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FARMER BROTHERS CO - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of many factors. The results of operations for the fiscal years ended June 30, 2014, 2013 and 2012 are not necessarily indicative of the results that may be expected for any future period. The following discussion should be read in combination with the consolidated financial statements and the notes thereto included in Part II, Item 8 of this report and with the "Risk Factors" described in Part I, Item 1A of this report. Overview We are a manufacturer, wholesaler and distributor of coffee, tea and culinary products. We are a direct distributor of coffee to restaurants, hotels, casinos, offices, QSR's, convenience stores, healthcare facilities and other foodservice providers, as well as private brand retailers in the QSR, grocery, drugstore, restaurant, convenience store and independent coffeehouse channels. We were founded in 1912, were incorporated in California in 1923, and reincorporated in Delaware in 2004. We operate in one business segment. Since 2007, Farmer Bros. has achieved growth primarily through the acquisition in 2007 of CBH, the parent company of CBI, a specialty coffee manufacturer and wholesaler, and the acquisition in 2009 from Sara Lee of certain assets used in connection with the DSD Coffee Business. Corrections to Previously Issued Financial Statements As discussed in Note 1, "Summary of Significant Accounting Policies-Corrections to Previously Issued Financial Statements," and Note 17, "Selected Quarterly Financial Data (Unaudited)," of the Notes to Consolidated Financial Statements contained in Part II, Item 8 of this report, subsequent to the issuance of our consolidated financial statements for the year ended June 30, 2013, we identified certain errors in the consolidated statements of operations and consolidated statements of cash flows. Accordingly, we have corrected the accompanying consolidated statements of operations and consolidated statements of cash flows for the fiscal years ended June 30, 2013 and 2012 and our unaudited quarterly financial data for each of the quarters in the fiscal year ended June 30, 2013 and for the first three quarters in the fiscal year ended June 30, 2014, in order to comply with GAAP. The corrections to the consolidated statements of operations include: 1. reclassification of fuel surcharges billed to customers previously netted against our fuel expenses in "Selling expenses" to "Net sales"; 2. reclassification of certain labor and overhead expenses previously included in "Selling expenses" and "General and administrative expenses" to "Cost of goods sold"; and 3. reclassification of "Net gains from sales of assets" previously presented within "Other, net" to a separate line item within "Income (loss) from operations." The corrections to the consolidated statements of cash flows include: 1. presentation of purchases of and proceeds from sales of trading securities held for investment on a gross basis instead of on a net basis as previously presented within the presentation of cash flows from operating activities; and 2. reclassification of an increase in our derivative liabilities previously presented as a reduction in the net activity in "Short-term investments" to a change in "Accrued payroll expenses and other current liabilities" within the presentation of cash flows from operating activities. These errors had no impact on the amounts previously reported in our consolidated balance sheets. The impact of these corrections to the applicable line items in our consolidated financial statements is set forth in Notes 1 and 17 of the Notes to Consolidated Financial Statements. Critical Accounting Policies and Estimates Management's discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). Our significant accounting policies are discussed in Note 1 to our consolidated financial statements, included herein at Part II, Item 8. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the 18 -------------------------------------------------------------------------------- reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to inventory valuation, including LIFO reserves, the allowance for doubtful accounts, deferred tax assets, liabilities relating to retirement benefits, liabilities resulting from self-insurance, tax liabilities and litigation. We base our estimates, judgments and assumptions on historical experience and other relevant factors that are believed to be reasonable based on information available to us at the time these estimates are made. While we believe that the historical experience and other factors considered provide a meaningful basis for the accounting policies applied in the preparation of the consolidated financial statements, actual results may differ from these estimates, which could require us to make adjustments to these estimates in future periods. We believe that the estimates, judgments and assumptions involved in the accounting policies described below require the most subjective judgment and have the greatest potential impact on our financial statements, so we consider these to be our critical accounting policies. Our senior management has reviewed the development and selection of these critical accounting policies and estimates, and their related disclosure in this report, with the Audit Committee of our Board of Directors. Coffee Brewing Equipment and Service We classify certain expenses related to coffee brewing equipment provided to customers as cost of goods sold. These costs include the cost of the equipment as well as the cost of servicing that equipment (including service employees' salaries, cost of transportation and the cost of supplies and parts) and are considered directly attributable to the generation of revenues from our customers. We capitalize coffee brewing equipment and depreciate it over a three or five year period, depending on the assessment of its useful life and report the depreciation expense in cost of goods sold. Investments Our investments consist of money market instruments, marketable debt, equity and hybrid securities. Investments are held for trading purposes and stated at fair value. The cost of investments sold is determined on the specific identification method. Dividend and interest income are accrued as earned. Exposure to Commodity Price Fluctuations and Derivative Instruments Our primary raw material is green coffee, an agricultural commodity. Green coffee prices are determined by worldwide forces of supply and demand, and, as a result, green coffee prices are volatile. Average coffee "C" market prices per pound for the fiscal years ended June 30, 2014, 2013 and 2012 were $1.75, $1.51 and $2.16, respectively. While the "C" market experienced a significant drop during the first two quarters of the fiscal year ended June 30, 2014, "C" market prices increased sharply in the third quarter of the fiscal year. In the fiscal year ended June 30, 2013 "C" market prices declined approximately 30.1% from the prior fiscal year. In general, increases in the price of green coffee could cause our cost of goods sold to increase and, if not offset by product price increases, could negatively affect our financial condition and results of operations. As a result, our business model strives to reduce the impact of green coffee price fluctuations on our financial results and to protect and stabilize our margins, principally through customer arrangements and derivative instruments. Customers generally pay for our products based either on a price schedule that we announce or on a commodity-based pricing mechanism whereby the changes in green coffee commodity costs are passed through to the customer. The pricing schedule is generally subject to adjustment, either on contractual terms or in accordance with periodic product price adjustments, typically monthly, resulting in, at the least, a 30-day lag in our ability to correlate the changes in our prices with fluctuations in the cost of raw materials and other inputs. Approximately 40% of our roast and ground coffee volume for the fiscal year ended June 30, 2014 was based on a price schedule. Approximately 60% of our roast and ground coffee volume for the fiscal year ended June 30, 2014 was sold to customers under commodity-based pricing arrangements. Consequently, while our revenues can fluctuate significantly as green coffee prices change, we would expect the impact of these price changes on our profitability to be less significant. In addition to our customer arrangements, we utilize derivative instruments to reduce further the impact of changing green coffee commodity prices. We purchase exchange-traded coffee-related derivative instruments to enable us to lock in the price of green coffee commodity purchases, typically three months in advance of the delivery date. These derivative instruments may be entered into at the direction of the customer under commodity-based pricing arrangements