Mike Keown - President and Chief Executive Officer David Robson - Treasurer and Chief Financial Officer.

Gerry Sweeney - Roth Capital Kara Anderson - B. Riley.

Good afternoon, ladies and gentlemen, and welcome to Farmer Brothers Third Quarter Fiscal Year 2018 Earnings Conference Call. At this time, all participations 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 call is being recorded. I would now like to turn the call over to your host [Sophie Crosby]. Please go ahead..

Thank you. Good afternoon, everyone. Thank you for joining Farmer Brothers third quarter fiscal year 2018 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. 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 2 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 Web site. I will now turn the call over to Mike Keown, President and Chief Executive Officer. Mike, please go ahead..

Thank you. Welcome, everyone, and thanks for joining us. I'd like to start today's call with the discussion of our financial and operational performance in the quarter, including areas where we fell short of expectations.

I'll then touch on elements of our strategy and what's next for us, looking forward, before turning it over to David for a more detailed review of our quarter and year-to-date financial results. We'll then open the call up for your questions.

While there continue to be areas of our business that we are proud of, such as SQF certification of our Northlake facility, new customer wins and ongoing progress with the integration of Boyds, there were other areas where we've missed expectations and aren't performing at the level we'd had hoped.

At the top of the list is our ability to forecast our new customer business in both DSD and direct ship. And while we are confident in the pipeline and are seeing new business come on, frankly, we missed in the quarter. I'd like to touch briefly on the financials before getting into the primary drivers of our third quarter performance.

Sales in the third quarter, including sales from the acquired Boyd's business, were up 14.3% year-over-year, and declined 2.3% on a year-over-year comparison, excluding the contribution of Boyd's. We processed nearly £28 million of green coffee volume in the third quarter.

With Boyd's included volume of green coffee processed and sold increased 13.7% year-over-year in the quarter.

Adjusted EBITDA of $10 million in Q3 declined from $12.2 million in the prior year period, and adjusted EBITDA margin was down 2.6%.While our top line results in coffee volumes were up from a year ago, our financial performance for the third quarter and year-to-date have tracked below where needed to meet our previous adjusted EBITDA guidance for the full fiscal year.

As a result, we are revising our outlook for fiscal 2018 adjusted EBITDA to be in the range of $44 million to $47 million. Now let me talk about the 4 primary drivers of our third quarter performance and how we are positioned going forward. First, direct store delivery, or DSD.

In the months since taking steps to restructure and modernize our DSD organization, we've spoken about progress made with new hires, training, implementing key growth planning processes and building a pipeline of new customer opportunities.

We've also discussed the rollout of our new selling technology, Smart Touch, which continued in the third quarter and was completed last month as planned. We are pleased with the new foundation we have put in place for the DSD business, and with some of the success we are beginning to see from our efforts out in the field.

However, as we've called out previously, under the channel-based selling approach, the typical selling cycle takes about 6 months or more from generation of the lead to a signed contract.

As a result, we are still not adding new business at the same pace as we have historically, which accounted for the largest portion of our miss in the third quarter.

We continue to believe, however, that the work to create a channel-based selling organization has been the right move to position our company for the future, based on where we believe the industry is headed.

We feel confident this approach can and will win us more business with larger national restaurant and retail chains, and therefore, generate more consistent growth over the long term as we convert the customers in our robust pipeline. Second, our direct ship business. During the quarter, we continue to see softness from two of our largest customers.

Each of these customers, from what we have seen, are experiencing business challenges of their own. Unfortunately, while we are winning new business and signing new contracts, the volume gains from our new customers this quarter did not offset the softness we experienced with these two large customers during the period.

With that said, even with the volume decline, these two accounts remain very important to us, and we are committed to being a valued supplier to them.

In particular, it's worth noting we grew each of these two accounts of our largest customers from a little more than 1 million pounds to well over 10 million pounds in the span of five years, and we are working to cultivate similarly steady ramp-up with our incoming direct ship customers.

We are very pleased to have received SQF certification of our Northlake, Texas roasting facility during our third quarter as I mentioned a moment ago. This was a final step for us to begin bringing in and growing volume with new direct ship accounts.

In the quarter, we won two limited time offers with an existing direct ship customer, we commenced production for a new customer and we are in the final implementation stage with a very significant customer.

