WEST - Westrock Coffee Brews A Solid Future But Concerns Remain

2024-01-02 23:13:55 ET

Summary

• Westrock Coffee Company's bearish outlook is underlined by declining traditional coffee sales, its primary revenue source, and uncertainties in its strategic shift towards RTD and extract segments.
• Despite efforts to adapt, the company faces financial challenges, including increasing debt and potential stock dilution, which could impact its financial stability and shareholder value.
• The current valuation, with a higher P/S ratio compared to the industry despite lower margins and growth, seems misaligned with the company's financial realities.

Thesis

Westrock Coffee Company’s ( WEST ) strategic pivot towards emerging segments like Ready-to-Drink and coffee extracts, amidst declining demand for traditional coffee, marks a critical period for its future growth. This shift, while aligning with current consumer trends, introduces significant financial and market risks, challenging the company's resilience and valuation in the dynamic coffee industry.

Introduction

Westrock Coffee Company is a player in the coffee and tea industry, particularly in the United States. Their operations encompass a wide range of services, including sourcing coffee beans, managing the supply chain, developing products, and distributing them. They are known for their large-scale operation, supplying over 20 million cups of coffee daily and being a major provider of coffee and tea to restaurants in the U.S.

The company's origins trace back to working with independent coffee farmers in East Africa, focusing on growth through investment in infrastructure, farmer development, and product innovation. Today, Westrock Coffee Company operates on a global scale, supplying products across five continents, with a focus on maintaining strong relationships with farmers in 35 origin countries.

Financial Performance

Source: Seeking Alpha

The decrease in Westrock Coffee's year-over-year (YoY) revenue, particularly in the third quarter of 2023, was largely due to a significant drop in demand for their traditional roast and ground coffee products during the early part of the quarter according to the latest quarterly report .

In the report, the company's CEO, Scott T. Ford, noted that while other segments of their business, such as flavors, extracts, ingredients, and single-serve product portfolios, showed progress, the negative impact from the reduced demand in the hot coffee segment during July and August was too substantial for other areas to compensate within that quarter. This trend indicates that a key part of their revenue, the traditional coffee segment, experienced a notable downturn during this period, which hurt their overall revenue performance??.

CSnews stated that:

The growth of at-home gourmet coffee preparation existed before 2020, although it was accelerated by the pandemic.

This is problematic as Westrock Coffee Company primarily serves commercial customers, including businesses, restaurants, and bars, rather than direct-to-consumer sales. Their traditional business model focuses on providing coffee and tea products, along with related solutions, to the food service industry, and office coffee services, among other commercial channels. More at-home traditional coffee preparation most likely results in a decrease in the consumption of traditional coffee at restaurants and coffee bars.

This problem seems to be already causing trouble for Westrock Coffee Company, as indicated by the declining revenue that turned negative this quarter. The issue furthermore affects the numbers further down in the income statement. The gross margin has decreased from 17.86% in the quarter ended 30-9-2022 to 15.97% in the quarter ended 30-9-2023. This drop in gross margin and revenue caused a steep fall in gross profit.

Furthermore, as the company is observing these trends themselves, it invests in heavily alternatives to traditional roast and ground coffee products. This led to increasing SG&A (Selling, General & Admin) expenses and a higher debt burden (causing higher interest expenses), leading to a negative operating income.

I will get more into these investments in the next section, "The future".

Source: Seeking Alpha (Retrieved on 12-31-2023)

As can be seen from the balance sheet, debt has increased significantly, which could be concerning as operating income has turned negative. However, the company still does have 64 million USD in cash and cash equivalents, which could be either used as a buffer or as resources to invest. Another trend I noticed in the balance sheets, is the increase in shares from 73 million to 88 million, which indicates heavy stock dilution. In line with what I have said before, these debt increases and stock dilution are needed to finance the investments.