to effectively lock in the purchase price of green coffee under such customer arrangements, in certain cases up to 18 to 24 months or longer in the future. Notwithstanding this customer direction, pursuant to Accounting Standards Codification 815, "Derivatives and Hedging" ("ASC 815"), we are considered the owner of these derivative instruments and, therefore, we are required to account 19 -------------------------------------------------------------------------------- for them as such. In the event the customer fails to purchase the products associated with the underlying derivative instruments for which the price has been locked-in on behalf of the customer, we expect that such derivative instruments will be assigned to, and assumed by, the customer in accordance with contractual terms or, in the absence of such terms, in accordance with standard industry custom and practice. In the event the customer fails to assume such derivative instruments, we will remain obligated on the derivative instruments at settlement. We generally settle derivative instruments to coincide with the receipt of the purchased green coffee or apply the derivative instruments to purchase orders effectively fixing the cost of in-bound green coffee purchases. As of June 30, 2014 and 2013, we had 19.8 million pounds and 49.6 million pounds of green coffee covered under coffee-related derivative instruments, respectively. We do not purchase any derivative instruments to hedge cost fluctuations of any commodities other than green coffee. The fair value of derivative instruments is based upon broker quotes. Beginning April 1, 2013, we implemented procedures following the guidelines of ASC 815 to enable us to account for certain coffee-related derivative instruments as accounting hedges in order to reduce the volatility created in our quarterly results from utilizing these derivative contracts and to improve comparability between reporting periods. As a result, beginning in the fourth quarter of fiscal 2013, a portion of the gains and losses from re-valuing the coffee-related derivative contracts to their market prices is being recorded in accumulated other comprehensive income (loss) ("AOCI") on our consolidated balance sheet and subsequently reclassified to cost of goods sold in the period or periods when the hedged transaction affects earnings. At June 30, 2014, approximately 98% of our outstanding coffee-related derivative instruments, representing 19.4 million pounds of forecasted green coffee purchases, were designated as cash flow hedges. At June 30, 2013, approximately 89% of our outstanding coffee-related derivative instruments, representing 44.0 million pounds of forecasted green coffee purchases, were designated as cash flow hedges. The portion of open hedging contracts that are not 100% effective as cash flow hedges and those that are not designated as accounting hedges are marked to period-end market price and unrealized gains or losses based on whether the period-end market price was higher or lower than the price we locked-in are recognized in our results of operations. Our risk management practices reduce but do not eliminate our exposure to changing green coffee prices. While we have limited our exposure to unfavorable green coffee price changes, we have also limited our ability to benefit from favorable price changes. Further, our counterparties may require that we post cash collateral if the fair value of our derivative liabilities exceed the amount of credit granted by each counterparty, thereby reducing our liquidity. At June 30, 2014, as we had a net gain position in our coffee-related derivative margin accounts, none of the cash in these accounts was restricted. At June 30, 2013, we had $8.1 million in restricted cash representing cash held on deposit in margin accounts for coffee-related derivative instruments due to a net loss position in our coffee-related derivative margin accounts. Changes in commodity prices could have a significant impact on cash deposit requirements under our broker and counterparty agreements. Allowance for Doubtful Accounts We maintain an allowance for estimated losses resulting from the inability of our customers to meet their obligations. In fiscal 2014, we reclassified $0.5 million of the allowance for doubtful long-term notes receivable to net with the corresponding notes receivable. Due to improved collection of our outstanding receivables, in fiscal 2013, we decreased the allowance for doubtful accounts by $0.8 million, however, in fiscal 2014 we increased the allowance for doubtful accounts by $0.1 million. Inventories Inventories are valued at the lower of cost or market. We account for coffee, tea and culinary products on the last in, first out ("LIFO") basis, and coffee brewing equipment parts on the first in, first out ("FIFO") basis. We regularly evaluate our inventories to determine whether market conditions are appropriately reflected in the recorded carrying value. At the end of each quarter, we record the expected effect of the liquidation of LIFO inventory quantities, if any, and record the actual impact at fiscal year-end. An actual valuation of inventory under the LIFO method is made only at the end of each fiscal year based on the inventory levels and costs at that time. If inventory quantities decline at the end of the fiscal year compared to the beginning of the fiscal year, the reduction results in the liquidation of LIFO inventory quantities carried at the cost prevailing in prior years. This LIFO inventory liquidation may result in a decrease or increase in cost of goods sold depending on whether the cost prevailing in prior years was lower or higher, respectively, than the current year cost. Inventories increased at the end of fiscal 2014 compared to fiscal 2013 and, therefore, no beneficial effect of liquidation of LIFO inventory quantities was recorded in cost of goods sold in fiscal 2014. We recorded $1.1 million and $14.2 million in beneficial effect of LIFO inventory liquidation in cost of goods sold in the fiscal years ended June 30, 2013 and 2012, respectively, which reduced net loss for the fiscal years ended June 30, 2013 and 2012 by $1.1 million and $14.2 million, respectively. 20 -------------------------------------------------------------------------------- Capacity Utilization We calculate our utilization for all of our manufacturing facilities on an aggregate basis based on the number of product pounds manufactured during the actual number of production shifts worked during an average week, compared to the number of product pounds that could be manufactured based on the maximum number of production shifts that could be operated during the week (assuming three shifts per day, seven days per week), in each case, based on our current product mix. Utilization rates for our manufacturing facilities were approximately 65%, 58% and 43% during the fiscal years ended June 30, 2014, 2013 and 2012, respectively. Since most of our customers do not commit to long-term firm production schedules, we are unable to forecast the level of customer orders with certainty to maximize utilization of manufacturing capacity. As a result, our manufacturing facility capacity utilization generally remains less than 100%. In order to meet increased customer demand, we may be required to move production between facilities or increase staffing, including through temporary labor and overtime. We believe that we currently have sufficient capacity to accommodate our current manufacturing needs. Impairment of Goodwill and Indefinite-lived Intangible Assets We perform our annual impairment test of goodwill and/or other indefinite-lived intangible assets as of June 30. Goodwill and other indefinite-lived intangible assets are not amortized but instead are reviewed for impairment annually, as well as on an interim basis if events or changes in circumstances between annual tests indicate that an asset might be impaired. Testing for impairment of goodwill is a two-step process. The first step requires us to compare the fair value of our reporting units to the carrying value of the net assets of the respective reporting units, including goodwill. If the fair value of a reporting unit is less than its carrying value, goodwill of the reporting unit is potentially impaired and we then complete step two to measure the impairment loss, if any. The second step requires the calculation of the implied fair value of goodwill, which is the residual fair value remaining after deducting the fair value of all tangible and intangible net assets of the reporting unit from the fair value of the reporting unit. If the implied fair value of goodwill is less than the carrying amount of goodwill, an impairment loss is recognized equal to the difference. In the fourth quarter of fiscal 2012, we recorded total impairment charges of $5.6 million related to our CBI acquisition including $5.1 million in impairment losses on goodwill, which was written down to