FARMER BROTHERS CO - Quarter Report: 2010 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2010

OR

For the transition period from              to             

Commission file number: 001-34249

FARMER BROS. CO.

(exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (310) 787-5200

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES  ¨    NO  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  ¨    NO  x

On April 30, 2010, the registrant had 16,161,739 shares outstanding of its common stock, par value $1.00 per share, which is the registrant’s only class of common stock.

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FARMER BROS. CO.

FORM 10-Q QUARTERLY REPORT

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PART I - FINANCIAL INFORMATION

FARMER BROS. CO.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except share and per share data)

The accompanying notes are an integral part of these financial statements.

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FARMER BROS. CO.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except share and per share data)

(Unaudited)

The accompanying notes are an integral part of these financial statements.

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FARMER BROS. CO.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

The accompanying notes are an integral part of these financial statements.

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FARMER BROS. CO.

Notes to Consolidated Financial Statements

(Unaudited)

Note 1. Farmer Bros. Co. and Summary of Significant Accounting Policies

The Company

Farmer Bros. Co. (including its consolidated subsidiaries, unless the context requires otherwise, herein referred to as “Company,” “we,” or “our”) is a manufacturer, wholesaler and distributor of coffee, tea and culinary products to the institutional food service segment. The Company was incorporated in California in 1923, and reincorporated in Delaware in 2004.

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States (“GAAP”) for complete consolidated financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals, unless otherwise indicated) considered necessary for a fair presentation of the interim financial data have been included. Operating results for the three and nine months ended March 31, 2010 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2010. Events occurring subsequent to March 31, 2010 have been evaluated for potential recognition or disclosure in the unaudited consolidated financial statements for the three and nine months ended March 31, 2010.

These accompanying unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K, as amended, for the fiscal year ended June 30, 2009, filed with the Securities and Exchange Commission (the “SEC”) on September 15, 2009.

Use of Estimates

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results may differ from those estimates.

Fair Value Measurements

Effective July 1, 2009, the Company implemented the requirements of Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures” (“ASC 820”), of the Financial Accounting Standards Board (the “FASB”) for its financial assets and liabilities. Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants. The Company maximizes the use of observable market inputs, minimizes the use of unobservable market inputs and discloses in the form of an outlined hierarchy the details of such fair value measurements. See Note 3 for additional information.

Coffee Brewing Equipment and Service

The Company records expenses related to coffee brewing equipment provided to customers in cost of goods sold. These costs include depreciation on capitalized equipment and the cost of servicing that equipment (including service employees’ salaries, cost of transportation and the cost of supplies and parts). Cost of coffee brewing equipment and service included in the accompanying consolidated financial statements for the fiscal quarters ended March 31, 2010 and 2009 is $6.2 million and $2.5 million, respectively. Cost of coffee brewing equipment and service included in the accompanying consolidated financial statements for the nine months ended March 31, 2010 and 2009 is $16.6 million and $7.1 million, respectively. The Company capitalized coffee brewing equipment in the amounts of $9.4 million and $5.0 million during the nine months ended March 31, 2010 and 2009, respectively. Depreciation expense related to capitalized coffee brewing equipment reported as cost of goods sold was $1.6 million and $0.8 million in the fiscal quarters ended March 31, 2010 and 2009, respectively. Depreciation expense related to capitalized coffee brewing equipment reported as cost of goods sold was $4.1 million and $1.1 million in the nine months ended March 31, 2010 and 2009, respectively.

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Revenue Recognition

Most products are sold and delivered to the Company’s customers at their places of business by the Company’s route sales employees. Revenue is recognized at the time the Company’s sales representatives physically deliver products to customers and title passes or upon acceptance by the customer when shipped by third party delivery.

In connection with the acquisition of the DSD Coffee Business described in Note 2, the Company entered into an agreement with Sara Lee Corporation (“Sara Lee”) pursuant to which the Company performs co-packing services for Sara Lee as Sara Lee’s agent. The Company recognizes revenue from this arrangement on a net basis, net of direct costs of revenue. As of March 31, 2010, the Company had $7.1 million of receivables from Sara Lee related to this arrangement, which are included in “Other receivables, net” (see Note 4).

