Laurie Little - SVP Mike Keown - President and CEO David Robson - CFO.

Chris Krueger - Lake Street Capital Markets Beth Lilly - Crocus Hill Partners Aman Gulani - B. Riley & Co..

Good afternoon, ladies and gentlemen, and welcome to the Farmer Bros. Third Quarter Fiscal 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we'll conduct a question-and-answer session and instructions will follow at that time. [Operator instructions] As a reminder, this conference is being recorded.

I would now like to turn the call over to your host, Laurie Little. You may begin..

Thank you, Norma. Good afternoon, everyone. Thank you for joining Farmer Bros.' third quarter fiscal year 2017 earnings conference call. Participating on today's call are Mike Keown, President and Chief Executive Officer; and David Robson, Treasurer and Chief Financial Officer.

Earlier today, we issued a press release, which is available on the Investor Relations section of our website, at www.farmerbros.com. The press release is also included as an exhibit to our Form 8-K available on our website and on the Securities and Exchange Commission's website at www.sec.gov.

Please note that all of the financial information presented on this conference call today is unaudited. A replay of this audio-only webcast will be available approximately 24 hours after the conclusion of this call. The link to the audio replay will also be available on our website.

Before we begin the call, please note various remarks that we make during this call about our future expectations, plans and prospects may constitute forward-looking statements for purposes of the safe harbor provisions under the federal securities laws and regulations.

These forward-looking statements represent our views only as of today and should not be relied upon as representing our views as of any subsequent date. Results could differ materially from those forward-looking statements.

Additional information on factors that could cause actual results and other events to differ materially from those forward-looking statements is available in the company's press release and in our public filings, which are available on the Investor Relations section of our website.

On today's call, we use certain non-GAAP financial measures, including non-GAAP net income, non-GAAP net income per common share diluted, EBITDA, EBITDA margin, adjusted EBITDA and adjusted EBITDA margin, in assessing our operating performance.

Reconciliation of these non-GAAP financial measures to their most directly comparable GAAP measures is included in our earnings press release, which is available on the Investor Relations section of our website. And with that, I will turn the call over to Mike Keown, President and CEO..

First, our relocation to Northlake is now essentially complete. Second, we fired up our roasters, and as of May, we have begun to produce roast and ground coffee products in the new facility. We are going through the quality certification process similar to what we did in our Houston and Portland facilities.

Third, we implemented a restructuring plan to reorganize our DSD operations to a channel-based selling strategy model, which was designed to drive sales growth. I will touch on these items in more detail. But first, some specifics of our quarterly results.

Coffee volume was up 6.9%, making this our fifth consecutive quarter that we achieved a volume growth rate of mid-single digits or higher. We are pleased to see our volume growth being driven by both existing and new customers.

In fact, if you look back when this management team began to fall into place in the fourth quarter of 2012, we have grown coffee pounds at a compound annual growth rate of about 7% during that period.

Of note, we may see the volume growth rate dip into the lower single digits in the fourth quarter compared to the prior year, as last year, we had very strong volume performance, partially driven by onboarding several new customers, where we often see some incremental volume as they fill their warehouses.

Revenue for the quarter increased 2.8% compared to the third quarter for fiscal 2016. We realized good revenue growth in roast and ground coffee of 6.4% and in line with our growth in coffee volume. We also had a 24% increase in tea revenue resulting from the addition of China Mist.

Our spice business, compared to the prior year period, declined $2.4 million or 29% due to the sale of our institutional spice assets. We also saw a roughly 8% or $700,000 decline in our frozen liquid coffee business due to a lost customer in the casino channel. Third quarter gross profit increased $1.2 million or 2.4% to $53.8 million.

We continue to drive gross margins in the 39% range, up 130 basis points as compared to the 9-month period last year, and for historical context, up 350 basis points compared to the same nine-month period in fiscal 2015, which I feel is a testament to the organization's success in delivering incremental gross margin rate improvements.

