reference, in 2012, Mr. Wahba worked for the entire year on a full time basis and received a full year bonus and his total compensation was $1.1 million. The point is that Mr. Wahba was extremely well paid for doing a short duration of work – which then culminated in the restatement of 3 years of financials which were signed under his watch. It is yet another example of Farmer Brothers providing excessive cash compensation to members of management despite dismal performance.
But the real payoff for Mr. Wahba came when he sold all of his stock. Even though he was still providing his consulting services to the company through May, Mr. Wahba sold all of his stock in company during the first week in March, immediately after he technically resigned. He sold 100% of his shares at prices of around $13, bringing in around $2 million.
On December 11th, Hortensia Gomez, the Vice President and Financial Controller sold 390 shares of Farmer Brothers stock for around $9,000. This amount is clearly not large, but based on the disclosure in the proxy, Gomez did not appear to have any other meaningful ownership of stock.
On the very next day, December 12th, the company filed an 8K to announce a “Separation Agreement” with Gomez. As with Mr. Wahba above, the terms of the separation appear to be very favorable for Ms. Gomez. Ms. Gomez will stay on for a transition period of about a month and will be paid severance of $150,000.
This announcement came just 2 weeks before the announcement that the auditor was being replaced.
On page 11 of the proxy, we can see that among all members of management, none of them have any meaningful ownership of stock in the company. Management members are in fact required by the company to own some amount of stock. But we can see that no member of management or the board (other than members of the Farmer family) hold even 1% of the shares in the company.
Members of the Farmer family continue to own around 37% of the outstanding shares, with Ms. Farmer Grossman holding 892,444 shares valued at around $20 million.
Management has demonstrated a strong preference for being compensated primarily in cash. For 2013, CEO Michael Keown received $1.6 million in compensation, mostly in cash.
Total compensation to management in 2013 came to around $4 million. To put this in perspective, management’s compensation alone amounted to around 50% of the company’s total loss of $8 million in 2013.
Farmer Brothers stock has been in the hands of the Farmer family members for generations now. They have shown no intention of selling substantial amounts of stock regardless of whether the price is high or low. The fluctuations on the share price therefore have very little impact on them at all.
But for members of management who do not already own stock, they have very little exposure to the long term share price movements. As a result of this, it creates the risk that they can be more focused on short term results which can be driven by pension accounting, derivatives speculation and other short term accounting techniques. When these provide any boost to the numbers, they are then compensated heavily and in cash.
Looking at the LIFO accounting
Any company which deals in perishable goods will invariably take steps to ensure that the goods they acquire are distributed as quickly as possible and that they are distributed in a “First in, First Out” (ie. “FIFO”) manner. This is common sense and is done simply to prevent spoilage. Farmer Brothers can certainly be expected to sell first the coffee it acquires earliest.
But from an accounting standpoint, the company has elected to report its inventory and COGS using the LIFO (“Last In, First Out”) method. This is particularly advantageous in a period of falling prices because they company always appears to be selling the cheapest coffee first, while holding as inventory the more expensive (“more valuable”) coffee.
The price of coffee beans of various varieties has been in a steady 3 year decline, with prices continuously falling by more than 50%.
If Farmer were to pay $2.00 per pound to buy coffee in January, but only $1.00 per pound to buy coffee in February, Farmer would then report that it is selling all of the $1.00 coffee before ever having to sell any of the $2.00 coffee. This means that gross margins are substantially higher because Farmer always appears to be selling the “cheapest” coffee first. It also overstates inventory because the “more expensive” coffee is held on the books.
LIFO accounting will always deliver superior accounting results in an environment where a company s seeing falling input prices. At the end of the year, Farmer then conducts what is known as a “LIFO Liquidation” where it attempts to “true up” this discrepancy. But because Farmer keeps buying more and more coffee, these older purchases at much higher prices are simply never reflected. This is true even though the physical coffee that was purchased at much higher prices was actually physically sold long ago. This means that the real margin is in fact much lower due to the higher prices paid for coffee at the time.
In any event, the ultimate impact of this LIFO accounting is not fully known until the end of each year, such that quarterly results can be misleading.
The company discloses this in the recent 10Q as follows:
Inventories are valued at the lower of cost or market. The Company accounts for coffee, tea and culinary products on the last in, first out (“LIFO”) basis and coffee brewing equipment manufactured 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. At the end of each quarter, the Company records the expected beneficial effect of the liquidation of LIFO inventory quantities, if any, and records the actual impact at fiscal year-end. An actual valuation of inventory under the LIFO method is madeonly at the end of each fiscal year based on the inventory levels and costs at that time.