Net Income (Loss) Per Common Share

Basic earnings (loss) per share (“EPS”) is computed by dividing net income (loss) by the weighted average common shares outstanding, including unvested share payment awards that contain rights to receive non-forfeitable dividends but excluding unallocated shares held by the Company’s Employee Stock Ownership Plan. Diluted EPS includes the effect of any potential shares outstanding, which for the Company consists of dilutive stock options. The dilutive effect of stock options (see Note 10) is calculated using the treasury stock method in which the denominator to compute diluted EPS includes potential additional shares from expected proceeds upon deemed exercise of the in-the-money stock options as of the end of the reporting period.

Effective July 1, 2009, the Company began using the “Two-Class Method” to compute EPS. The Two-Class Method considers unvested restricted stock with a right to receive non-forfeitable dividends as participating securities and allocates earnings to participating securities in the computation of EPS. The Company computed EPS using the Two-Class Method for all periods presented. For the three and nine months ended March 31, 2010 and 2009, the Company incurred a net loss and, therefore, potentially dilutive shares issuable under stock options were excluded from the computation of EPS since including them would be antidilutive.

Dividends Declared

The following dividends were declared in the first nine months of fiscal 2010 on the dates indicated (in thousands, except per share amounts):

Impairment of Goodwill and Intangible Assets

The Company performs an annual goodwill and indefinite-lived intangible assets impairment test as of June 30 of each fiscal year. Goodwill and other indefinite lived intangible assets are not amortized but instead are reviewed for impairment annually and on an interim basis if events or changes in circumstances between annual tests indicate that an asset might be impaired. Indefinite lived intangible assets are tested for impairment by comparing their fair values to their carrying values. Testing for impairment of goodwill is a two-step process. The first step requires the Company to compare the fair value of its reporting units to the carrying value of the net assets of the respective reporting units, including goodwill. If the fair value of the reporting unit is less than the carrying value, goodwill of the reporting unit is potentially impaired and the Company then completes step two to measure the impairment loss, if any. The second step requires the calculation of the implied fair value of goodwill by 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 addition to an annual test, goodwill and indefinite lived intangible assets must also be tested on an interim basis if events or circumstances indicate that the estimated fair value of such assets has decreased below their carrying value. There were no such events or circumstances during the nine months ended March 31, 2010.

Recently Adopted Accounting Standards

In January 2010, the Company adopted Accounting Standards Update (“ASU”) No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements,” which amends ASC 820. This new accounting guidance requires expanded fair value measurement disclosures in quarterly and annual financial statements. The new guidance clarifies existing disclosure requirements for the Level 2 and Level 3 fair value measurement. Additionally, the new guidance also requires details of significant transfers of assets between Level 1 and Level 2 fair value measurement categories, including the reasons for such transfers, as well as gross presentation of activity within the Level 3 fair value measurement category. This guidance is effective for the Company on January 1, 2010, except for the gross presentation of Level 3 activity, which is effective January 1, 2011. The adoption of this new accounting guidance did not impact the results of operations, financial position or cash flows of the Company.

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On February 24, 2010, the FASB issued ASU No. 2010-09, “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements” (“ASU No. 2010-09”), which amends FASB ASC 855, “Subsequent Events.” According to this standard, SEC filers are no longer required to disclose the date through which subsequent events have been evaluated in originally issued and revised financial statements. ASU No. 2010-09 was effective immediately and the Company adopted these new requirements on February 24, 2010.

Effective July 1, 2009, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — a replacement of FASB Statement No. 162” (“SFAS No. 168”). Under SFAS No. 168, the historical GAAP hierarchy was eliminated and ASC became the single official source of authoritative, non-governmental GAAP, other than guidance issued by the SEC. All other literature became non-authoritative. SFAS No. 168 became effective for financial statements issued for interim and annual periods ending after September 15, 2009. It has been codified within ASC 105, “Generally Accepted Accounting Principles” (“ASC 105”). The Company adopted ASC 105 on July 1, 2009. Since ASC 105 does not change GAAP, the standard did not impact the results of operations, financial position or cash flows of the Company.

In December 2008, the FASB issued FSP SFAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets” (“FSP SFAS 132(R)-1”). FSP SFAS 132(R)-1 amends SFAS No. 132(R), “Employer’s Disclosures about Pensions and Other Postretirement Benefits,” to require additional disclosures about assets held in an employer’s defined benefit pension or other postretirement plan. FSP SFAS 132(R)-1 is effective for fiscal years ending after December 15, 2009 and is effective for the Company in fiscal 2010. FSP SFAS 132(R)-1 was codified within ASC 715, “Compensation-Retirement Benefits.”