With the addition of our new Northlake production facility, we have added capacity to help meet production needs for growth in coffee volume. Depending on the type of growth we may realize, our future gross margin rate could be impacted.

Our direct ship business generally has lower margin rates with higher volumes per customer, while traditionally, our DSD business delivers higher margins, but generally at lower volume level per customer. Next, taking a look at EBITDA.

As David will detail later, we delivered strong improvement in EBITDA of about 53% over the prior year and up 24% on an adjusted basis. We believe that this improvement demonstrates that, in aggregate, our initiatives are taking hold.

Next, I'd like to touch upon our key events in the quarter including updates on our Corporate Relocation Plan, DSD reorganization and acquisitions. As I mentioned earlier, I'm delighted to announce that our new state-of-the-art Northlake, Texas facility is up and running, including our new corporate headquarters.

Construction is complete, and we are excited to have recently fired up our roasters and begun to manufacture coffee here. This is a major milestone in our transformation and it is indicative of the strength and commitment of our team.

This new facility brings with it additional capacity to accommodate business growth, and is designed with a focus on quality and food safety, in addition to production efficiency. In addition, as I mentioned, we are currently going through a process to obtain SQF certification, as we have in our Houston and Portland facilities.

We remain on track to achieve the expected $18 million to $20 million in annualized cost savings from our corporate relocation, with the remaining $3 million to $5 million to be delivered in fiscal 2018, which we expect to be split evenly between gross profit and SG&A. Shifting to the DSD reorganization now.

In mid-February, we announced the restructuring of our DSD sales model to a channel-based selling model from primarily geographic strategy. We believe that this change will better serve our customers and lead to improved sales growth, while maintaining the value-add provided by the DSD delivery and service model.

We also believe this will drive future top line growth while resulting in annual cost savings of approximately $2 million to $2.6 million beginning in the first quarter of fiscal 2018.

While it is a bit early, we are pleased with the progress made to date in hiring some very good talent from the outside and better utilizing existing talent in the DSD organization. Moving on to acquisitions. The addition of China Mist and West Coast Coffee has gone smoothly. They are now part of our operations.

We are very pleased with the progress thus far. We will continue to evaluate other M&A opportunities that have the potential to benefit the interest of our stockholders and our customers over both the short and long term. Now I will turn the call over to David for a more detailed review of our third quarter results..

Thanks, Mike, and thank you for the nice introduction. I'm glad to be part of the Farmer Bros. team and reporting on results for the quarter. Beginning with the income statement, net sales for the quarter were $138.2 million, representing a 2.8% increase as compared to the prior year.

The year-over-year improvement is primarily the result of $5.3 million or a 6.4% increase in roast and ground coffee net sales, and a $1.5 million increase or 24.4% in tea product net sales, driven by the addition of China Mist, partially offset by a $2.4 million decrease in net sales of spice products resulting from the sale of our international spice business.

And as Mike mentioned, we also saw a $700,000 or 7.6% decline in frozen liquid coffee sales due to the loss of a large casino customer. Our normalized comp growth, after excluding the impact from both the acquisition of China Mist and West Coast Coffee and the divestiture of our spice assets, was 2.4%.

Also as Mike mentioned, we had a 6.9% increase in coffee pounds sold in the third quarter, and year-to-date, we increased 6.9%. Gross margin in the third quarter was 38.9% of sales compared to 39.1% of sales in the prior year quarter.

Gross margin decreased by 20 basis points, impacted by startup costs for our Texas production facility of 40 basis points, primarily offset by favorable pricing. Operating expenses in the third quarter were $51.8 million as compared to $52.3 million recorded in the prior year period, a decrease of $0.5 million or 0.9% of sales.

The decrease was primarily due to lower restructuring costs of $0.7 million, offset by higher proxy costs of $0.2 million. In the third quarter of this year, we incurred $2.5 million in restructuring costs compared to $3.2 million in the prior year quarter.

