2023-04-25 12:55:12 ET
Summary
- I think the financial performance has been fairly weak so far, with net loss growing in the teeth of rising sales. If growing sales doesn't generate profits, what does?
- Additionally, the capital structure has deteriorated massively, with long-term debt up substantially. You may have noticed that interest rates are relatively high at the moment.
- In spite of this, I'm buying, because the shares are at or near all-time low valuations. Additionally, insiders have poured in their own capital.
Since I wrote my latest cautious note on Farmer Bros. Co. (FARM) way back in mid-October, the shares have dropped about 37% against a gain of 15.4% for the S&P 500. Subsequent to that article being published, I did sell my small stake in the business, so things have worked out rather well. Since the company has reported earnings yet again, I thought I'd review the name again to see if it's worth buying back in. After all, a stock trading at a price of $3.05 is a much less risky investment than the same stock when it's trading at $4.88. I'll decide whether or not to buy back in again by looking at the latest financial news, and by looking at the valuation. I also want to pay some attention to what insiders are doing, as they know this business better than any of us ever will.
You're busy, and I'm busy. You may be busy putting the finishing touches on your next submission to "Nature", or you may be planning an exotic, life expanding trip, or you may be trying to work out which supermodel to take to dinner this weekend. I'm also busy preparing my next Dungeons and Dragons campaign, and catching up on back episodes of Young and The Restless. Either way, we all have things to do, which is why I write a "thesis statement" paragraph at the beginning of each of my articles. This handy paragraph allows you readers to come into the article, and get the "gist", before being exposed to the full "Doyle mojo" experience that comes with reading an entire article. I know that my writing can be "a bit much", so the thesis statement helps you avoid the emotional pain of an entire 1,900 words. You're welcome. Anyway, I'm not happy with the most recent financial performance. The company has grown the top line, but the bottom line (i.e. the source of investor returns) continues to deteriorate. The capital structure is also in far worse shape, with long term debt much higher today than it was 4 short years ago. In this interest rate environment, that's troublesome in my view. That written, the stock is trading either at or very near all-time low valuations. At some point, this thing will start to trade on the balance sheet, which is in relatively better shape in my view, in spite of the uptick in debt. For that reason, I'm taking a small, speculative "flyer" position on this name today. I'll be happy if the stock spikes from here, because that means I'll make money on my flyer. I'll be happy if the shares continue to languish, because that means I'll be able to buy more at a very cheap price. When I worked full time in investing, I was told repeatedly that when you find an investment that you're happy with no matter what happens to price, you buy that investment. For that reason, I'll be buying a few thousand shares of Farmer Bros. today. That ends the thesis statement. If you read on from here, that's on you. Since you've been warned, I don't want to read any complaints about my thinly disguised bragging or the fact that I spell words like "beahviour" properly.
Financial Snapshot
In my previous missives, I've made a big deal about, "gone on about" as the young people say, a company that grows losses in the teeth of rising revenues. The reason for this is that, if growing sales don't grow net income, what does? Alongside this very obvious question, I sometimes feel obliged to remind investors that income is the source of all owner returns that come in the form of dividends and/or growing book value. In other words, growing revenue is great, because it helps pay for employees, rental space, suppliers, and everyone else who gets paid before owners. Additionally, of course the government needs to wet their beak. I mean, they need a taste. So, net income is what we, as investors, should be focused on. If growing sales don't lead to rising net income, the sales growth is hardly relevant in my view.
Remember that sermon, as the points raised may very well come up again when I write about Farmer Brothers. An investor may be forgiven for feeling optimistic here, given that revenue for the 6 months ended December 31 of 2022 was about 12% higher than it was the previous year. The problem is that the revenue uptick was swamped by the 23% growth in COGS. This caused loss from operations to swell by $13 million from -$7.844 million to -$20.98 million. The company was heroic in controlling selling expenses (up only 1.45%) and G&A (down 12.4%), but unfortunately, this wasn't enough. Most troubling of all is the fact that interest expense rose 49%, or $2.7 million from $5.515 million to $8.221 million in for the first six months of FY 2023. This is troublesome in my estimation, because, as you may have noticed, interest rates are noticeably higher now than they were when the company had $42.26 million less debt on their balance sheet all the way back in 2019. The fact that debt has ballooned $42.26 million or 60% in four short years speaks volumes about the risk here in my view.
