Farmer Brothers Company (FARM)

SECOND:        OUR OPERATING RESULTS ARE, IN FACT, BETTER THAN YOU WOULD INFER FROM THE “PROFIT” ON OUR FINANCIAL STATEMENTS.

In 2006, when compared with 2005, our sales increased 5%, and our gross profit margins were essentially flat – but our operating expenses increased 3%.

That meant that, although our operating profit was better in 2006 than it was in 2005, we still reported a loss from operations in 2006 of $2.9 million.

We did earn a net profit in 2006, thanks to income from non-operating activities such as dividend and interest income.

But a more careful look at our annual report will show that the story is more complicated – and, I think, more positive.

The results in our annual report reflect the accounting treatment of our contributions to our Employee Stock Ownership Plan (our “ESOP”).

On our Cash Flow Statement, you will see that our ESOP compensation expense has a sizable impact on operating income.  This is, in fact, a non-cash expense – for those who are not accountants or financial analysts, this means that each year we make an accounting entry to reflect the value of our ESOP stock awards, but we did not spend actual cash.  We spent the cash 3 years ago when we purchased the shares for the ESOP.

Put differently, this accounting entry reflects the price of shares that we allocated to employees during the fiscal year from the shares that we previously purchased.

This accounting entry amounted to an expense of $4.5 million in 2006 and, in 2005, $6.1 million.  Without this non-cash expense, the Company would have reported an operating profit in 2006 of $1.6 million, and it would have nearly broken even on an operating basis in 2005.

Because this is a non-cash expense, of course, it does not affect our liquid assets.

That helps explain why our cash and investments grew in 2006, even though we spent more than $5 million of our cash for dividends. We ended the fiscal year with $181.7 million – up from $180.9 million at the end of fiscal 2005.

So, our operations added to our cash in 2006 AND the Board increased your dividend AND we were able to increase our investments in the Company’s future.

ABOUT THE ESOP.

Thanks to the ESOP, our employees are stockholders – and, for most employees their individual ownership of Company stock through the ESOP is beginning to represent a meaningful personal financial asset.

By aligning employee interests with those of all stockholders, we’re confident that our employees realize that the value of their ownership position will increase with their continued good efforts and hard work.  How can you find a more direct incentive?