zero. Indefinite-lived intangible assets are tested for impairment by comparing their fair values to their carrying values. In our annual test of impairment in the fourth quarter of fiscal 2014, we determined that the book value of trademarks acquired in connection with the CBI acquisition and DSD Coffee Business acquisition was lower than the present value of the estimated future cash flows and concluded that the trademarks were not impaired. In our annual test of impairment in the fourth quarter of fiscal 2013, we determined that the book value of a certain trademark acquired in connection with the DSD Coffee Business acquisition was higher than the present value of the estimated future cash flows and concluded that the trademark was impaired. As a result, we recorded an impairment charge of $0.1 million to earnings in the fourth quarter of fiscal 2013. Long-Lived Assets, Excluding Goodwill and Indefinite-lived Intangible Assets We review the recoverability of our long-lived assets whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Long-lived assets evaluated for impairment are grouped with other assets to the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. The estimated future cash flows are based upon, among other things, assumptions about expected future operating performance and may differ from actual cash flows. If the sum of the projected undiscounted cash flows (excluding interest) is less than the carrying value of the assets, the assets will be written down to the estimated fair value in the period in which the determination is made. There were no such events or circumstances during the fiscal years ended June 30, 2014 and 2013. Self-Insurance We are self-insured for workers' compensation insurance subject to specific retention levels and use historical analysis to determine and record the estimates of expected future expenses resulting from workers' compensation claims. The estimated outstanding losses are the accrued cost of unpaid claims. The estimated outstanding losses, including allocated loss adjustment expenses ("ALAE"), include case reserves, the development of known claims and incurred but not reported claims. ALAE are the direct expenses for settling specific claims. The amounts reflect per occurrence and annual aggregate limits maintained by the Company. The analysis does not include estimating a provision for unallocated loss adjustment expenses. We account for our accrued liability relating to workers' compensation claims on an undiscounted basis. The estimated gross undiscounted workers' compensation liability relating to such claims was $9.6 million and $9.9 million, respectively, and 21 -------------------------------------------------------------------------------- the estimated recovery from reinsurance was $1.2 million and $1.6 million, respectively, as of June 30, 2014 and 2013. The short-term and long-term accrued liabilities for workers' compensation claims are presented on our consolidated balance sheets in "Other current liabilities" and in "Accrued workers' compensation liabilities," respectively. The estimated insurance receivable is included in "Other assets" on our consolidated balance sheets. In May 2011, we did not meet the minimum credit rating criteria for participation in the alternative security program for California self-insurers for workers' compensation liability. As a result, we were required to post a $5.9 million letter of credit as a security deposit with the State of California Department of Industrial Relations Self-Insurance Plans. At June 30, 2014, this letter of credit continues to serve as a security deposit and has been increased to $6.5 million. Management believes that the amount recorded at June 30, 2014 is adequate to cover all known workers' compensation claims at June 30, 2014. If the actual costs of such claims and related expenses exceed the amount estimated, additional reserves may be required which could have a material negative effect on operating results. If our estimate were off by as much as 15%, the reserve could be under or overstated by approximately $1.3 million as of June 30, 2014. The estimated liability related to our self-insured group medical insurance at June 30, 2014 and 2013 was $0.8 million and $1.1 million, respectively, recorded on an incurred but not reported basis, within deductible limits, based on actual claims and the average lag time between the date insurance claims are filed and the date those claims are paid. General liability, product liability and commercial auto liability are insured through a captive insurance program. We retain the risk within certain aggregate amounts. Cost of the insurance through the captive program is accrued based on estimates of the aggregate liability claims incurred using certain actuarial assumptions and historical claims experience. Our liability reserve for such claims was $0.4 million and $0.5 million at June 30, 2014 and 2013. The estimated liability related to our self-insured group medical insurance, general liability, product liability and commercial auto liability is included on our consolidated balance sheets in "Other current liabilities." Retirement Plans We provide pension plans for most full-time employees. Generally the plans provide benefits based on years of service and/or a combination of years of service and earnings. We are required to recognize the funded status of a benefit plan in our consolidated balance sheet. We are also required to recognize in other comprehensive income (loss) ("OCI") certain gains and losses that arise during the period but are deferred under pension accounting rules. We have a defined benefit pension plan, the Farmer Bros. Co. Pension Plan for Salaried Employees (the "Farmer Bros. Plan"), for the majority of our employees who are not covered under a collective bargaining agreement, and two defined benefit pension plans for certain hourly employees covered under collective bargaining agreements (the "Brewmatic Plan" and the "Hourly Employees' Plan"). In addition, we contribute to two multiemployer defined benefit pension plans, one multi-employer defined contribution pension plan, and eight multiemployer defined contribution plans other than pension plans that provide medical, vision, dental and disability benefits for active, union-represented employees subject to collective bargaining agreements. In the fourth quarter of fiscal 2013, we determined that we would shut down our equipment refurbishment operations in Los Angeles, California and move them to our Oklahoma City distribution center effective August 30, 2013. Due to this shut down, all hourly employees responsible for these operations in Los Angeles were terminated and their pension benefits in the Brewmatic Plan were frozen effective August 30, 2013. As a result, we recorded a pension curtailment expense of $34,000 in the fourth quarter of fiscal 2013. We amended the Farmer Bros. Plan, freezing the benefit for all participants effective June 30, 2011. After the plan freeze, participants do not accrue any benefits under the the Farmer Bros. Plan, and new hires are not eligible to participate in the Farmer Bros. Plan. As all plan participants became inactive following this curtailment, net (gain) loss is now amortized based on the remaining life expectancy of these participants instead of the remaining service period of these participants. We obtain actuarial valuations for our single employer defined benefit pension plans. In fiscal 2014 we discounted the pension obligations using a 4.15% discount rate and estimated an 8.0% long-term return on plan assets. The performance of the 22 -------------------------------------------------------------------------------- stock market and other investments as well as the overall health of the economy can have a material effect on pension investment returns and these assumptions. A change in these assumptions could affect our operating results. At June 30, 2014, the projected benefit obligation under our single employer defined benefit pension plans was $139.7 million and the fair value of plan assets was $103.5 million. The difference between the projected benefit obligation and the fair value of plan assets is recognized as a decrease in OCI and an increase in pension liability and deferred tax assets. The difference between plan obligations and assets, or the funded status of the plans, significantly affects the net periodic benefit cost and ongoing funding requirements of those plans. Among other factors, changes in interest rates, mortality rates, early retirement rates, investment returns and the market value of plan assets can affect the level of plan funding, cause volatility in the net periodic benefit cost, increase our future funding requirements and require premium payments to the Pension Benefit Guaranty Corporation. For the fiscal year ended June 30, 2014, we made $1.3 million in contributions to our single employer defined benefit pension plans and recorded $2.3 million in