In June 2008, the FASB issued FSP No. EITF 03-6-1, “Determining Whether Instruments Granted in Share Based Payment Transactions Are Participating Securities” (“FSP No. EITF 03-6-1”). FSP No. EITF 03-6-1 clarifies that share based payment awards that entitle their holders to receive non-forfeitable dividends before vesting should be considered participating securities and included in the calculation of basic EPS. The Company adopted FSP No. EITF 03-6-1 on July 1, 2009. Adoption of the standard did not have a material impact on the Company’s consolidated financial statements. FSP No. EITF 03-6-1 was codified within ASC 260, “Earnings Per Share.”

In April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP No. FAS 142-3”). FSP No. FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets.” The Company adopted FSP No. FAS 142-3 on July 1, 2009 on a prospective basis. Adoption of the standard did not have a material impact on the Company’s consolidated financial statements. FSP No. FAS 142-3 was codified within ASC 275, “Risks and Uncertainties,” and ASC 350, “Intangibles-Goodwill and Other.”

In December 2007, the FASB issued SFAS No. 141 (Revised), “Business Combinations” (“SFAS 141(R)”), replacing SFAS No. 141, “Business Combinations” (“SFAS 141”), and SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—An Amendment of ARB No. 51” (“SFAS 160”). SFAS 141(R) retains the fundamental requirements of SFAS 141, broadens its scope by applying the acquisition method to all transactions and other events in which one entity obtains control over one or more other businesses, and requires, among other things, that assets acquired and liabilities assumed be measured at fair value as of the acquisition date, that liabilities related to contingent considerations be recognized at the acquisition date and re-measured at fair value in each subsequent reporting period, that acquisition related costs be expensed as incurred, and that income be recognized if the fair value of the net assets acquired exceeds the fair value of the consideration transferred. SFAS 160 establishes accounting and reporting standards for noncontrolling interests (i.e., minority interests) in a subsidiary, including changes in a parent’s ownership interest in a subsidiary and requires, among other things, that noncontrolling interests in subsidiaries be classified as a separate component of equity. Except for the presentation and disclosure requirements of SFAS 160, which are to be applied retrospectively for all periods presented, SFAS 141(R) and SFAS 160 are to be applied prospectively in financial statements issued for fiscal years beginning after December 15, 2008. SFAS 141(R) and SFAS 160 were effective for the Company beginning July 1, 2009. Although the accounting on future transactions is expected to be impacted, the Company did not have any material impact to its historical financial statements from the adoption of SFAS 141(R) and SFAS 160.

Additionally, for business combinations for which the acquisition date occurs prior to the effective date of SFAS 141(R), the acquirer is required to apply the requirements of ASC 740, “Income Taxes,” as amended by SFAS 141(R), prospectively. After the effective date of SFAS 141(R), changes in the valuation allowance for acquired deferred tax assets and dispositions of uncertain income tax positions must be recognized as an adjustment to income tax expense, rather than through goodwill. The impact of the adoption of SFAS 141(R) on the Company’s consolidated financial statements will largely be dependent on the size and nature of the business combinations completed after July 1, 2009. SFAS 141(R) was codified within ASC 805, “Business Combinations” (“ASC 805”).

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In April 2009, the FASB issued FSP No. 141R-1, “Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies” (“FSP No. 141R-1”). FSP No. 141R-1 amends the provisions in SFAS 141(R) for the initial recognition and measurement, subsequent measurement and accounting, and disclosures for assets and liabilities arising from contingencies in business combinations. FSP No. 141R-1 eliminates the distinction between contractual and non-contractual contingencies, including the initial recognition and measurement criteria in SFAS 141(R), and instead carries forward most of the provisions in SFAS 141(R) for acquired contingencies. FSP No. 141R-1 is effective for contingent assets and contingent liabilities acquired in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company adopted FSP No. 141R-1 on July 1, 2009. Adoption of the standard did not have a material impact on the results of operations, financial position or cash flows of the Company. FSP No. 141R-1 was codified within ASC 805.