We believe these new customers have the potential to grow and become some of our top accounts over time, and our pipeline continues to be healthy and strong. It is this type of new business that leads us to be so excited about our ability to increase volume over time and to leverage the investment made in our Northlake facility.

Third, our Boyd's acquisition. Revenue and volume from this business was in line with our expectations, and as I mentioned earlier, the addition of this business drove our increased top line and overall volume for the quarter.

As we worked to complete the integration, and more specifically, as we work through the transition services agreement or TSA, with Boyd's, we saw higher-than-expected cost in the third quarter. Since closing, we have searched and seized upon opportunities to accelerate the integration process.

As examples of this, we have taken leadership of all direct ship customers, have begun to produce product in Farmer Brothers facilities, are well down the path of integrating DSD, and have all Boyd routes on Smart Touch and have hired some very talented people into the Farmer Brothers organization.

Once the transition arrangements have ended, the coffee production is combined and under our full control and the integration is completed, we anticipate being fully able to realize the synergies from this transaction.

In terms of the integration activities in our projected timeline, the integration is proceeding largely as planned and we remain confident we will complete the integration in our expected 15 to 18-month timeframe, of which we're about 8 months in. And finally, our fourth driver, which was the increased transportation and freight expense.

While we continue to achieve cost savings in target areas of our business, these savings were more than offset in the third quarter by a rise in transportation and freight cost, a rise that is significantly affecting the broader packaged goods, food distribution and retailing industries.

As we look forward, we are working to control the costs that are within our control and we'll look for additional opportunities to reduce operating expenses. As I indicated earlier, we continue to be excited about how Farmer Brothers is positioned in the market, and about our growth opportunities.

As most of you know, coffee is a growing business estimated to be a $76 billion industry in the U.S, and price points are on the rise. We believe we have significantly strengthened our platform for long-term growth in the past 18 months through our acquisitions, particularly our acquisition of Boyd's.

We continue to make significant progress in sustainable cultivation, manufacturing and distribution practices while maintaining our commitment to serving the finest products available, all of which help make us a more attractive partner for customers and potential customers.

We have a DSD channel-based strategy that is beginning to generate new, better quality customer wins. We are expanding our distribution network, adding to our customer base and exploring new product categories. The SQF certification of our Northlake roasting facility is allowing us to bring on large national direct ship customers.

And longer term, with our recent acquisitions, we believe we have established the ability to grow through M&A in addition to growing organically. We continue to believe that we have the right foundation in place for industry-leading sustainability programs to achieve superior results.

And while we have work to do, our team is highly focused and motivated to deliver improved results in Q4 and stronger financial performance in fiscal 2019. However, we are also keenly aware that we need to improve our ability to better execute and forecast in several areas of the business with a focus on sales.

I'll now turn the call over to David for a more detailed review of our financial results.

David?.

Thanks, Mike. I'll now go into further detail regarding our results this quarter.

As all of you had the chance to review the press release, I'll only touch on a few key areas, beginning with coffee volumes.Green coffee processed and sold in the quarter increased 13.7% year-over-year with the inclusion of Boyd's volume.Coffee volumes increased by 3.3 million pounds over last year.

Volumes from our base business were down 3.8% to a year ago, driven largely by softness from 2 large national accounts and lower DSD sales.The mix of coffee volumes processed and sold across our distribution network during the quarter was approximately 9.6 million pounds or 34.8% of the total volume through our DSD network, while direct ship customers represented approximately £17.8 million of green coffee processed and sold or 64.2% of total volume, and sales through distributors, including through new distributor relationships acquired through Boyd's, made up the remainder.

Turning now to the income statement. Net sales for the quarter were $157.9 million, an increase of $19.7 million or 14.3% compared to the prior year quarter. This increase was driven primarily by a $22.8 million net sales contribution from the acquisition of Boyd's. Excluding Boyd's, net sales decreased $3.1 million or 2.2%.

This 2.2% decrease is primarily a result of softness from 2 large national accounts, lower DSD sales and the impact of price decreases to our cost-plus customers due to lower hedge cost of green coffee.

Although we were disappointed with the pounds and revenue performance of our base business during the quarter, we're confident that our recently achieved SQF certification will help us to increase business with large national customers through our new, state-of-the-art Northlake facility, and we expect to realize volume and top line benefits from our new DSD sales channel model in future quarters.

Gross margin in the quarter was 37.2% of net sales compared to 38.9% of net sales in the prior year quarter, a decrease of 170 basis points compared to last year.