reduction in pension expense. We expect to make approximately $2.6 million in contributions to our single employer defined benefit pension plans in fiscal 2015 and accrue a credit to pension expense of approximately $34,000 per year beginning in fiscal 2015. These pension contributions are expected to continue at this level for several years; however a deterioration in the current economic environment would increase the risk that we may be required to make larger contributions in the future. The following chart quantifies the effect on the projected benefit obligation and the net periodic benefit cost of a change in the discount rate assumption and the impact on the net periodic benefit cost of a change in the assumed rate of return on plan assets under our single employer defined benefit pension plans for fiscal 2015: ($ in thousands) Farmer Bros. Plan Discount Rate 3.7% Actual 4.15% 4.7% Net periodic benefit credit $ (382 ) $ (392 ) $ (418 ) Projected benefit obligation $ 142,235 $ 133,135 $ 124,943 Farmer Bros. Plan Rate of Return 7.0% Actual 7.50% 8.0% Net periodic benefit cost (credit) $ 90 $ (392 ) $ (873 ) Brewmatic Plan Discount Rate 3.7% Actual 4.15% 4.7% Net periodic benefit credit $ (19 ) $ (17 ) $ (16 ) Projected benefit obligation $ 4,220 $ 3,991 $ 3,786 Brewmatic Plan Rate of Return 7.0% Actual 7.50% 8.0% Net periodic benefit credit $ (1 ) $ (17 ) $ (34 ) Hourly Employees' Plan Discount Rate 3.7% Actual 4.15% 4.7% Net periodic benefit cost $ 407 $ 375 $ 348 Projected benefit obligation $ 2,844 $ 2,619 $ 220 Hourly Employees' Plan Rate of Return 7.0% Actual 7.50% 8.0% Net periodic benefit cost $ 384 $ 375 $ 366 Postretirement Benefits We sponsor a postretirement defined benefit plan that covers qualified non-union retirees and certain qualified union retirees. The plan provides medical, dental and vision coverage for retirees under age 65 and medical coverage only for retirees age 65 and above. Under this postretirement plan, our contributions toward premiums for retiree medical, dental and vision coverage for participants and dependents are scaled based on length of service, with greater Company contributions for retirees with greater length of service, subject to a maximum monthly Company contribution. Our retiree medical, dental and vision plan is unfunded, and its liability was calculated using an assumed discount rate of 4.3% at June 30, 2014. We project an initial medical trend rate of 8.0% in fiscal 2014, ultimately reducing to 4.5% in 10 years. We also provide a postretirement death benefit to certain of our employees and retirees, subject, in the case of current employees, to continued employment with the Company until retirement, and certain other conditions related to the manner of 23 -------------------------------------------------------------------------------- employment termination and manner of death. We record the actuarially determined liability for the present value of the postretirement death benefit. We have purchased life insurance policies to fund the postretirement death benefit wherein we own the policy but the postretirement death benefit is paid to the employee's or retiree's beneficiary. We record an asset for the fair value of the life insurance policies which equates to the cash surrender value of the policies. Share-based Compensation We measure all share-based compensation cost at the grant date, based on the fair value of the award, and recognize that cost as an expense in our consolidated statements of operations over the requisite service period. The process of estimating the fair value of share-based compensation awards and recognizing share-based compensation cost over the requisite service period involves significant assumptions and judgments. We estimate the fair value of stock option awards on the date of grant using the Black-Scholes valuation model which requires that we make certain assumptions regarding: (i) the expected volatility in the market price of our common stock; (ii) dividend yield; (iii) risk-free interest rates; and (iv) the period of time employees are expected to hold the award prior to exercise (referred to as the expected holding period). In addition, we estimate the expected impact of forfeited awards and recognize share-based compensation cost only for those awards ultimately expected to vest. If actual forfeiture rates differ materially from our estimates, share-based compensation expense could differ significantly from the amounts we have recorded in the current period. We will periodically review actual forfeiture experience and revise our estimates, as necessary. We will recognize as compensation cost the cumulative effect of the change in estimated forfeiture rates on current and prior periods in earnings of the period of revision. As a result, if we revise our assumptions and estimates, our share-based compensation expense could change materially in the future. In fiscal 2014 and 2013, we used an estimated 6.5% annual forfeiture rate to calculate share-based compensation expense based on actual forfeiture experience. We have outstanding share-based awards that have performance-based vesting conditions in addition to time-based vesting. Awards with performance-based vesting conditions require the achievement of certain financial and other performance criteria as a condition to the vesting. We recognize the estimated fair value of performance-based awards, net of estimated forfeitures, as share-based compensation expense over the performance period based upon our determination of whether it is probable that the performance targets will be achieved. At each reporting period, we reassess the probability of achieving the performance criteria and the performance period required to meet those targets. Determining whether the performance criteria will be achieved involves judgment, and the estimate of share-based compensation expense may be revised periodically based on changes in the probability of achieving the performance criteria. Revisions are reflected in the period in which the estimate is changed. If performance goals are not met, no share-based compensation expense is recognized, and, to the extent share-based compensation expense was previously recognized, such share-based compensation expense is reversed. Income Taxes Deferred income taxes are determined based on the temporary differences between the financial reporting and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Estimating our tax liabilities involves judgments related to uncertainties in the application of complex tax regulations. We make certain estimates and judgments to determine tax expense for financial statement purposes as we evaluate the effect of tax credits, tax benefits and deductions, some of which result from differences in the timing of recognition of revenue or expense for tax and financial statement purposes. Changes to these estimates may result in significant changes to our tax provision in future periods. Each fiscal quarter we re-evaluate our tax provision and reconsider our estimates and assumptions related to specific tax assets and liabilities, making adjustments as circumstances change. Deferred Tax Asset Valuation Allowance We assess whether a valuation allowance should be recorded against deferred tax assets based on the likelihood that the benefits of the deferred tax assets will or will not ultimately be realized in future periods. In making such assessment, significant weight is to be given to evidence that can be objectively verified, such as recent operating results, and less consideration is to be given to less objective indicators, such as future earnings projections. After consideration of positive and negative evidence, including the recent history of losses, we cannot conclude that it is more likely than not that we will generate future earnings sufficient to realize our deferred tax assets as of June 30, 2014. Accordingly, a valuation allowance of $72.6 million has been recorded to offset this deferred tax asset. The valuation allowance decreased by $9.9 million in the fiscal year ended June 30, 2014 and increased by $3.1 million and $20.7 million in the fiscal years ended June 30, 2013 and 2012, respectively. Deferred tax assets were $74.6 million as of June 30, 2014 compared to $84.7 million as of June 30, 2013. In fiscal 2014, deferred tax assets decreased primarily due to the utilization of net operating 24 -------------------------------------------------------------------------------- losses to offset taxable income. Additionally, a cumulative loss in OCI related to coffee hedging, which previously represented a deferred tax asset, became a cumulative gain as of the end of the year which lowered the total net deferred tax assets. In fiscal 2013, deferred tax assets increased primarily due to net loss carryovers and a decrease in expected pension asset values related to a change in actuarial assumptions. Liquidity and Capital Resources Credit Facility On September 12, 