Good afternoon. Welcome to the Farmer Brothers fiscal second quarter 2023 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will follow at that time. If anyone should require operator assistance during this conference call, please press Star then zero on your touchtone telephone. As a reminder, this call is being recorded. Joining me today are Deverl Maserang, President and Chief Executive Officer, and Scott Drake, Chief Financial Officer. Earlier today, the company issued its inaugural quarterly shareholder letter, which is available on the investor relations section of Farmer Brothers website at www.farmerbros.com. The shareholder letter is also included as an exhibit to the company's Form 8-K and is available on the company's website and on the Securities and Exchange Commission's website at www.sec.gov.
A replay of this audio-only webcast will be available approximately two hours after the conclusion of this call. The link to the audio replay will also be available on the company's website. Before we begin the call, please note that all of the financial information presented is unaudited, and that various remarks made by management during this call about the company's 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 the company's views only as of today and should not be relied upon as representing the company's 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 shareholder letter and public filings.
On today's call, management will also reference certain non-GAAP financial measures, including adjusted EBITDA and adjusted EBITDA margin in assessing the company's operating performance. Reconciliation of these non-GAAP financial measures to their most directly comparable GAAP measures is also included in the company's shareholder letter. I will now turn the call over to Deverl. Deverl, please go ahead.
Good afternoon, and thank you for joining us. As you saw today, we have now moved our quarterly reporting to a shareholder letter format. This approach better enables us to provide our investors with context around our performance, strategy, and progress. If you haven't had a chance to view it can be found on our IR website. With that, on the call today, I will provide some highlights from the quarter, and Scott will go into a bit more detail on the financials, and then we will field some questions. Looking at our results for the fiscal second quarter, we reported sales growth of 12% paired with a slight sequential increase in our gross margin. We are finally beginning to see the benefit of contracted price increases and overall customer demand across our national account and DSD businesses.
We have more work to do here, have already seen additional progress early in calendar 2023. Additionally, we improved adjusted EBITDA as we held operating costs in check despite inflationary pressures. We also believe that fiscal Q2 will prove to be the high-water mark for our coffee input cost. While we're encouraged with the early progress, we recognize that our results need to improve from here to achieve the performance our turnaround work has laid the groundwork for. We think the right factors are in place to see that improvement. The short-term pricing headwinds we have faced more recently are expected to alleviate. Our turnaround has improved our underlying operating cost structure and our strategic growth initiatives, while in the very early stage, are progressing nicely.
This gives us confidence in a more pronounced recovery in sales and margins in the second half of our fiscal year, helped by a much more favorable cost environment. We remain vigilant as we manage through the near term, and our vision of a path for long-term profitable growth remains steadfast. I will now turn it to Scott. Scott?
Thanks, Deverl. Let's dive right in. Net sales in the Q2 of fiscal 2023 were $132.7 million, up 12% year-over-year. Growth in sales primarily reflects traction with new customers and higher per pound pricing in both our DSD and direct ship sales. This was partially offset by lower volume, which was primarily due to the loss of a large customer at one of our major national accounts in our direct ship sales channel. Gross margin was 22.9% in Q2, which an incremental improvement on a quarter-over-quarter basis. Margins in the quarter reflect what we believe were peak coffee costs, combined with the previously noted lag that accompanies our contractual cost plus pricing agreements in the direct ship sales channel. We expect margins to improve further over the next 2 quaters-3 quarters.
Adjusted EBITDA loss was $3.1 million in the quarter, an improvement over the last quarter from a loss of $4.9 million. The adjusted EBITDA margin also improved quarter-over-quarter by 170 basis points. Our unrestricted cash balance increased by $7.8 million to $17.6 million as of the end of the calendar year. The increase in unrestricted cash was due to a decrease in working capital, net proceeds from the sale of branch assets, and net borrowings under our credit facilities. Turning to direct ship and DSD. We saw low double-digit percentage sales growth in our direct ship business on a year-over-year basis as we began to see pricing realization after a lag period that depressed the first quarter of fiscal 2023 performance.
On the volume front, one of our large national accounts experienced the loss of a major customer, which led to a decrease in our pound volume compared to the prior-year period. Looking ahead, we expect that the direct ship business continues to improve. We saw positive momentum in our DSD business as revenue was up in the low double-digit percentage range, driven by our pricing increases. Although volume decreased in the quarter compared to last year, there was strong unit and pricing momentum in December that carried over to January, and we expect continued progress on pricing actions in the coming quarters.
Looking ahead, our focus in the coming quarters remains on completing the final elements of our turnaround, driving process improvements that will result in sustainable higher levels of performance, and executing on our exciting growth initiatives, including SHOTT and REVIVE, that bring more services and products to customers and leverage our national distribution footprint. In recent weeks, we have started seeing the benefit of our ongoing pricing efforts as these take effect across our direct ship and DSD customers. This development, paired with our falling coffee prices, leave us optimistic that gross margins will recover towards prior year levels exiting our 2023 fiscal year in June. At the same time, current economic headwinds are placing pressure on talent acquisition and wages, as well as transportation and other operations.
