Farmer Brothers: Is The Coffee Too Hot, Or Just Right?

| About: Farmer Brothers (FARM)

Farmer Brothers (NASDAQ:FARM) looks like a classic Peter Lynch value stock. It is relatively unknown, management owns a big stake, it is a simple business (they roast coffee and sell it) and it sells below intrinsic value. It is currently way out of favor (that's why it is so cheap) as it has been unable to produce a profit in six years (what a way to celebrate your 100th birthday).

The coffee purveyor is in the process of a turnaround attempt and progress (albeit slow) is starting to materialize: (1) it has attempted to get "lean and mean" by cutting unnecessary payroll, exiting its pension plans and consolidating sales routes. (2) it has had success leveraging its national direct store delivery presence, by gaining new customers, obtaining economies of scales, while eliminating redundancies in the process (3) the brewing up of its top line is unfolding nicely, evidenced by the acquisition of substantial contracts in the Las Vegas market, including the Bellagio, MGM Grand and the Hard Rock properties. Another feather in its cap? How about securing the coffee business of the iconic, "In-N-Out Burger chain".

Smart investors are starting to take notice, such as legendary value investor Michael Price. He owns a 2% stake and didn't get to be listed as a member of the Forbes 500 list by making poor choices. Want another investment Guru for confirmation? Try Mario Gabelli. He bought too.

Analysts are beginning to show interest: Both Roth Capital Partners and Sidotti & Company now provide research coverage on this microcap. Roth has a Buy rating in effect and a $11 target price, while Sidotti has broadcasted a $15 goal. A further caffeine jolt came from Barron's. The financial magazine recently wrote a flattering piece entitled "A Coffee Seller Perks Up", highlighting the companies quest to regaining profitability.

CBI and Private labeling efforts: this segment produces about 20% of the company's overall revenue and management has high hopes for further expansion. Its Coffee Bean International arm concentrates on a higher end product. Brands such as: McGarvey, Sierra, Cains, Prebica and Metropolitan are all being showcased as premium coffees. Private labeling is also starting to flourish, highlighted by its Target contract, enabling the retailer to sell coffee under its own "Archer Farms" brand.

Fourth quarter earnings: FARM is scheduled to release its fourth quarter earnings the first week of September, and analysts are expecting a nice improvement. Sales are slated to rise 6.7% from $119 million to $127 million, while earnings are forecasted to be 11 cents versus a 66 cent loss. There is a chance the company could beat this, especially since the cost of green coffee beans have dropped nearly 40% in the last six months, and its overall cost structure has been reduced. The only caveat would be if the company is successful in exiting its remaining pension plan, as that would require a fourth quarter charge that could wipe out all profits.

Ownership and sale prospects: The Farmer family owns 37% of the outstanding shares, while the ESOP own another 14%. It could be argued that the founding family is getting impatient and readying to convert their ownership position to cash. After all, what advantage is there in holding the shares when they no longer provide an income (the cash dividend was suspended nearly three years ago)? You would think that their advanced age might prompt them to consider monetizing their investment at a nice premium, especially since the industry is already consumed in the heat of consolidation, thanks to German Conglomerate Joh.A.Benckiser swallowing up of Peet's Coffee and Tea (NASDAQ:PEET) for nearly $1 billion.

Logical buyers on the short list: (1) Coca Cola (NYSE:KO) or PepsiCo (NYSE:PEP)-they both have been hankering for a coffee company (2) JM Smucker (NYSE:SJM) (Folgers), Kraft (KFT) (Maxwell House) or Green Mountain Coffee Roasters (NASDAQ:GMCR)- all would love to complement their roasting operations (3) Food service mammoths such as Sysco (NYSE:SYY) or US Food Service-to exploit FARM's national DSD footprint (5) private equity- to parlay its vast real estate holdings and take advantage of the benefits of its $60 million tax loss carryover.

The downside: In just the last three months, FARM's shares have climbed nearly 20% on steadily increasing volume. This surge has taken out both its 100 day and 200 day moving average lines and obliterated overhead resistance near the $9.00 area, before a slight pull back to the mid $8's. The question is: Has an improved fourth quarter already been baked into the share price? It is a risk that is always present, but likely won't occur. The reasoning? Since FARM's expectations still remain quite low, they should be relatively easy to surpass and shareholder's handsomely rewarded.

Disclosure: I am long FARM.