The largest driver of the decline was 123 basis point increase in manufacturing cost, largely driven by our new Northlake facility, which was not a significant part of our cost structure a year ago, with additional decreases due to less leverage on lower year-over-year volume in our base business.

The addition of Boyd's also put downward pressure on our gross margins, given it has a slightly lower gross margin rate compared to the Farmer Brothers base business. The remaining decrease primarily relates to a nonrecurring LIFO benefit on spice inventory, which occurred in the third quarter of last year.

Operating expenses in the quarter were $61.7 million or 39.1% of net sales as compared to $51.8 million or 37.5% of net sales recorded in the prior year quarter.

The increase of $9.9 million reflects an $8.4 million increase in selling and general and administrative expenses, exclusive of the related depreciation and amortization from the addition of the Boyd's business this year, higher depreciation and amortization of $1.1 million, and acquisition and integration cost of $1.6 million.

Additionally, as Mike mentioned, as we work through the transition service agreement associated with the Boyd's acquisition, we saw higher-than-expected cost in the third quarter.

These items were partially offset by a $2.5 million decrease in restructuring and other transition expenses associated with the Corporate Relocation Plan from last year and reduced payroll and employee benefit cost of $1.3 million.

Further, once the transition arrangements associated with Boyd's have ended, our coffee production is combined and the integration is complete, we anticipate being able to realize the synergies expected from this acquisition. Expenses in the quarter also reflect an impairment charge of $3.8 million associated with China Mist.

During the quarter, we performed our annual impairment testing of all of our intangible assets and we determined that the estimated fair value of the China Mist trademark and customer relationships exceeded their carrying value.

During the quarter, we lost a significant China Mist customer, which impacted our assessment of the estimated fair value of China Mist intangible assets.

Finally, during the quarter, we also experienced higher freight cost of $0.9 million when compared to freight cost for Q3 of last year, which we're able to offset with other cost savings initiatives. For the nine months ended March 31, we have experienced higher freight cost of $1.8 million compared to last year.

Going forward, we expect our operating expense leverage, excluding onetime integration expenses, to improve over time as we realize cost savings related to the Boyd's integration. Turning to interest expense. Interest expense was $902,000 in the third quarter, up from $517,000 last year due to higher borrowings compared to the prior year period.

We expect interest expense to remain at higher levels compared to last year given the borrowings associated with the Boyd's acquisition, which closed in early October. Turning to income taxes. We recorded $297,000 in income tax expense this quarter compared to $1.4 million of income tax expense in the prior year period.

We recorded an income tax expense on a loss during the quarter, primarily due to changes in the tax rules associated with the 2 -- the new tax law enacted in December of last year. On a go-forward basis, we expect our effective tax rate to be approximately 28%.

The resulting net loss in the third quarter was $3.9 million or a loss available to common stockholders of $0.24 per diluted common share compared to net income of $1.6 million or $0.10 per diluted common share in the prior year period.

Adjusted EBITDA was $10.5 million for the quarter compared to $12.2 million in the prior year period, while adjusted EBITDA margin was 6.7% compared to 8.8% in the prior year period. Now let's turn to the balance sheet. At the end of the quarter, we had $7 million in cash and we had $85.9 million borrowed on our revolving credit facility.

Our debt, net of cash, at the quarter-end was $78.9 million compared to $11.9 million as of March 31, 2017, and $79 million as of December 31, 2017. Our debt net of cash was essentially flat compared to last quarter, as we used our cash flows generated from our base business operations primarily to fund our integration activities with Boyd's.

Our availability under our credit facility was $35.7 million at the end of this quarter, up from $24.5 million at the end of the second quarter of fiscal '18. The $11.2 million increase in availability during the quarter is primarily related to the inclusion of assets related to the Boyd's business into our borrowing base.

Now turning to capital expenditures.

For the current quarter, our capital expenditures in cash were $11.2 million, with $8.3 million related to maintenance CapEx and $2.9 million related to the expansion of the company's production lines in the Northlake facility, which includes work to integrate the production volume from the integration of the Boyd's business.

Year-to-date, we have spent $17.4 million in maintenance CapEx, which is currently in line with our expectations of $20 million to $22 million of maintenance CapEx annually. Depreciation and amortization expense was $7.4 million this quarter versus $6.5 million in the prior year quarter.