The future

Based on the details from Westrock Coffee Company's Third Quarter 2023 Earnings Conference Call , there is some optimistic news and projects for the future:

The company is focusing on the launch of a new $300 million extract and RTD facility in Conway, Arkansas, scheduled to begin commercial production in the second quarter of 2024. This facility is significant as it represents a major expansion in Westrock’s capacity to produce coffee extracts and ready-to-drink products. The significant investment in the RTD and extract segments aligns with current consumer trends toward convenient, ready-to-drink coffee products and diverse flavor profiles.

The global ready-to-drink (RTD) coffee market was valued at over USD 26.18 billion in 2023 and is expected to grow at a CAGR of 7.90% from 2024 to 2032. This growth is driven by the increasing coffee culture and demand for convenient, affordable, on-the-go coffee options. This growth can be attributed to increasing demand for coffee-flavored products across various industries, including food and beverages, cosmetics, and more. In other words, the market is big and it offers a nice growth rate. Moreover, t he Coffee Extract market , valued at USD 2.45 billion in 2022, is projected to reach USD 3.75 billion by 2030, growing at a CAGR of 5.5% during the forecast period from 2023 to 2030??. Westrock has nearly sold out its extract manufacturing capacity in Concord, North Carolina. This indicates a growing demand in their extract segment, and the Conway facility will further increase this capacity. Because of these reasons, I expect that the investments will cause a nice revenue bump in these departments in the following quarters.

In the future, I do believe these investments will provide a solid revenue bump in the respective departments. As these segments are playing more and more of a role in the total revenue, I do believe that in the short to medium future, the total revenue growth will become positive again. As it is not yet the main source of income and the decline in traditional coffee is still happening, I believe that the total growth of revenue will be mellow. Also, as these investments require huge investments and expenses, I believe that further down in the income statements, we will still see negative numbers.

Challenges

Westrock Coffee Company faces the challenge of declining demand for traditional coffee, its main revenue source. Moreover, significant investments in new Ready-to-Drink (RTD) and extract segments present risks related to market acceptance and profitability, requiring close performance tracking. The company's increased debt and investment costs could lead to financial strain, especially if new ventures don't offset the decline in traditional coffee sales, highlighting the need for rigorous financial health monitoring. Furthermore, stock dilution, indicated by an increase in common stock, could impact shareholder value.

Overall, investors should carefully observe the statistics of these issues regularly to monitor the risks of this company.

Valuation

Source: Yahoo Finance. The industry medians are calculated with data available from 12 small market cap companies in the Packaged Foods industry. Data is retrieved on 12-31-2023.

The valuation table shows us that the P/S ratio of Westrock Coffee Company is higher than that of the industry, whilst having a lower gross margin and lower historical revenue growth. Furthermore, the industry does have a reasonable P/E ratio, while Westrock Coffee Company does not make a profit at the moment. Based on the analyses in the previous section, I do not believe that Westrock Coffee Company should be valued the way it is now. In my view, the fair value of the P/S ratio should be below that of the industry, roughly around 0.65. This would indicate a decline of -35% in the P/S ratio, meaning a change in the P (stock price) of -35%.

Conclusion

In conclusion, Westrock Coffee Company's bearish outlook is underlined by declining traditional coffee sales, its primary revenue source, and uncertainties in its strategic shift towards RTD and extract segments. Despite efforts to adapt, the company faces financial challenges, including increasing debt and potential stock dilution, which could impact its financial stability and shareholder value. The current valuation, with a higher P/S ratio compared to the industry despite lower margins and growth, seems misaligned with the company's financial realities.

However, a significant outperformance in Westrock's Ready-to-Drink (RTD) and extract segments, with revenue and profitability surpassing expectations, could counteract the decline in traditional coffee sales and lead to a reevaluation of the bearish outlook. If scaling the new Conway facility results in operational efficiencies and cost reductions, this could positively impact the company's financial health. The introduction of innovative products that align with emerging consumer trends or successful expansion into new, high-growth markets could provide strong new revenue streams and diversify Westrock's business model. Such boosts could push up the stock price, countering my thesis.

Overall, a more cautious and potentially lower valuation seems warranted for Westrock Coffee Company, reflecting its current struggles and uncertain future in a rapidly evolving market.

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