In April 2009, the FASB issued FSP No. 107-1 and Accounting Principles Board Opinion (“APB”) No. 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP FAS No. 107-1 and APB No. 28-1”). FSP FAS No. 107-1 and APB No. 28-1 amend SFAS No. 107, “Disclosures about Fair Value of Financial Instruments,” to require disclosures about the fair value of financial instruments for interim reporting periods ending after June 15, 2009. The Company adopted FSP FAS No. 107-1 and APB No. 28-1 on July 1, 2009. Adoption of the standards did not have an impact on the Company’s financial statement disclosures. FSP FAS No. 107-1 and APB No. 28-1 were codified within ASC 825, “Financial Instruments.”

In August 2009, the FASB issued ASU No. 2009-5, which amends subtopic ASC 820-10, “Fair Value Measurements” (“ASC 820-10”), as it relates to the fair value measurement of liabilities. ASU No. 2009-5 provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, an entity is required to measure fair value utilizing one or more of the following techniques: (1) a valuation technique that uses the quoted market price of an identical liability or similar liabilities when traded as assets; or (2) another valuation technique that is consistent with the principles of ASC 820, such as a present value technique. The Company adopted ASU No. 2009-5 on October 1, 2009. Adoption of ASU No. 2009-5 did not impact the results of operations, financial position or cash flows of the Company.

New Accounting Pronouncements

In June 2008, the FASB released a proposed SFAS, “Disclosure of Certain Loss Contingencies, an amendment of FASB Statements No. 5 and 141” (the “Proposed Statement”), for a comment period that ended during August 2008. The Proposed Statement would (a) expand the population of loss contingencies that are required to be disclosed, (b) require disclosure of specific quantitative and qualitative information about those loss contingencies, (c) require a tabular reconciliation of recognized loss contingencies and (d) provide an exemption from disclosing certain required information if disclosing that information would be prejudicial to an entity’s position in a dispute. The Proposed Statement would be effective for financial statements issued for fiscal years ending after December 15, 2008, and for interim and annual periods in subsequent fiscal years. Following the effective date of the ASC, SFAS No. 5 was codified within Topic 450, “Contingencies.” When and if the Proposed Statement is approved in final form by the FASB, the Company will evaluate whether the adoption of the Proposed Statement will have any material impact on its results of operations, financial condition or cash flows.

In October 2009, the multiple-element arrangements guidance codified in ASC 605-25, “Revenue Recognition – Multiple Element Arrangements,” was modified by the FASB as a result of the final consensus reached on EITF Issue No. 08-1, “Revenue Arrangements with Multiple Deliverables,” which was codified by ASU No. 2009-13. The guidance in ASU No. 2009-13 supersedes the existing guidance on such arrangements and is effective for the first annual reporting period after June 15, 2010 and is effective for the Company beginning on July 1, 2010. Adoption of ASU No. 2009-13 is not expected to materially affect the results of operations, financial condition or cash flows of the Company.

In April 2010, the FASB issued ASU 2010-12, “Income Taxes (ASC 740): Accounting for Certain Tax Effects of the 2010 Health Care Reform Acts.” After consultation with the FASB, the SEC stated that it “would not object to a registrant incorporating the effects of the Health Care and Education Reconciliation Act of 2010 when accounting for the Patient Protection and Affordable Care Act.” The Company does not expect the provisions of ASU 2010-12 to have a material impact on the financial position, results of operations or cash flows of the Company.

Note 2. Acquisition

Effective as of February 28, 2009, the Company completed the acquisition from Sara Lee Corporation, a Maryland corporation (“Seller”), and Saramar, L.L.C., a Delaware limited liability company (“Saramar” and collectively with Seller, “Seller Parties”) of certain assets used in connection with Seller Parties’ direct store delivery coffee business in the United States (the “DSD Coffee Business”). The acquired business generally consists of manufacturing and selling coffee, tea and related products through a network of facilities and vehicles which was acquired to complement and expand the Company’s previously existing operations. This business also includes the distribution, sale and service of brewed and liquid coffee equipment, as well as the right to distribute sauces and dressings to customers of the DSD Coffee Business. The results of operations of the DSD Coffee Business were included in the Company’s consolidated financial statements beginning on March 1, 2009.