2011, we entered into an Amended and Restated Loan and Security Agreement (the "Loan Agreement") among the Company and CBI, as Borrowers, certain of the Company's other subsidiaries, as Guarantors, the Lenders party thereto, and Wells Fargo Bank, National Association ("Wells Fargo"), as Agent. On January 9, 2012, the Loan Agreement was amended in connection with JPMorgan Chase Bank, N.A. ("JPMorgan Chase"), becoming an additional Lender thereunder. On March 18, 2013, the Loan Agreement was amended further ("Amendment No. 2") to amend the definition of "Maximum Credit" available thereunder to $75.0 million from $85.0 million. Pursuant to Amendment No. 2, Wells Fargo agreed to provide a commitment of $53.0 million and JPMorgan Chase agreed to provide a commitment of $22.0 million. On February 28, 2014, we entered into Amendment No. 3 to the Loan Agreement which, among other things, amended the definition of "Applicable Margin" set forth in the Loan Agreement to provide for interest rates based on modified Monthly Average Excess Availability levels with a range of PRIME + 0% to PRIME + 0.50% or Adjusted Eurodollar Rate + 1.75% to Adjusted Eurodollar Rate + 2.25%. The Loan Agreement provides for a senior secured revolving credit facility of up to $75.0 million, with a letter of credit sublimit of $20.0 million. The revolving credit facility provides for advances of 85% of eligible accounts receivable and 75% of eligible inventory (subject to a $60.0 million inventory loan limit), as defined. The Loan Agreement has an amendment fee of 0.375% and an unused line fee of 0.25%. Outstanding obligations under the Loan Agreement are collateralized by all of the Borrowers' assets, including the Company's preferred stock portfolio. The term of the Loan Agreement expires on March 2, 2015. We cannot provide assurances that we will be able to refinance any of our indebtedness under the credit facility on commercially reasonable terms or at all. The Loan Agreement contains a variety of affirmative and negative covenants of types customary in an asset-based lending facility, including those relating to reporting requirements, maintenance of records, properties and corporate existence, compliance with laws, incurrence of other indebtedness and liens, limitations on certain payments, including the payment of dividends and capital expenditures, and transactions and extraordinary corporate events. The Loan Agreement allows us to pay dividends, provided, among other things, certain liquidity requirements are met, the aggregate amount of all such payments in any fiscal year is not in excess of $7.0 million ($1.75 million in any fiscal quarter), and no event of default exists or has occurred and is continuing as of the date of any such payment and after giving effect thereto. The Loan Agreement also contains financial covenants requiring the Borrowers to maintain minimum Excess Availability and Total Liquidity levels. The Loan Agreement allows the Lenders to establish reserve requirements, which may reduce the amount of credit otherwise available to us, to reflect events, conditions, or risks that would have a reasonable likelihood of adversely affecting the Lender's collateral or our assets, including our green coffee inventory. The Loan Agreement provides that an event of default includes, among other things, subject to certain grace periods: (i) payment defaults; (ii) failure by any guarantor to perform any guarantee in favor of Lender; (iii) failure to abide by loan covenants; (iv) default with respect to other material indebtedness; (v) final judgment in a material amount not discharged or stayed; (vi) any change of control; (vii) bankruptcy or insolvency; and (viii) the failure of the Farmer Bros. Co. Employee Stock Ownership Benefit Trust, created by the Company to implement the Farmer Bros. Co. Employee Stock Ownership Plan ("ESOP"), to be duly qualified under Section 401(a) of the Internal Revenue Code of 1986, as amended, or exempt from federal income taxation, or if the ESOP engages in a material non-exempt prohibited transaction. Effective December 1, 2012, we entered into an interest rate swap transaction utilizing a notional amount of $10.0 million and a maturity date of March 1, 2015. We entered into the swap transaction to effectively fix the future interest rate during the applicable period on a portion of our borrowings under the revolving credit facility. The swap transaction was intended to manage our interest rate risk related to our borrowings under the revolving credit facility and required us to pay a fixed rate of 0.48% per annum in exchange for a variable interest rate based on 1-month USD LIBOR-BBA. We terminated the swap 25 -------------------------------------------------------------------------------- transaction on March 5, 2014. As of June 30, 2014, we had no interest rate swap transactions in place. As of June 30, 2013, the fair value of the interest rate swap included in "Other current liabilities" was $25,000. We did not designate our interest rate swap as an accounting hedge. In fiscal 2014 and 2013, we recorded in "Other, net" in our consolidated statement of operations a loss of $5,000 and $25,000, respectively, for the change in fair value of our interest rate swap. No such gains or losses were recorded in fiscal 2012. On June 30, 2014, we were eligible to borrow up to a total of $69.9 million under the credit facility. As of June 30, 2014, we had outstanding borrowings of $0.1 million, utilized $10.1 million of the letters of credit sublimit, and had excess availability under the credit facility of $59.7 million. The weighted average interest rate on our outstanding borrowings under the credit facility was 1.76% at June 30, 2014. As of June 30, 2014, we were in compliance with all of the restrictive covenants under the Loan Agreement. As of August 31, 2014, we had estimated outstanding borrowings of $2.8 million, utilized $11.2 million of the letters of credit sublimit, and had excess availability under the credit facility of $58.6 million. As of August 31, 2014, the weighted average interest rate on our outstanding borrowings under the credit facility was 2.1%. Liquidity We generally finance our operations through cash flows from operations and borrowings under our revolving credit facility described above. As of June 30, 2014, we had $12.0 million in cash and cash equivalents and $22.6 million in short-term investments. At June 30, 2014, as we had a net gain position in our coffee-related derivative margin accounts, none of the cash in these accounts was restricted. We believe our revolving credit facility, to the extent available, in addition to our cash flows from operations and other liquid assets, are sufficient to fund our working capital and capital expenditure requirements for the next 12 months on the basis of current operations; provided, we are able to extend or replace this credit facility which expires in March 2015. We may be unable to extend or replace this credit facility on terms acceptable to us, or at all. We generate cash from operating activities primarily from cash collections related to the sale of our products. Net cash provided by operating activities was $52.9 million in fiscal 2014 compared to $21.9 million in fiscal 2013 and $18.1 million in fiscal 2012. The increase in net cash provided by operating activities in fiscal 2014 compared to the prior fiscal year was due to a higher level of cash inflows from operating activities. In fiscal 2014, we had $12.1 million in net income as compared to $(8.5) million in net loss in fiscal 2013. At June 30, 2014, as we had a net gain position in our coffee-related derivative margin accounts, the restriction on $8.1 million was released, contributing to the improvement in cash inflows in fiscal 2014 compared to fiscal 2013, which included a $6.5 million increase in restricted cash due to a net loss position in our coffee-related derivative margin accounts at June 30, 2013. Net cash used in investing activities increased to $20.7 million in fiscal 2014, compared to $10.2 million in fiscal 2013 and $14.5 million in fiscal 2012, primarily due to increased capital expenditures. In fiscal 2014, cash inflows from sales of fixed assets, primarily real estate, were $4.5 million and cash outflows for capital expenditures were $25.3 million. In fiscal 2013, cash inflows from sales of fixed assets, primarily real estate, were $5.7 million and cash outflows for capital expenditures were $15.9 million. In fiscal 2012, cash inflows from sales of fixed assets, primarily real estate, were $3.0 million and cash outflows for capital expenditures were $17.5 million. Net cash used in financing activities was $22.8 million in fiscal 2014 compared to $12.9 million in fiscal 2013 and $5.8 million in fiscal 2012. Net cash used in financing activities in fiscal 2014 included net repayments on our credit facility of $20.6 million partially offset by $1.5 million in proceeds from stock option exercises, compared to net repayments of $10.8 million, partially offset by $1.2 million in proceeds from stock option exercises in fiscal 2013. Net repayments on our credit facility in fiscal 2012 were $4.0 million. In fiscal 2014, we capitalized $25.3 million in property, plant and equipment purchases which included $13.6 million in expenditures to replace normal wear and tear of coffee brewing equipment, $0.7 million in building and facility improvements, $9.3 million in expenditures for vehicles, and machinery and equipment, and $1.7 million in information technology related expenditures. The increase in cash outflows for property, plant and equipment compared to the prior fiscal year was primarily due to increases in the purchase of coffee brewing equipment and replacement vehicles. Our expected capital expenditures for fiscal 2015 include expenditures to replace normal wear and tear of coffee brewing equipment, vehicles, and machinery and equipment, and are expected to be below fiscal 2014 levels on the basis of our current operations. 