Of the $2.5 million in restructuring costs incurred in this quarter, $1.3 million was associated with the DSD reorganization plan and $1.2 million related to our Corporate Relocation Plan.

Also during the quarter, we incurred incremental operating expenses associated with the inclusion of China Mist and West Coast Coffee into our business, amounting to $1.3 million, as well as $0.3 million in acquisition-related consulting expenses.

These higher expenses were essentially offset by lower workers' compensation expense, medical benefits and incentive compensation.

When you exclude the year-over-year impact of restructuring costs and other transition expenses, proxy costs, gains on the sale of our assets, our operating expenses were 35.7% of net sales this quarter compared to 36.8% of sales in the third quarter of last year, a 110-basis point improvement.

This normalized run rate of 35.7% of net sales for the current quarter is consistent with the normalized run rate for the 9 months of this fiscal year at 35.5% of sales. Turning to income from operations in the third quarter.

We achieved $2.1 million compared to $0.3 million in the prior year period, an improvement of $1.8 million, primarily due, as I mentioned, to the increase in gross profit of $1.2 million and a reduction in overall operating expenses of $0.5 million.

Total other expenses were $947,000 in the third quarter of this year, which is about the same as the prior year quarter. Turning to income taxes. We recorded income tax expense of $1.4 million this quarter as compared to $43,000 in the prior year quarter. We had an effective tax rate of 47% this quarter compared to a tax rate of 4% in the prior year.

Our effective tax rate was lower than the statutory rate in the third quarter of last year, as we had a 100% valuation allowance against our deferred tax assets, which we utilized to offset nearly all the income tax expense generated during that period.

We were able to release the majority of our valuation allowance against our deferred tax assets in the fourth quarter of last year. Going forward, we expect our effective income tax rate to be approximately 40%.

Our tax rate this quarter was 47%, which was higher than 40%, due to a true-up of our tax provision to our annual tax return filing which was prepared this quarter. As a result of all the factors I just mentioned, net income was $1.6 million this quarter, as compared to $1.2 million in the prior year quarter, a $402,000 increase.

Net income per diluted common share this quarter was $0.10 versus $0.07 in the prior year quarter, an increase of 43%. Looking at our non-GAAP net income, we generated $3 million in the quarter or $0.17 per diluted common share, versus $4 million or $0.24 per diluted share -- common share in the prior year quarter.

The decline in non-GAAP net income of $1 million year-over-year was impacted by the higher marginal tax rate recognized this quarter as compared to the prior year quarter. Excluding the impact of a higher tax rate, year-over-year non-GAAP net income improved by $500,000.

Non-GAAP net income in the quarter excluded the impact of restructuring and other transition expenses of $2.5 million or $0.15 per diluted common share.

Net gains from the sale of spice assets of $272,000 or $0.02 per diluted common share, net gains from the sale of other assets of $86,000 or $0.01 per diluted common share, nonrecurring proxy contest-related expenses of $196,000 or $0.01 per common diluted share, and the tax effect of all the non-GAAP adjustments of $930,000 or $0.06 per diluted common share.

EBITDA generated during the quarter was $10 million as compared to $6.6 million during the third quarter of last year, a $3.4 million or 53% increase. EBITDA margin was 7.3% this quarter versus 4.9% in Q3 of '16, a 240-basis point improvement.

I should point out that we will begin reporting EBITDA going forward in addition to adjusted EBITDA for all periods presented, as we believe this measure is frequently used by security analysts, investors and other interested parties to evaluate companies in our industry.

The historical presentation of adjusted EBITDA was recast to be comparable to the current period presentation. With that, adjusted EBITDA generated during the quarter was $12.2 million versus $9.8 million in the third quarter last year, a 24% improvement.

Adjusted EBITDA margin was 8.8% this quarter versus 7.3% in Q3 of '16, a 150-basis point improvement. The 8.8. % achievement in adjusted EBITDA this quarter was the strongest performance we have seen this year, moving our year-to-date adjusted EBITDA up to 8.4% or $34.3 million.