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The assets purchased include, among other things, the following: (i) a manufacturing plant in Houston, Texas, a spice plant in Oklahoma City, Oklahoma, and a warehouse in Indianapolis, Indiana; (ii) 64 leased branch facilities in 31 states; (iii) a vehicle fleet consisting of 431 owned and leased vehicles; (iv) certain tangible personal property; (v) inventories of raw materials, work in process, finished goods and packaging; (vi) certain contracts, permits, books and records; (vii) prepaid expenses relating to the DSD Coffee Business; and (viii) all goodwill relating to the DSD Coffee Business. The Company also acquired Seller Parties’ rights (including related goodwill) in the trademarks and trade names relating to the SUPERIOR^®, MCGARVEY^®, CAIN’S^®, IRELAND^®, JUSTIN LLOYD^®, METROPOLITAN^®, PREBICA^®, WECHSLER^®, WORLD’S FINEST^® and CAFÉ ROYAL^® brands.

Subject to certain post-closing adjustments relating to the amount of consumable inventory and prepaid expenses at closing, and after giving effect to certain reimbursement obligations of the parties relating to accounting costs, IT carve-out costs, and transfer taxes and fees, as well as real and personal property tax and utility prorations, the amount paid to Seller was $45.6 million, which consisted of $16.1 million of Company cash and proceeds of a bank loan of $29.5 million. The Company paid approximately $2.7 million of acquisition related expenses. At closing, the Company assumed certain liabilities, including obligations under contracts, environmental liabilities with respect to the transferred facilities, pension liabilities, advertising and trade promotion accruals, and accrued vacation as of the closing for hired personnel. Seller Parties retained all liabilities that were not specifically assumed by the Company. The Company re-financed and replaced certain leases relating to the DSD Coffee Business vehicles in the fourth quarter of fiscal 2009. Additionally, the Company assumed lease liabilities for sixty-four branch facility leases with lease terms that generally do not exceed three years.

In connection with the closing, Seller Parties and the Company entered into certain operational agreements, including trademark and formula license agreements, co-pack agreements, a liquid coffee distribution agreement, a transition services agreement, and a green coffee and tea purchase agreement. One of the co-pack agreements provides that Seller will manufacture branded products for the Company for a period of three years. Under this agreement the Company has agreed to purchase certain minimum product quantities from Seller subject to certain permitted reductions. The transition services agreement pursuant to which Seller agreed to perform a number of services for the Company on an interim basis, including hosting, maintaining and supporting IT infrastructure and communications, was scaled back in February 2010 to include only certain IT infrastructure support.

The accompanying consolidated financial statements do not include pro-forma historical information, as if the results of the DSD Coffee Business had been included from the beginning of the periods presented, since the use of forward-looking information would be necessary in order to meaningfully present the effects of the acquisition. Forward-looking information, rather than historical information, would be required since the DSD Coffee Business was operated as part of a larger business within Seller and there will be a different operating cost structure and different operations support under the Company’s ownership. The Company has not provided forward-looking information with respect to incremental costs and expenses to be incurred because such information is not determinable.

The acquisition has been accounted for as an asset purchase. The total purchase price has been allocated to tangible and intangible assets based on their estimated fair values as of February 28, 2009 as determined by management based upon a third-party valuation. The purchase price allocation was finalized in the period ended March 31, 2010 and the estimated initial total fair value of net assets acquired was reduced from $48.3 million to $47.8 million as summarized in the following table:

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Intangible assets consist of trademarks, customer relationships, and service agreements with a gross carrying value and accumulated amortization as of March 31, 2010 of $13.0 million and $1.5 million, respectively. The accumulated amortization represents aggregate amortization for the thirteen months ended March 31, 2010 from February 28, 2009, the date of acquisition.

Estimated aggregate amortization of intangible assets for each of the following five years based on the estimated fair values of the intangible assets is expected to be approximately $1.3 million.

Note 3. Investments and Derivative Instruments

The Company purchases various derivative instruments as investments or to create economic hedges of its interest rate risk and commodity price risk. At March 31, 2010 and June 30, 2009, derivative instruments are not designated as accounting hedges. The fair value of derivative instruments is based upon broker quotes. The Company records unrealized gains and losses on trading securities and changes in the market value of certain coffee contracts meeting the definition of derivatives in “Other, net income (expense).”