The increase in this expense resulted primarily from investments made at our new Northlake facility, the deployment of the new Smart Touch devices used by our DSD organization and the depreciation and amortization from the acquisition of Boyd's Coffee.

The acquisition of Boyd's Coffee added $0.3 million in depreciation and amortization expense in the quarter.

Based on our existing fixed asset commitments and the useful lives of our intangible assets, including the addition of Boyd's, we currently expect depreciation and amortization expense to run at approximately $7.5 million to $8 million per quarter for the next several quarters. Lastly, I'd like to turn to the Boyd's acquisition.

We continue to estimate that the Boyd's business will contribute approximately $13 million to $16 million in incremental adjusted EBITDA on an annual basis post-integration.

To date, we have incurred approximately $6.7 million in acquisition and integration cost and we currently expect to spend an additional $2.3 million to $4.3 million of onetime cost to complete the integration.

To date, we have spent $2.2 million in CapEx cost associated with the Boyd's acquisition and we expect to spend an additional $5.8 million to $8.8 million in CapEx over the next 9 to 12 months to complete the integration.

As Mike mentioned earlier, our outlook for the remainder of the fiscal year has changed based on third quarter and year-to-date results tracking below prior expectations.

We now expect our full year adjusted EBITDA will be between $44 million to $47 million for the consolidated business in fiscal '18.While our third quarter results fell short of our expectations, we continue to see opportunity for growth and operating margin expansion as we look ahead to fiscal '19.

We anticipate several drivers to contribute to improved profitability, including realizing additional synergies from Boyd's as we complete our integration, driving incremental top line as the DSD channel sales team matures and becomes fully productive and attracting greater volume orders from large, new, direct ship customers at our SQF certified Northlake facility.

Now I'll turn the call back to Mike for closing remarks..

Thanks, David. Again, as I noted earlier, we recognize that we have more work to do to get our entire business operating the way we believe it can.

However, our view of the industry and the prospects for Farmer Brothers remains positive, as we continue to see both organic and inorganic growth opportunities and continue to be focused on leveraging the investments we have made in our roasting facilities, expanding our distribution network, adding new customers and increasing our business with existing customers.

Coffee is a growing category, and we are well positioned to capitalize on that growth. As we look forward to the remainder of fiscal 2018 and to fiscal 2019, we remain focused on executing across all areas of our business and unlocking Farmer Brothers full potential. As always, I thank those on the call for your continued interest in Farmer Brothers.

And with that, I'd like to open the call up for questions.

Operator?.

Thank you [Operator Instructions]. Our first question comes from Gerry Sweeney of Roth Capital. Your line is open..

A question -- I mean, obviously, you -- in the prepared remarks, you mentioned you won, I think, there's a lot of detail here, but 2 limited time offers plus, I don't know if you said a very significant customer win or potential for a very significant customer win.

Could you frame that out? Is this something that's on a trial basis you're sitting down discussing? Just wanted to flesh that out a little bit more if possible..

Sure, Jerry. It's Mike. I'll take that. So when you think about the quarter, we won a couple of limited time offers with an existing customer, which is nice. But I think on a more important basis, we commenced production for a new customer, which we're very excited about. And we're in the final implementation stage with another very significant customer.

Our pipeline continues to be robust and we've got a good foundation in place. To kind of help you frame it, if you look at the combination of channel sales, direct sales and DSD, give you a little more perspective there.

Two large healthcare systems, a significant fresh Tex-Mex chain and then national customers that have the potential to grow to £5 million in year 1 once they're on-boarded. That being said, we have a lot to do to execute in the implementation phase, which you've gotten a sense for is producing samples the customer typically audits us and so forth.

So we feel like we've got the great potential to get the ball over the goal line. But a little bit more work to do..

So this is….

So, Jerry, one thing to add to that to give you color, because we don't always give out big customer wins. But you could probably see it in our CapEx spend in the quarter. Outside of our maintenance CapEx, we spent close to $4 million, $3.9 million. $1.8 million of that is for Boyd's.

But the balance is really investments we're making related to new customers..

Yes, got that. And when you, when we talked about implementation, I mean, is this, what's the timeline between samples auditing and the final decision process? I mean….

Well, it's driven by the customer. But if I had to give you the middle of the bell curve, I'd say about a quarter..

About a quarter?.

And again, that's driven by the customers and our ability to deliver through that process. But we've been through this process before and we're confident that if we execute well, we'll be in very good shape..