We continue to move aggressively to contain and manage these pressures. We fundamentally believe our cost structure is better positioned than it has been in years to drive better performance as macro conditions abate. Our near-term objectives are to bring Farmer Brothers back to profitability, improve our competitive position for sustainable long-term growth, and enhance our ability to manage macroeconomic challenges and challenges within our industry. We will now open it up for questions. Operator?
Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone. If you're using a speaker phone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question comes from Gerry Sweeney with ROTH MKM, excuse me. Please go ahead.
Afternoon, Deverl and Scott, thanks for taking my call.
Hey, Gerry .
Hello.
Wanted to talk about prices, pricing. I know you talked a little bit about it there in the prepared remarks, but I think one of the things we discussed in the past was, especially on the DSD side, was not just instituting price increases but making sure that they were appropriately or fully pushed through at the street level and maintained at the street level. I think it's really two questions. One, how is that going? Two, I believe some of your IT initiatives were being put in place to help also facilitate that. Wanted to see if we could get an update on that front.
Yeah. Yeah, you bet, Gerry. When we think of pricing, obviously the direct ship is the more straightforward one, You didn't ask, but we'll get that out of the way.
Sure.
It's that pricing agreement we have with all those customers. It's kind of a cost plus pass through. There's that lag in that direct ship side of the business that we've talked about. Specific to DSD, maybe it's a little bit on us that we haven't unpacked this a little more fully. You're right. We continue to see inflationary costs in the business that we have to pass through. We're doing so. Even in our DSD business, a lot of our larger national DSD customers are under a pricing agreement as well. We have several of these that have windows of execution for changes to the contract, including pricing.
For example, we've been doing those changes, but some of those contractual changes with those larger customers, you know, they've been happening in November, December. There's some still in January, February as well. That's one we'll continue to see momentum on that front in regards to the pricing. The good news is that we think we've seen the peak pricing or peak cost for coffee as well as other costs are starting to plateau as well. We think we're gonna get both momentum on the pricing side and start to see some relief on the cost of goods side, and the two of those will combine for the stronger margins that we expect to see in the coming quarters. Regarding the long-term solve, which is I think what you're getting at with the IT solution, you're exactly right.
The IT solution may take a little longer as we work through it, but we're currently underway with a, basically a re-engineering of our pricing function for DSD, taking out some of the complexity, taking out, quite honestly, some of those variables that we have less control over that we've talked about. We're gonna be testing and rolling out this new pricing engine for DSD here over the next two quarters. By the end of the fiscal year, we think we'll have substantially improved pricing for DSD and, you know, better insights, better controls, all those things. We think that's another reason for our bullishness on margins and sales for the coming quarters.
Gotcha. Would you be able to quantify or qualify, you know, where you are on your pricing versus where you would like to be or should be or however you would phrase that? In aggregate, I guess.
Right. I think you're right. I think in aggregate, I would call it, you know, middle innings, you know, moving towards the latter stages of the game, but still in the middle innings, unfortunately. It's one of the things we really want to address with these new engines and our new logic is wherever we can, you know, move, you know, more swiftly, we wanna be able to do so. That's one of the things we're really targeting with some of these improvements.
Got it. You did touch upon it for a second. This was down on my list of questions, was I guess, well, it impacted both direct ship and I think DSD, but, you know, some of the hedging, contractual structure and delays. Last quarter, you talked about, you know, Q2, which we just had, you know, some improvement, but more substantial improvement in Q3 and Q4. How does that work out, or is that still sort of on the table per se?
Yeah, exactly. I think that when you look at the program we have, really, we hedge so that we can have more certainty around our costs. Theoretically, when prices are rising like they were the last couple of years, that's when you saw us get much more coverage, and we went much longer on our contractual coverage of those costs. When we had the thesis that prices were gonna be falling, we've obviously shortened up our coverage quite a bit so that we could get to those lower prices as quick as possible. We are still working through some of those inventories. You know, it has to be brought in, manufactured, distributed, sold, et cetera, to get some way all the way to the P&L.
We're starting to see that now, but that is another thing that, you know, that lag, along with some of the pricing lags we've talked about, are both we're seeing progress, but we're just gonna need, you know, some more time, a few more months here to continue to work through them. The good news on both fronts is that they're accelerating. You know, through Q3, Q4, and even Q1, we think we'll continue to have these tailwinds and really see nice progress.
On that front, how long does it take for sort of inventory to roll through? Obviously pricing is down, you know, it was well over $2... well above $2 a pound, now it's below, on, you know, on average. How long does it take to sort of see that benefit?
You know, it's interesting. If you look at our Like any other business, if you look at our top SKUs, those turn quite a bit. You know, it's pretty regular.