If inventory quantities decline at the end of the fiscal year compared to the beginning of the fiscal year, the reduction results in the liquidation of LIFO inventory quantities carried at the cost prevailing in prior years. This LIFO inventory liquidation may result in a decrease or increase in cost of goods sold depending on whether the cost prevailing in prior years was lower or higher, respectively, than the current year cost. Accordingly, interim LIFO calculations must necessarily be based on management’s estimates of expected fiscal year-end inventory levels and costs. Because these estimates are subject to many forces beyond management’s control, interim results are subject to the final fiscal year-end LIFO inventory valuation. The Company anticipates its inventory levels at June 30, 2014 will be same as of June 30, 2013 and, therefore, did not record an adjustment to cost of goods sold for the three months ended September 30, 2013. No adjustment to cost of goods sold was recorded for the three months ended September 30, 2012.
By contrast, Starbucks uses a more accurate moving average cost rather than LIFO. Likewise, Green Mountain Coffee uses a method which is in line with FIFO, as opposed to the unusual use of LIFO at Farmer Brothers.
In any event, during the recent multi year price decline in coffee, Farmer Brothers use of LIFO accounting has been able to benefit interim gross margins and is inconsistent with other players in the coffee space.
Self insuring to save money on insurance premiums
The LIFO accounting above is inconsistent with the physical flow of goods through Farmer Brothers. It is also a short sighted way to provide an apparent boost to gross margins.
Likewise, the company has chosen to self insure itself rather than pay full insurance premiums. This is the case even though the company has disclosed that it does not meet minimum credit criteria to participate in such a program in its home state ofCalifornia.
According to the 10K
In May 2011, we did not meet the minimum credit rating criteria for participation in the alternative security program for California self-insurers. As a result we were required to post a $5.9 million letter of credit as a security deposit to the State of California Department of Industrial Relations Self-Insurance Plans. As of June 30, 2013, this letter of credit continues to serve as a security deposit and has been reduced to $5.4 million.
The full impact of the decision to self insure against these substantial risks is large enough that it is included as its own separate risk factor.
WE ARE SELF-INSURED AND OUR RESERVES MAY NOT BE SUFFICIENT TO COVER FUTURE CLAIMS.
We are self-insured for many risks up to significant deductible amounts. The premiums associated with our insurance continue to increase. General liability, fire, workers’ compensation, directors and officers liability, life, employee medical, dental and vision and automobile risks present a large potential liability. While we accrue for this liability based on historical experience, future claims may exceed claims we have incurred in the past. Should a different number of claims occur compared to what was estimated or the cost of the claims increase beyond what was anticipated, reserves recorded may not be sufficient and the accruals may need to be adjusted accordingly in future periods.
The company justifies its decision to self insure based on the fact that in the past it has not faced many substantial clams. This is no different than a homeowner rejecting insurance because his house has never burned down in the past. The entire purpose of insurance is to provide small payments which are known in advance and fixed in order to avoid unknown catastrophic losses later.
As with the pension errors and the substantial derivative speculation, the short sighted decision to boost the short term bottom line by virtue of self insuring does not seem to be a responsible one for any company which seeks to serve the best interests of long term and risk averse shareholders.
Conclusion
Shares of coffee related stocks have been strong performers over the past year, in part due to the falling prices for coffee beans which has helped to boost margins. In the past 12 months, shares of Starbucks are up 37%, while Green Mountain Coffee is up 74%. Small cap Farmer Brothers is roughly a double.
Enthusiasm for coffee related stocks has helped to boost Farmer Brothers despite the fact that it continues to lose money and despite the fact that much larger problems are quickly emerging.
Relative to other players in the coffee space, Farmer Brothers is a small company which has a limited following and limited research coverage. As a result, many of its substantial problems have gone largely unnoticed and the stock has simply been buoyed by strong sentiment for coffee stocks in general.
It is now the case that the true economic results for Farmer Brothers are more heavily impacted by the results of derivative speculation and pension obligations than by the actual business of selling coffee. But investors have missed these items because they are reported “below the line” of reported net income.
We have now seen meaningful resignations within the finance department and have seen the auditor replaced. This all happened along with a substantial restatement of the audit committee charter, which distanced itself from 3 years of inaccurate financials.
Members of the Farmer family have been able to exert substantial influence on the company despite little to no background in managing a public company. This becomes more concerning in light of the fact that the company is now facing much larger problems with growing derivatives losses and a pension obligation which is underfunded by at least $40 million.
The mistakes which occurred over the past 3 years were blessed by both management (the finance team) and by auditor E&Y. All of these parties are now gone and the going financials books will now be evaluated by new auditor Deloitte.
Given the history of problems and the increasingly complex situation at Farmer Brothers, there is a substantial risk that a stringent audit by a new auditor will reveal even larger problems for Farmer Brothers.
Farmer Brothers spent much of 2012 in the $7-8 range. This was before the ramp of in money losing derivative speculation, before the 3 year financial restatement and before the replacement of the auditor.
As these problems come to a head (and to the extent that they become a focus of new auditor Deloitte), Farmer Brothers should certainly be expected to return to levels of $7-8 or below. This would still value the company at well over $100 million.
Disclosure: I am short FARM, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.