The Company groups its assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

The Company’s preferred stock investments have been grouped as follows at March 31, 2010:

There were no transfers of assets between Level 1 and Level 2 as of March 31, 2010. Investments, consisting of marketable debt and equity securities, money market instruments and various derivative instruments, are held for trading purposes and are stated at fair value. Investments are as follows:

Gains and losses, both realized and unrealized, are included in “Other, net income (expense).” Net realized and unrealized gains and losses are as follows:

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Preferred stock investments as of March 31, 2010 consisted of securities with a fair value of $35.2 million in an unrealized gain position and securities with a fair value of $19.3 million in an unrealized loss position. Preferred stock investments as of June 30, 2009 consisted of securities with a fair value of $16.5 million in an unrealized gain position and securities with a fair value of $26.0 million in an unrealized loss position. The following table shows gross unrealized losses and fair value for those investments that were in an unrealized loss position as of March 31, 2010 and June 30, 2009, aggregated by the length of time those investments have been in a continuous loss position:

Note 4. Accounts Receivable, net

Note 5. Inventories

Inventories are valued at the lower of cost or market. Costs of coffee, tea and culinary products are determined on the last in, first out (LIFO) basis. Costs of coffee brewing equipment manufactured are accounted for on the first in, first out (FIFO) basis. 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. Accordingly, interim LIFO calculations must necessarily be based on management’s estimates of expected fiscal year-end inventory levels and costs. Because these estimates are subject to many forces beyond management’s control, interim results are subject to the final fiscal year-end LIFO inventory valuation.

Note 6. Employee Benefit Plans

The Company provides 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. Retirees are also eligible for medical and life insurance benefits.

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Company Pension Plans

The Company has a contributory defined benefit plan for the majority of its employees not covered under a collective bargaining agreement (Farmer Bros. Co. Plan) and non-contributory defined benefit pension plan for certain hourly employees covered under a collective bargaining agreement (Brewmatic Plan). The net periodic benefit costs for the defined benefit plans were as follows:

Components of net periodic benefit cost

Weighted-average assumptions used to determine net periodic benefit cost

Basis used to determine expected long-term return on plan assets

Historical and future expected rates of return of multiple asset classes were analyzed to develop a risk-free real rate of return and risk premiums for each asset class. The overall rate for each asset class was developed by combining a long-term inflation component, the risk-free real rate of return, and the associated risk premium. A weighted average rate of return was developed based on those overall rates of return and the target asset allocation of the plans.

Note 7. Bank Loan

On March 2, 2009 the Company and its wholly owned subsidiary, Coffee Bean International, Inc. (“CBI”), as Borrowers, and the Company’s other subsidiaries, as Guarantors, entered into a Loan and Security Agreement (the “Loan Agreement”), with Wells Fargo Bank, National Association (“Wells Fargo”), successor, by merger to Wachovia Bank, National Association, as Lender, providing for a $50 million senior secured revolving credit facility expiring in February 2012 to help finance the DSD Coffee Business acquisition and for general corporate purposes. The Loan Agreement contains a variety of restrictive covenants customary in an asset-based lending facility, including a fixed charge coverage requirement, and it places limits on capital expenditures and dividends. All outstanding obligations under the Loan Agreement are collateralized by perfected security interests in the assets of the Company and CBI, excluding the preferred stock held in investment accounts. The revolving line provides for advances of 85% of eligible accounts receivable and 65% of eligible inventory, as defined. The agreement has an unused commitment fee of 0.375%. The interest rate varies based upon line usage, borrowing base availability and market conditions. The range is PRIME + 0.25% to PRIME + 0.75% or LIBOR + 2.25% to LIBOR + 2.75%, subject to a minimum for LIBOR based advances of 3.25%. The interest rate on the Company’s outstanding borrowings was 3.5% at March 31, 2010. Due to the short-term nature of the credit facility and the variable interest rate, fair value of the balance outstanding approximates carrying value.

On May 7, 2010, the Company and Wells Fargo entered into a Letter Agreement regarding Waiver of Event of Default (the “Waiver Agreement”) pursuant to which Wells Fargo agreed to waive the Company’s failure to satisfy the fixed charge coverage covenant as of February 28, 2010 and March 31, 2010 under the Loan Agreement. The foregoing description of the Waiver Agreement is not complete and is qualified in its entirety by the actual terms of the Waiver Agreement, a copy of which is incorporated herein by reference and attached hereto as Exhibit 10.9.