As we look to the fourth quarter of this year, with the initiatives we have in place, we would expect to deliver a similar level of adjusted EBITDA performance as we realized this quarter. Now let's turn to the balance sheet. At the end of the quarter we had $5.7 million in cash and cash equivalents and $26.5 million in short-term investments.

In addition, we had $44.2 million borrowed on our revolving credit facility.

Our net debt, after subtracting cash and short-term investments, was $13 million at the end of the quarter compared to net cash and short-term investments in excess of debt of $14.9 million in the preceding quarter ended December 31, 2016, which is an increase in net debt of $27.9 million during the quarter.

We increased our borrowings net of cash and short-term investments during the quarter, primarily to fund our new facilities and for payments associated with the acquisition of West Coast Coffee.

Given we are currently a net borrower and we intend to -- we will intend to liquidate our short-term investments during the fourth quarter of '17, and we will utilize the proceeds to pay down our credit facility.

At the end of the quarter, we had capital spend on our new facility, we anticipate spending an additional $16 million to $18 million in the fourth quarter of this year. Our cash spend on maintenance capital will range between $2.5 million to $3.5 million in the fourth quarter of this year.

Excluding capital expenditures on our new facility, we expect maintenance capital for the full year to rub between $20 million to $22 million annually. During the quarter, we also added property, plant and equipment associated with our acquisition of West Coast Coffee of $1.4 million. Now turning to depreciation and amortization expense.

Our expense was $6.5 million this quarter versus $5.2 million in the prior year quarter. We anticipate our depreciation and amortization expense to increase to $7 million to $7.5 million in the fourth quarter of this year.

We also anticipate our depreciation and amortization expense to run at approximately $8 million to $8.5 million per quarter in fiscal year '18, based on our existing fixed asset commitments and the useful lives of our intangible assets. Turning to inventory.

At the end of the quarter, we had $60.7 million in inventory consisting of $35.4 million in coffee inventory, $21 million in tea and culinary inventory and $4.2 million in coffee brewing equipment parts.

Total inventory increased $6.2 million or 11.3% over March of last year, primarily due to higher green coffee inventory, which we expect to bring down in the fourth quarter.

At the end of the quarter, we held coffee-related derivatives covering 12 million notional pounds of green coffee as compared to 19 million notional pounds covered as of December 31, 2016.

In addition, we had green coffee fixed price contract commitments of $68.9 million at the end of this quarter versus $69 million as of December 31, 2016, associated with the move and relocation of Torrance operations and other related costs.

We expect to incur approximately $31.6 million in aggregate cash cost to fully complete the relocation plan, of which we expect to spend an additional $900,000 through October of 2017. Turning to construction costs.

We estimate that the total construction costs for the building, facilities and land will be approximately $60 million, of which we have paid an aggregate of $54.7 million as of the end of this quarter. We estimate the total costs for machinery and equipment, furniture and fixtures in the $30 million to $39 million range.

As of March 31, the company had spent an aggregate of $20.2 million on machinery and equipment, furniture and fixtures. In aggregate, the estimated total cost for the new facility still remains within our established budget, currently forecasted to range between $90 million to $99 million. Now, I'll turn the call back to Mike for closing remarks..

Thanks, David. In closing, we are pleased with the progress of our turnaround strategy by delivering solid financial results and demonstrating substantial improvements in our operations. Before I open the call to questions, I would like to recognize 2 of our long-standing board members. As we announced 2 weeks ago, Dr.

Berger and Hami Assadi will not seek reelection to the board at the conclusion of their terms in December 2017, ending for each, decades of distinguished service to the company. Guenter has been with the company for a remarkable 57 years. During his tenure, he spent 25 years working for Roy F.

Farmer as Vice President of the Torrance inventory, production, coffee roasting and distribution operations. He became President and then Chief Executive Officer in 2005, and continued his service as a member of the Farmer Bros. Board of Directors following his retirement in 2007.

