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Coffee Holding Company: A “Gross”-ly Understood Business2/3/2014

Companies mentioned:

Coffee Holding Co. (JVA) - $4.96

Why Read?

Coffee Holding Company (JVA) is a distributor of green and roasted coffee beans. This company firstcame to my attention in 2011 when it had a wild run up during the rapid expansion of Green MountainCoffee Company’s K-cup sales and units. JVA rose from around $5 to the low $30s where the ownersof the family run business, the Gordon brothers sold the majority of their shares. Since then they haveyet to buy a single share and have only continued to liquidate their holdings.

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!  Commodity business with zero pricing power:  JVA sources and sells green and roastedcoffee beans, which it sources through brokers. Its major customer is Green Mountain CoffeeCompany, which represented 60%, 62%, and 56% in 2013, 2012, and 2011, respectively. It is avery thin margin business with gross margins ranging from 4%-7% over the trailing 3 years.

!  Asymmetric hedging dynamics leads to losses: In order to guarantee product for customers,JVA must enter long coffee futures contracts. As the price of coffee has ranged from $107.68to 231.24 (ICO Composite) since October 31, 2007, and price volatility increased: JVA has lost-$9.2mn from hedging activities compared to a total EBITDA ex. Hedging impact of $19.9mnover the same time period. Because JVA cannot prop trade coffee futures and short contracts,they have been forced into asymmetric market dynamics.

!  Inconsistent cash flows and misunderstood valuation:  JVA operates a commodity-basedbusiness where it facilitates the distribution of green and roasted coffee beans, its main valueadd is carrying pricing risk during its inventory and contract periods. If coffee prices continueto remain suppressed, hedging losses will continue, dollars sales will compress, and fixed costswill deleverage.

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Commodity business with zero pricing power

Since 2010, gross profit margin adjusted for hedging gains/losses has languished between 7% and 10%with very little operational improvement. JVA has very little pricing power and is beholden to itsreliance on its largest customer, GMCR.

Besides, GMCR, JVA has seen very little growth among its other customers. In 2012, JVA sold 207mn

pounds of coffee to GMCR. In 2013, the company removed this disclosure, which we see as a negativesign indicating management is choosing to cloud its reliance on GMCR as its main customer instead offocusing on increasing other customer sales. Note the ~(400) bps gross margin contraction coincidedwith the rise in GMCR sales, talk about pricing power. 

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Asymmetric hedging dynamics leads to losses

JVA’s operational results are completely beholden to the results of its hedging activities as demonstratedby its consistent operating margin results over the last 3 years between +5% and -2%. In spite ofconsistent operating margin results, actual margin dollars have fallen has revenues have declined withfalling coffee prices, another signal of lackluster organic growth.

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Inconsistent cash flows and misunderstood valuation

In 4 of its last 12 quarters, JVA has reported negative earnings, negative EBITDA, and negative cashflow. Before its large run up in 3Q11, JVA never traded more than 6x EBITDA/EV. During 3Q11,many retail momentum investors and speculators invested in the company as sales jumped on the backof GMCR’s rapid success. These investors did not understand the lack of pricing power in JVA’sbusiness model as well as the long-term trends in the decline in raw coffee bean prices.

I’ve laid out a few different hypothetical results for JVA.

Bear Realistic Bull Extreme Bull

Average Coffee Price  $1.19 $1.19 $1.49 $1.49

Revenue 148,014 148,014 185,993 187,610

Revenue Growth 10% 10% 39% 40%

Gross Profit Margin 6% 6% 7% 10%

EBITDA 1,585 1,585 2,848 8,195

EV/EBITDA Multiple 8x 14x 14x 14x

Price per share $1.31 $2.69 $5.40 $16.68

We realistically estimate fair value to be around $2.69 per share, assuming revenues increase +10% onthe back of a -5% decline in coffee prices and GPM remains around 6%. This assumes multiples do notcontract from 14x EV/EBITDA (last time JVA had positive EBITDA) Given the company’s profitabilityis completely dependent on the price and volatility and inconsistent cash-flows we have concluded thatthe market (investors mainly retail players operating off of Seeking Alpha), do not appreciate thecyclicality of the business.

Risks: 

Considering the rebounding coffee prices during Jan. 2014 there is a possibility that JVA could report astrong quarter on the back of hedging gains. Although this will please headline watchers, it does notsignal any improvements in the core business. We are not experts at predicting coffee prices but for nowam trusting in the long-term trend of oversupply, overplanting, and continued increase in productionfrom SE Asia (Vietnam in particular).

Remember, coffee prices are nowhere near their all time lows. In 2001 the ICO composite price was$45.59 compared to $106.56 in Dec. 2013. Continued volatility will only hurt JVA, we remain skeptical.

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