26 --------------------------------------------------------------------------------Our working capital is composed of the following: June 30, (In thousands) 2014 2013 Current assets(1) $ 157,460 $ 139,749 Current liabilities(2) 76,870 76,550 Working capital $ 80,590 $ 63,199 __________ (1) Includes $5.2 million in coffee-related short-term derivative assets at June 30, 2014 and $8.1 million in restricted cash at June 30, 2013. (2) Includes $9.9 million in coffee-related short-term derivative liabilities at June 30, 2013. Liquidity Information: June 30, (In thousands) 2014 2013 2012Capital expenditures $ 25,267 $ 15,894 $ 17,498 Results of Operations Fiscal Years Ended June 30, 2014 and 2013 Overview In fiscal 2014, green coffee commodity prices continued to fall during the first two quarters and rose sharply in the third quarter and fuel costs remained high. Our average cost of green coffee purchased fell from $1.70 per pound in fiscal 2013 to $1.46 per pound in fiscal 2014. In fiscal 2014, we continued our hedging strategy intended to reduce the impact of changing green coffee commodity prices through the purchase of exchange-traded coffee-related derivative instruments for our own account and at the direction of customers under commodity-based pricing arrangements. To address the ongoing high fuel costs, in fiscal 2014, we continued to bill our customers fuel surcharges. We continued our efforts to improve efficiencies by consolidating our coffee blends while maintaining original roasting profiles, resulting in a reduction in the number of coffee blends by 22. We also continued to optimize and simplify our product portfolio by discontinuing over 400 SKU's. We completed the integration of the enterprise resource planning system in all of our facilities under one common software platform. We continued to improve our real-estate asset management by divesting underutilized properties. We also made measurable progress in our facilities and in our outreach programs under our sustainability initiatives in fiscal 2014. Operations Net sales in fiscal 2014 increased $14.5 million, or 2.8%, to $528.4 million from $513.9 million in fiscal 2013. The change in net sales in fiscal 2014 compared to fiscal 2013 was due to the following: Year Ended June 30, (In millions) 2014 vs. 2013 Effect of change in unit sales $ 34.6 Effect of pricing and product mix changes (20.1 ) Total increase in net sales $ 14.5 Unit sales increased 8% in fiscal 2014 as compared to fiscal 2013, partially offset by a 5% decrease in average unit price resulting in an increase in net sales of 3%. The increase in unit sales was primarily due to a 12% increase in unit sales of roast and ground coffee products, which accounted for approximately 60% of our total net sales, while the decrease in average unit price was primarily due to the lower average unit price of roast and ground coffee products primarily driven by the pass-through of lower green coffee commodity purchase costs to our customers. In fiscal 2014, we processed and sold approximately 87 million pounds of green coffee as compared to approximately 76 million pounds of green coffee processed and sold in fiscal 2013. There were no new product category introductions in fiscal 2014 or 2013 which had a material impact on our net sales. 27 --------------------------------------------------------------------------------The following table presents net sales aggregated by product category for the respective periods indicated: Year Ended June 30, 2014 2013 (In thousands) $ % of total $ % of total Net Sales by Product Category: Coffee (Roast & Ground) $ 319,251 60 % $ 305,623 59 % Coffee (Frozen) 37,840 7 % 36,311 (1) 7 % Tea (Iced & Hot) 28,452 5 % 27,919 (1) 6 % Culinary 56,567 11 % 61,447 12 % Spice 31,876 6 % 32,431 6 % Other beverages(2) 50,572 10 % 46,233 (1) 9 % Net sales by product category 524,558 99 % 509,964 99 % Fuel surcharge 3,822 1 % 3,905 1 % Net sales $ 528,380 100 % $ 513,869 100 % ____________(1) Recategorized consistent with fiscal 2014 presentation. (2) Includes all beverages other than coffee and tea. Cost of goods sold in fiscal 2014 increased $3.8 million, or 1.1%, to $332.5 million, or 62.9% of net sales, from $328.7 million, or 64.0% of net sales in fiscal 2013. The decrease in cost of goods sold as a percentage of net sales in fiscal 2014 was primarily due to a 14.2% decrease in the average cost of green coffee purchased. Inventories increased at the end of fiscal 2014 compared to fiscal 2013 and, therefore, no beneficial effect of liquidation of LIFO inventory quantities was recorded in cost of goods sold in fiscal 2014. The beneficial effect of liquidation of LIFO inventory quantities reduced cost of goods sold by $1.1 million in the prior fiscal year. Gross profit in fiscal 2014 increased $10.7 million, or 5.8%, to $195.9 million from $185.2 million in fiscal 2013. Gross margin increased to 37.1% in fiscal 2014 from 36.0% in the prior fiscal year. The increase in gross profit was primarily due to the increase in net sales from higher unit sales of roast and ground coffee, frozen coffee, tea products and other beverages. The increase in gross margin was primarily due to a 14.2% decrease in the average cost of green coffee purchased as compared to the prior fiscal year. Gross profit in fiscal 2013 included the expected beneficial effect of the liquidation of LIFO inventory quantities in the amount of $1.1 million. In fiscal 2014, operating expenses increased $2.2 million, or 1.2%, to $187.0 million, or 35.4% of net sales, from $184.8 million, or 36.0% of net sales, in fiscal 2013. The increase in operating expenses in fiscal 2014 was primarily due to a $3.6 million increase in general and administrative expenses and lower net gains from sales of assets compared to fiscal 2013, partially offset by a $1.9 million decrease in selling expenses and by the absence of impairment losses on intangible assets. The increase in general and administrative expenses in fiscal 2014 was primarily due to an increase in accruals for anticipated bonus payments for eligible employees, higher ESOP compensation expense and expenses in connection with the restatement of certain prior period financial statements included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2013, partially offset by lower retiree medical expenses and depreciation and amortization expenses. The decrease in selling expenses was primarily due to lower retiree medical expenses and depreciation and amortization expenses, partially offset by higher payroll-related expenses from increased headcount, an increase in freight costs, additional accruals for self-insurance claims and accruals for anticipated bonus payments for eligible employees. Income from operations in fiscal 2014 was $8.9 million compared to $0.4 million in fiscal 2013, primarily due to the improvement in gross profit. Total other income (expense) Total other income in fiscal 2014 was $3.9 million compared to total other expense of $(9.7) million in fiscal 2013, primarily due to net gains on derivative instruments and investments of $3.1 million compared to net losses on derivative instruments and investments of $(11.1) million in fiscal 2013. The net gains on derivative instruments and investments in fiscal 2014 were primarily due to net gains on coffee-related derivative instruments not designated as accounting hedges. Net gains on such coffee-related derivative instruments in fiscal 2014 were $2.7 million compared to net losses on such coffee-related 28 -------------------------------------------------------------------------------- derivative instruments of $(11.3) million in fiscal 2013. The increase in net gains on such coffee-related derivative instruments in fiscal 2014 compared to fiscal 2013 was due to the increase in coffee commodity prices in the second half of fiscal 2014. For the fiscal years ended June 30, 2014 and 2013, we recognized $(0.3) million and $(0.4) million, respectively, in