Guenter's vast knowledge, wisdom and guidance were instrumental as the company expanded into specialty coffee and grew its geographic reach, ensuring that the company was well-prepared for continued success for the next 100 years. Hami has been part of the Farmer Bros.

family since 1985, working in various roles including Tax Manager, Cost Accounting Manager, Assistant to Corporate Secretary and in production and inventory control, before her retirement in 2007. Hami has been a valuable member of the board since 2011.

The company has benefited from their contributions through the investment of their time, talent and passion to our business.

While we will continue to benefit from Guenter and Hami's service and contribution through the end of their terms, we want to acknowledge that their support and valuable guidance will be missed, and once again thank them for their years of loyalty and dedication.

As a brief update, we are conducting a search for new board members to nominate, and we'll provide an update as appropriate. And with that, I'd like to open the call up to a few questions.

Operator?.

Thank you. [Operator instructions] Our first question comes from Francesco Pellegrino of Sidoti & Company..

Francesco? Operator, why don't we go to the next question, and we'll circle back..

Thank you. [Operator instructions] Our next question comes from Chris Krueger of Lake Street Capital..

Hi. Good afternoon..

Good afternoon..

On the last few quarterly calls, you guys mentioned specific customer wins. I was wondering if you had anything to report there during this quarter? And if you can comment on the potential pipeline going forward..

Thanks Chris. It's Mike. I'll take this one. We don't have any specific customers to announce in this quarter. But I would reiterate what I said over, I think, the past several calls. The pipeline is very deep. We're optimistic. And if you look back over the last few years, we've got a pretty strong track record of bringing on new customers.

So, I remain bullish, but nothing specific to report at this point..

And then just to be clear, to go after some of these potential opportunities, is getting that SQF Level 3 certification kind of the first step before you can really go after it?.

No. We're -- we've been aggressively pursuing new customers as we developed an optimism that the plant was going to start up. So, we're not slowing down at all while we achieve those certification levels. We have customers in multiple phases of the pipeline, but nothing too solid to report.

But to answer your question, no, we're not -- what I think I understand the question to be, we're not waiting for that to pursue new customers..

All right. Thank you..

[Operator instructions] Our next question comes from Beth Lilly at Crocus..

Thank you. A question for you.

If you look at the model going forward and what you think you're able to achieve with the new facility in terms of operational improvements and cost savings, can you give us a sense of where you think you can get EBITDA margins to over the next, let's call it, two to three years?.

Hi. This is David. We have -- we don't give out guidance. We gave kind of guidance out for the next quarter, which says our EBITDA will probably stay about where it was this last quarter, but we're certainly trying to pursue a model that we drive north of 10% EBITDA in the long-term, but we can't give you any more details on that..

Okay. And so, the north of 10% is based on the facility of Northlake up and running, the additions of customers, things like that.

That's your -- would you say that's your goal over the next two to three years?.

I wouldn't give that kind of specificity, but clearly, we've made an investment in this new facility and gives us added capacity where we can attract new customers and win business, and that's our plan..

Okay. Great. Thank you so much..

Thank you. [Operator instructions] I'm showing no questions in the queue at this time. I'll turn the call back over to our host for closing remarks. Mr. Keown, please go ahead..

As always, I would like to thank those on the call for your continued interest in Farmer Bros., and we look forward to speaking with you all again soon..

Excuse me, Norma. I think we have one more question..

Yes, we do. Kara Anderson from B. Riley & Co..

Hey guys. This is Aman. I'm jumping in for Kara. Just wanted to get -- you guys increased green coffee pound by 6.9%.

Was this mostly due to DSD business? What are we looking at here?.

No, I think it's more tiny. So, the amount we buy every year, it'll move around. And I think, when you get to the fourth quarter, it's going to get consistent where it was last year..

Okay. That's it for me..

Okay. Thank you very much once again..

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may disconnect. Have a great day..