Mm-hmm.
I'll use an example from DSD and our spices and teas. You know, some of those products, they kind of have a growing season, an ordering season, and you really only place your orders, you know, once or twice a year for some of those items. You've got, you know, longer inventory, and it just takes a little longer for those to turn. I think on average, when you look at it's, you know, people can do the kind of quick inventory turns, but , we're usually at a couple of months, you know, two to three months, I would say on average. Again, you've got, with DSD, you have that sale and that turn, and then you've got your collection, you know, your AR period there that would tack on to the end of that.
With DSD, you've kind of got the customer notification. Even if you're going to change prices or move some of these things, there's usually a 30-day or so notification period. That tends to make it, you know, just feel longer and really because it is longer than the 60-90 days we talk about so much.
Got it. Then, you know, unrestricted cash was up and, you know, just looking at the balance sheet, inventories were down. I actually... I mean, I didn't scrub the balance sheet or go through it, but, you know, I would imagine as co-cost of coffee reduces working capital just like an inventory should decline as well. Is that a fair assumption, and is that what drove 2Q, or are we just seeing, you know, with some of the initiatives you put in place, just better inventory management, et cetera?
Yeah, you're exactly right that our inventory should get some natural benefit of lower cost as we move forward. In Q2, what you really saw was the benefit of some of the actions we've talked about through the summer months of 2022 and then into the fall, where, you know, we were focused on restructuring our debt, which we did successfully. Then we had mentioned how we were gonna really turn our focus to getting more efficient with working capital. Q2 was really the result of that. The inventory and some of the other efficiencies you see were really the result of us getting in and getting more efficient with our inventory, with our processes, safety stocks, all those different components that go into that. It got a little better for us.
Quite honestly, it's also been helpful, and it was the right time to do so because more of the supply chains were turning to normal. You know, it's a time where we can have more reliance on vendors and products and timing, so we're able to do a lot of this progress. We're not done yet. We'll continue with the efficiency and have the benefit of lower costs, you know, with coffee, certainly.
I'm gonna ask one more. I'm not sure if there's anyone in queue. Labor, you know, historically, it's been challenging to get labor in the last couple of years and trouble led to some challenges around rolling out additional routes or reinstating routes, et cetera. Any issues there, or what's that looking like? Obviously, you know, you also had the REVIVE business, curious as to-
Yeah.
update on that front.
Gerry, labor is... We've invested in HR. We've pulled some new resources in. As you know, we pulled in a new CHRO just over a year ago. She's put her fingerprints on the organization, new head of recruiting, working on different programs with various technical schools and training program. What that has resulted, I'll speak to REVIVE first. We've been able to recruit against our.
Turnover in REVIVE on techs and have net adds per week, which is what's contributing to being able to get more techs on the street. Now we're just working those folks to get them fully trained and productive on their specific tech routes in REVIVE. Then on the DSD side, we've had, I'd say a little less success from where we were with REVIVE, but solid performance on maintaining our RSR headcount and being able to get people back on routes and continue to add routes as the volume justifies those routes.
We're still very much focused on optimization of those RSRs as we add them back, whether it be for turnover or specifically, coverage on PTO or for adding additional RSRs to be able to, you know, change route structures when the route starts to get to a point where it has too much volume on the route, and we need to add a route so we can pick up additional volume for customers that may be underserved. That's an ongoing optimization. We have a group that continues to lead that with our DSD team, and that's been very successful. The HR side, we've been able to turn the tide.
I'd say from a macroeconomic perspective over the past quarter, you know, we've seen, as while the labor rates have continued to, unemployment rate's still quite low, we've been able to react to that and be able to get more applicants through and hired and on the street. I'm sensing right now, given the new programs we've been putting in place through our HR team and through our DSD frontline team, that we've been able to hold our own and not deteriorate on the negative side and lose more than we can add. That's been very positive.
Yeah. Gerry, just quickly, one external view, just 'cause I happened to have seen it last week. I unfortunately, I don't recall where, but there was an article I saw that noted the restaurant industry in the United States is still, they estimate, about 1 million workers short from where they would like to be. We still see that with our customers and, you know, we're hopeful for improvement there as well.
Got it. I appreciate it. Thanks for taking my questions.
Thanks, Gerry.
Thank you.
This concludes our question and answer session. I would like to turn the conference back over to Deverl for any closing remarks.
Thank you. Overall, while we've had the foundation in place, market dynamics have been difficult. We are very focused on sharpening execution as we manage through this period. We're encouraged by our progress this quarter and are optimistic that the expected favorable pricing environment that Scott spoke of in the prepared remarks and in the coming quarters will support meaningful improvement in our results. The strategy is in place, and we are determined to show the benefits of the hard work the team has completed as we move through fiscal 2023 and into the next fiscal year. Thank you for attending today.
The conference has now concluded. Thank you for attending today's presentation. You may all now disconnect.