losses on coffee-related derivative instruments designated as cash flow hedges due to ineffectiveness. Income taxes In fiscal 2014, we recorded income tax expense of $0.7 million compared to income tax benefit of $(0.8) million in fiscal 2013. Income tax expense in fiscal 2014 was primarily attributable to cash taxes paid. The Company has generated approximately $0.2 million of excess tax benefits related to stock compensation, the benefit of which will be recorded to additional paid in capital if and when realized. The Company made a determination in the quarter ended June 30, 2014 that it would not, at this time, pursue certain refund claims requested on its amended tax returns for the fiscal years ended June 30, 2003 through June 30, 2008. The Internal Revenue Service previously denied these refund claims upon audit and maintained that decision upon appeal. The Company released its tax reserve related to these refunds in the fourth quarter of fiscal 2014. Income tax benefit for fiscal 2013 was primarily attributable to the gain on postretirement benefits. Income tax expense or benefit from continuing operations is generally determined without regard to other categories of earnings, such as discontinued operations and OCI. An exception is provided in ASC 740, "Tax Provisions" ("ASC 740"), when there is aggregate income from categories other than continuing operations and a loss from continuing operations in the current year. In this case, the income tax benefit allocated to continuing operations is the amount by which the loss from continuing operations reduces the income tax expense recorded with respect to the other categories of earnings, even when a valuation allowance has been established against the deferred tax assets. In instances where a valuation allowance is established against current year losses, income from other sources, including gain from postretirement benefits recorded as a component of OCI, is considered when determining whether sufficient future taxable income exists to realize the deferred tax assets. As a result, for the fiscal year ended June 30, 2013, we recorded income tax expense of $1.1 million in OCI related to the gain on postretirement benefits, and recorded a corresponding income tax benefit of $1.1 million in continuing operations. Net Income As a result of the foregoing factors, net income was $12.1 million, or $0.76 per diluted common share, in fiscal 2014 compared to net loss of $(8.5) million, or $(0.54) per common share, in fiscal 2013. Fiscal Years Ended June 30, 2013 and 2012 Overview In fiscal 2013, green coffee commodity prices continued to fall but fuel costs remained high. Green coffee "C" market prices fell from $1.70 per pound at the end of fiscal 2012 to $1.20 per pound at the end of fiscal 2013. In fiscal 2013 we continued our hedging strategy intended to reduce the impact of changing green coffee commodity prices through the purchase of exchange-traded coffee-related derivative instruments for our own account and at the direction of customers under commodity-based pricing arrangements for longer periods of time than was done previously, because the cost of coffee significantly declined in fiscal 2013 and in the second half of fiscal 2012, making these long-term futures contracts relatively less expensive than they had been previously. Beginning April 1, 2013, we implemented procedures following the guidelines of ASC 815 to enable us to account for certain coffee-related derivative instruments as accounting hedges in order to reduce the volatility created in our quarterly results from utilizing these derivative contracts and to improve comparability between reporting periods. As a result, beginning in the fourth quarter of fiscal 2013, a portion of the gains and losses from re-valuing the coffee-related derivative contracts to their market prices is being recorded in AOCI on our consolidated balance sheets and reclassified to cost of goods sold when the hedged transaction affects earnings. To address the increase in freight and fuel expense, the fuel surcharge instituted in fiscal 2011 and 2012 continued in fiscal 2013. In fiscal 2013, we invested in additional sales and marketing training and product re-branding. We also launched the Artisan Collection by Farmer Brothers™, our premium line of coffees, and the new Farmer Brothers teas. During fiscal 2013, we completed the integration of certain key functions including marketing, green coffee management, national sales and human resources at our Portland and Torrance facilities. We also continued to improve our real-estate asset management by divesting underutilized properties. 29 --------------------------------------------------------------------------------Operations Net sales in fiscal 2013 increased $15.2 million, or 3.0%, to $513.9 million from $498.7 million in fiscal 2012. The change in net sales in fiscal 2013 compared to fiscal 2012 was due to the following: Year Ended June 30, (In millions) 2013 vs. 2012 Effect of change in unit sales $ 57.9 Effect of pricing and product mix changes (42.7 ) Total increase in net sales $ 15.2 Unit sales increased 14% in fiscal 2013 as compared to fiscal 2012, partially offset by a 9% decrease in average unit price resulting in an increase in net sales of 3%. The increase in unit sales was primarily due to a 12% increase in unit sales of roast and ground coffee products, which accounted for approximately 59% of our total net sales, while the decrease in average unit price was primarily due to the lower average unit price of roast and ground coffee products driven by the pass-through of lower green coffee commodity purchase costs to our customers. In fiscal 2013, we processed and sold approximately 76 million pounds of green coffee as compared to approximately 60 million pounds of green coffee processed and sold in fiscal 2012. There were no new product category introductions in fiscal 2013 or 2012 which had a material impact on our net sales. The following table presents net sales aggregated by product category for the respective periods indicated: Year Ended June 30, 2013 2012 (In thousands) $ % of total $ % of total Net Sales by Product Category: Coffee (Roast & Ground) $ 305,623 59 % $ 290,526 58 % Coffee (Frozen) 36,311 (1) 7 % 36,171 (1) 7 % Tea (Iced & Hot) 27,919 (1) 6 % 28,799 (1) 6 % Culinary 61,447 12 % 63,230 13 % Spice 32,431 6 % 34,826 7 % Other beverages(2) 46,233 (1) 9 % 41,890 (1) 8 % Net sales by product category 509,964 99 % 495,442 99 % Fuel surcharge 3,905 1 % 3,259 1 % Net sales $ 513,869 100 % $ 498,701 100 % ____________(1) Re-categorized consistent with fiscal 2014 presentation. (2) Includes all beverages other than coffee and tea. Cost of goods sold in fiscal 2013 decreased $3.6 million, or 1.1%, to $328.7 million, or 64.0% of net sales, from $332.3 million, or 66.6% of net sales, in fiscal 2012. The decrease in cost of goods sold as a percentage of net sales in fiscal 2013 was primarily due to a 31% decrease in the average cost of green coffee purchased and a reduction in inventory, which resulted in the liquidation of LIFO inventory quantities carried at lower costs prevailing in prior years. The beneficial effect of this liquidation of LIFO inventory quantities reduced cost of goods sold by $1.1 million compared to $14.2 million in the prior fiscal year. Gross profit in fiscal 2013 increased $18.8 million, or 11.3%, to $185.2 million from $166.4 million in fiscal 2012. Gross margin increased to 36.0% in fiscal 2013 from 33.4% in the prior fiscal year. The increases in gross profit and gross margin were primarily due to the increase in net sales and a 31% decrease in the average cost of green coffee purchased in fiscal 2013. In fiscal 2013, operating expenses decreased $3.4 million, or 1.8%, to $184.8 million, or 36.0% of net sales, from $188.2 million, or 37.7% of net sales, in fiscal 2012. The decrease in operating expenses in fiscal 2013 was primarily due to a $10.1 million decrease in losses from impairment of goodwill and intangible assets, and pension withdrawal expense and $4.2 million in higher net gains on sales of assets, primarily real estate, compared to fiscal 2012, partially offset by a $10.8 million 30 -------------------------------------------------------------------------------- increase in expenses primarily from our investments in additional sales and marketing training, expenses related to the launch of the Artisan Collection by Farmer Brothers™ and the new Farmer Brothers teas, higher startup costs associated with the increase in national account customers, higher expenses related to severance and storm-related losses in our Moonachie, Oklahoma City and Houston distribution centers. In our annual test of impairment in the fourth quarter of fiscal 2013, we determined that the book value of a certain trademark acquired in connection with the DSD Coffee Business acquisition was higher than the present value of the estimated future cash flows and concluded that