All that written, I'm of the view that it's possible for a troubled company like this one to be a great investment at the right price, so I'm willing to finally buy if the shares are sufficiently cheap.
The Stock
If you're one of my regulars for some reason, first, welcome back, I guess. Second, you likely know what time it is. It's time for me to point out, yet again, that a great company can be a terrible investment at the "wrong" price, while a troubled company like this one can be a decent investment if you acquire it at a sufficiently steep discount. This is because the stock and the company are distinctly different things. Specifically, the company roasts, wholesales, and sells coffee, tea, and allied products, while the stock is a piece of virtual paper that represents an ownership stake in the business. That bit of virtual paper gets traded around based on the crowd's ever changing views about the future of the company, future demand for coffee, the price action of relevant commodities, and the value of "stocks" as an asset class. In my view, the crowd's behaviour can often be summarized as "fire, aim, ready", as it tends to overreact to news, whether that news is positive or negative. For example, the market may be fixated on the ongoing problems on the income statement, while ignoring the real estate value embedded in the capital structure .
The point I'm trying to get across is that there's often a disconnect between expectations, and market reality. I really hate to remind investors of this, because it'd be terrible if I came off as a braggart, but spotting the discrepancy between then current expectations and likely future reality is what allowed me to sidestep a large capital loss on this stock when it was objectively cheap.
Previously, I concluded that the shares were too optimistically priced (i.e. the pendulum was "too rosy"), and now they may be too pessimistically priced. I'll make that determination by looking at the valuation, and I'll only buy if the shares are cheap enough.
As my regulars know, I determine whether shares are cheap or not in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value likes sales, earnings, free cash flow, book value, and the like. Ideally, I want to see shares trading at a discount to both the overall market and their own history. When I last reviewed Farmer Brothers, the shares were trading at a price to sales ratio of .189, and a price to book of .876. If you're new to this "investing" business, that is very, very cheap. Fast forward to the present, and the shares are now between 16% and 40% cheaper per the following:
This stock proves, pretty definitively, that no matter how cheap a stock is, it can always go cheaper. That written, it's worth pointing out that the shares are now trading hands below levels seen during the pandemic.
If you're a regular reader, you also know that I think ratios can be instructive, but I also want to try to work out what the market is "thinking" about a given investment. If you read my stuff regularly, you know that the way I do this is by turning to the work of Professor Stephen Penman and his book "Accounting for Value." In this book, Penman walks investors through how they can apply some high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit opaque, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and we can infer what the market is currently "expecting" about the future. Applying this approach to Farmer Brothers at the moment suggests the market is assuming that this company will grow earnings at a rate of 3% in perpetuity. Although I consider this to be a fairly optimistic forecast, it's not egregiously so in my view. There's also the matter of insider buying activity.
Insider Activity
With apologies to Orwell, all investors are equal, but some investors are more equal than others. Some people are just better at allocating capital. Some are good at it because they have the emotional temperament necessary to do well in the stock market. Some people do well because they have teams of analysts at their disposal. Some people are insiders at a given company and thus know more than any Wall Street analyst ever will about that company. With that in mind, I want to point out that there's been a relatively long and strong history of insider purchases of Farmer Brothers stock over the past few years. When I'm on the same side of the table as the people who know this business best, I feel more comfortable than I otherwise would.
Given the above, I'll be nibbling on these shares today. They're trading at or very near all-time lows, depending on how you measure it, and the people who know the business best remain committed to it. Losses continue to mount, but at some point this business starts to trade on its balance sheet, which is in relatively better shape in my view. Specifically, I'll be taking a ? position in Farmer Brothers today, and will buy more if the market price continues to languish over the next few months. The implication of this is that I'd be happy whatever the short term price movement is.
For further details see:
Nibbling On Farmer Bros.