And I assume that £5 million, was those customers in aggregate?.

Yes. We, trying to find a way to kind of bucket them for you. But it's interesting as we brought on, over the last six years, a number of customers that have exceeded this level of pounds, the real magic is to continue to provide great customer service. We intend to start with a glide path up. And as you execute, it keeps coming on board.

But we're trying to find a way in a world where we can't share the customers for you all to get a sense of the magnitude by putting them together..

Well, on that front, if you're looking at £5 million, this, and I am not sure if you would want to provide this detail, but I mean is that something like 10% or what percentage of the company's total businesses? Is that possible just for an order of magnitude?.

Well, if you think just last year, we did £95 million. This year, with the addition of Boyd's, of course, we're going to grow. So we're going to be well north of £100 million, probably between £105 million and £110 million. So yes, that's a big customer for us from a pounds perspective..

And then switching gears real quick and then I'll jump back in line. Gross margin is a little lower than I think most people expected. I think you've called out the biggest driver in that was Northlake Facility. I believe last quarter was about an 80 basis point drag.

And these aren't exact numbers but I think you said about 120 -- or you said a good portion of the 123 basis points was from Northlake.

At what point can you actually -- can you switch maybe the Boyd's production into Northlake and start absorbing some of that overhead? Are you stuck in that TSA? And pardon me, I don't know if stuck is the right word, but are contractually bound to the TSA for a certain period of time? But when can you move the Boyd's to Northlake and maybe absorb some of that overhead if possible?.

Yes, the TSA is designed to end 12 months after it started. So it started in October of last year. I wouldn't call it stuck in. We actually wanted that timeframe so we can integrate. And we're going through now getting our facility ready to integrate that. So you're going to see that volume start to flow through in fiscal '19..

Is there enough Boyd's coffee to sort of bring that -- eliminate that drag on the margins from Northlake? I would suspect it would maybe shift the other way?.

Well, we have a lot of capacity at this plant. We said it's 24 million pounds to 28 million pounds today. With additional investment, it could go up to 100 million pounds. So Boyd is about 14 million pounds. We certainly want to add more than just that to help leverage it -- lot of ability to leverage it with growth..

[Operator Instructions] And we have a follow-up question from Gerry Sweeney of Roth Capital..

Well I'll take the opportunity since it's been given to me.

Freight cost, I assume, that is the higher oil prices, vis-à-vis, gasoline, et cetera, and is there a way to mitigate this freight -- those costs on a go forward basis?.

Well, Jerry, I'll just take a step back. You've certainly seen that both from a driver perspective and more recently a fuel perspective, there is definitely inflationary pressures. So we'll work as we can to find cost savings to offset that.

I think the question a number of us are trying to sort through is, just how big and how far in the future will that go. And I don't think anybody has a magic -- magical view of what that looks like for the future.

I think what we found is over time, we found ways to do that but in the near term, there's definitely headwinds that we'll be encountering as many people are in our business around freight..

[Operator Instructions] And we have a question from the line of Kara Anderson from B. Riley..

So I joined late. But I did want to ask about the Nestlé and Starbucks alliance that was announced earlier this week, and if you could speak to any implications for Farmer, what it might mean for your business? Thanks.

It's a good question. I've only read about it probably what you've read in the press. So I can't say that we have a full grasp, given the recent announcement. At a high level, it appears to be more focused on retail, and while we have a retail business, more of our businesses in food service.

So I don't think it saves value we see an immediate impact one way or another. Though it's certainly notable to see what's going on around the globe in coffee right now.

But I think from what we said our job is to execute against our customer pool, prospective customer pool, and continue to execute against Boyd's is our clearest path to value creation..

And I would say, Kara, keep in mind that coffee is such a fragmented market that we compete in. A lot of small players were a high-service model through our DSD. We have a lot of great national accounts. I don't see any near-term implications from that we see at the moment..

[Operator Instructions] And I'm not showing any further questions in queue. I'd like to turn the call back to Mike Keown for closing remarks..

Well. Thank you, once again. As I noted earlier, we recognize that we have more work to do to get our entire business operating the way we believe it can.

However, our view of the industry and the prospects for Farmer Brothers remain positive as we continue to see many opportunities to grow our business over both the short term and the medium and the longer term. As always, I thank those on the call for your continued interest in Farmer Brothers. Thank you, very much..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day..