the trademark was impaired. As a result, we recorded an impairment charge of $0.1 million to earnings in the fourth quarter of fiscal 2013. In the fourth quarter of fiscal 2013, we determined that we would shut down our equipment refurbishment operations in Los Angeles, California and move them to our Oklahoma City distribution center effective August 30, 2013. Due to this shut down, all hourly employees responsible for these operations in Los Angeles were terminated and their pension benefits in the Brewmatic Plan were frozen effective August 30, 2013. As a result, we recorded a pension curtailment expense of $34,000 in the fourth quarter of fiscal 2013. Income from operations in fiscal 2013 was $0.4 million compared to loss from operations of $(21.8) million in fiscal 2012, primarily due to the improvement in gross profit. Total other income (expense) Total other expense in fiscal 2013 was $(9.7) million compared to $(5.1) million in fiscal 2012, primarily due to higher net losses on derivative instruments and investments of $(11.1) million in fiscal 2013 compared to $(6.2) million in fiscal 2012. Net losses on derivative instruments and investments were primarily due to net losses on coffee-related derivative instruments not designated as accounting hedges. Net losses on coffee-related derivative instruments in fiscal 2013 were $(11.3) million compared to $(7.3) million in fiscal 2012. The increase in net losses on coffee-related derivative instruments in fiscal 2013 compared to fiscal 2012 was due in large part to the increase in the number of futures contracts combined with a continued decline in green coffee commodity costs in fiscal 2013. There was a significant increase in the number of our coffee-related derivative instruments as of June 30, 2013 covering 49.6 million pounds of green coffee compared to 18.2 million pounds of green coffee covered as of June 30, 2012. The increase in the number of such contracts was primarily due to the increase in the number of our national account customers because a majority of the contracts are purchased for their accounts. Additionally, during the first three quarters of fiscal 2013, when none of our coffee-related derivative instruments was designated as an accounting hedge, we recognized in our consolidated statements of operations, the net unrealized and realized losses from the continuing decline in green coffee commodity prices below our locked-in prices as the derivative contracts were re-valued to their market prices. For the fiscal year ended June 30, 2013, we recognized $(0.4) million in losses on coffee-related derivative instruments designated as cash flow hedges due to ineffectiveness. Income taxes In fiscal 2013, we recorded an income tax benefit of $0.8 million compared to $0.3 million in fiscal 2012. Income tax benefit in fiscal 2013 was primarily attributable to the gain on postretirement benefits. Income tax expense or benefit from continuing operations is generally determined without regard to other categories of earnings, such as discontinued operations and OCI. An exception is provided in ASC 740, "Tax Provisions" ("ASC 740"), when there is aggregate income from categories other than continuing operations and a loss from continuing operations in the current year. In this case, the income tax benefit allocated to continuing operations is the amount by which the loss from continuing operations reduces the income tax expense recorded with respect to the other categories of earnings, even when a valuation allowance has been established against the deferred tax assets. In instances where a valuation allowance is established against current year losses, income from other sources, including gain from postretirement benefits recorded as a component of OCI, is considered when determining whether sufficient future taxable income exists to realize the deferred tax assets. As a result, for the fiscal year ended June 30, 2013, we recorded income tax expense of $1.1 million in OCI related to the gain on postretirement benefits, and recorded a corresponding income tax benefit of $1.1 million in continuing operations. Income tax benefit in fiscal 2012 was primarily attributable to the settlement of certain tax issues with the Internal Revenue Service and the State of California during our exam appeals. In fiscal 2012, unrecognized tax benefits related to certain tax refunds were released and the resulting benefit was recorded. 31 -------------------------------------------------------------------------------- Net Loss As a result of the foregoing factors, net loss decreased to $(8.5) million, or $(0.54) per common share, in fiscal 2013 from $(26.6) million, or $(1.72) per common share, in fiscal 2012. Non-GAAP Financial Measures In addition to net income (loss) determined in accordance with GAAP, we use certain non-GAAP financial measures, including "Adjusted EBITDA" and "Adjusted EBITDA Margin," in assessing our operating performance. We believe these non-GAAP financial measures serve as appropriate measures to be used in evaluating the performance of our business. Effective January 1, 2014, we corrected our presentation of "Net gains from sales of assets" previously presented within "Other, net" to a separate line item within "Income (loss) from operations" in order to comply with GAAP. In concert with this correction in presentation and to better reflect cash earnings of the Company as measured and evaluated by management, we began using the non-GAAP financial measure "Adjusted EBITDA," defined as net income (loss) excluding the impact of income taxes, interest expense, depreciation and amortization expense, ESOP and share-based compensation expense, non-cash impairment losses, non-cash pension withdrawal expense and other similar non-cash expenses. We reference Adjusted EBITDA frequently in our decision-making because it provides supplemental information that facilitates internal comparisons to the historical operating performance of prior periods. In addition, we base certain of our forward-looking estimates on Adjusted EBITDA to facilitate quantification of planned business activities and enhance subsequent follow-up with comparisons of actual to planned Adjusted EBITDA. We define "Adjusted EBITDA Margin" as Adjusted EBITDA expressed as a percentage of net sales. Adjusted EBITDA and Adjusted EBITDA Margin as defined by us may not be comparable to similarly titled measures reported by other companies. We do not intend for non-GAAP financial measures to be considered in isolation or as a substitute for other measures prepared in accordance with GAAP. Set forth below is a reconciliation of reported net income (loss) to Adjusted EBITDA: Year Ended June 30, (In thousands) 2014 2013 2012 Net income (loss), as reported(1) $ 12,132 $ (8,462 ) $ (26,576 ) Income tax expense (benefit) 705 (825 ) (347 ) Interest expense 1,258 1,782 2,137 Depreciation and amortization expense 27,334 32,542 32,113 ESOP and share-based compensation expense 4,692 3,563 3,287 Impairment losses on goodwill and intangible assets - 92 5,585 Pension withdrawal expense - - 4,568 Adjusted EBITDA(1) $ 46,121 $ 28,692 $ 20,767 Adjusted EBITDA Margin 8.7 % 5.6 % 4.2 % ______________ (1) Includes: (a) $3.8 million in net gains from sales of assets, primarily real estate, in fiscal 2014; (b) $4.5 million in net gains from sales of assets, primarily real estate, and $1.1 million in beneficial effect of liquidation of LIFO inventory quantities in fiscal 2013; and (c) $14.2 million in beneficial effect of liquidation of LIFO inventory quantities in fiscal 2012. 32 -------------------------------------------------------------------------------- Contractual Obligations The following table contains information regarding total contractual obligations as of June 30, 2014, including capital leases: Payment due by period Less Than 1-3 3-5 More Than (In thousands) Total One Year Years Years 5 Years Contractual obligations: Operating lease obligations $ 10,036 $ 3,527 $ 4,111 $ 2,211 $ 187 Capital lease obligations(1) 10,441 4,205 5,134 1,048 54 Pension plan obligations 80,592 7,024 14,524 15,391 43,653 Postretirement benefits other than pension plans 14,286 939 2,155 2,657 8,535 Revolving credit facility 78 78 - - - Purchase commitments(2) 43,448 43,448 - - - Total contractual obligations $ 158,881 $ 59,221 $ 25,924 $ 21,307 $ 52,429 ______________ (1) Includes imputed interest of $1,260. (2) Commitments under coffee purchase contracts for which all delivery terms have been finalized but the related coffee has not been received as of June 30, 2014. Amounts shown in the table above: (a) include all coffee purchase contracts that the Company considers to be from normal purchases; and (b) do not include amounts related to derivative instruments that are recorded at fair value on the Company's consolidated balance sheets. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements. 33-------------------------------------------------------------------------------- |