On March 31, 2010, the Company was eligible to borrow up to a total of $50.0 million under the credit facility. As of March 31, 2010, the Company had borrowed $33.8 million of this amount, utilized $3.2 million of its letters of credit sub-limit, and had excess availability of $13.0 million under the credit facility.

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Note 8. Stock-Based Compensation

Stock Options

On December 10, 2009, the Company granted 198,789 shares issuable upon exercise of non-qualified stock options with an exercise price of $18.41 per share to eligible employees, officers and directors under the Farmer Bros. Co. 2007 Omnibus Plan (the “Plan”). Shares under the options ratably vest over a three-year period. Following are the weighted average assumptions used in the Black-Scholes Merton valuation model for the grants issued during the nine months ended March 31, 2010 and 2009:

The Company estimates forfeitures based on its historical pre-vest forfeiture rate and will revise those estimates in subsequent periods if actual forfeitures differ from those estimates. The Company’s assumption regarding expected stock price volatility is based on the historical volatility of its stock price. The risk-free interest rate is based on U.S. Treasury zero-coupon issues at the date of grant with a remaining term equal to the expected life of the stock options.

The following table summarizes stock option activity for the nine months ended March 31, 2010:

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $18.74 at March 31, 2010, representing the last trading day of the quarter, which would have been received by award holders had all award holders exercised their awards that were in-the-money as of that date. As of March 31, 2010, there was approximately $1.4 million of unamortized compensation expense related to stock options and 104,481 shares vested during the nine months ended March 31, 2010. Compensation expense recognized in general and administrative expenses for the three month periods ended March 31, 2010 and 2009 was $0.1 million and $0.1 million, respectively, and $0.3 million and $0.4 million, respectively, for the nine months ended March 31, 2010 and 2009.

Restricted Stock

On December 10, 2009, the Company granted 45,722 shares of restricted stock to eligible employees, officers and directors under the Plan. Shares of restricted stock issued to eligible employees generally vest at the end of three years from the grant date. Shares of restricted stock issued to non-employee officers and directors vest ratably over three years. Restricted stock-based compensation expense is recognized on a straight-line basis over the service period based on the estimated fair value of the restricted stock that is ultimately expected to vest. Restricted stock based compensation expense recognized in general and administrative expenses for the three months ended March 31, 2010 and 2009 was $0.1 million and $0.1, respectively. Restricted stock based compensation expense recognized in general and administrative expenses for the nine months ended March 31, 2010 and 2009 was $0.3 million and $0.3 million, respectively. As of March 31, 2010, there was approximately $1.0 million of unamortized compensation expense related to restricted stock, and 5,860 shares vested during the nine months ended March 31, 2010. The following table summarizes the status of the Company’s restricted stock as of March 31, 2010:

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Note 9. Income Taxes

The Company adjusts its effective tax rate each quarter based on its current estimated annual effective tax rate. The Company also records the tax impact of certain discrete items, unusual or infrequently occurring tax events and the effects of changes in tax laws or rates, in the interim period in which they occur. In addition, the Company evaluates its deferred tax assets quarterly to determine if a valuation allowance is required.

Consideration of whether a valuation allowance should be recorded against deferred tax assets is 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. In the fourth quarter of fiscal 2009, the Company evaluated its deferred tax assets in accordance with these requirements.

A significant negative factor was the Company’s three year historical cumulative loss as of the end of the fourth quarter of fiscal 2009, compared to the size of deferred tax assets. The deferred tax assets in fiscal 2009 increased to $41.4 million as compared to $21.6 million in fiscal 2008. This increase primarily resulted from decreased pension asset values which in turn created increased pension plan contribution obligations. These considerations outweighed the Company’s ability to rely on projections of future taxable income and future appreciation of pension assets as of June 30, 2009. Accordingly, as of June 30, 2009, a valuation allowance of $33.3 million was recorded to offset this deferred tax asset. Of this amount, $19.7 million was recorded as tax expense and $13.6 million was recorded as a reduction in other comprehensive income.

As a result of recent federal legislation allowing a five year net operating loss carryback period for net operating losses incurred in tax years ending in 2008 or 2009, the Company increased its income tax receivable and recorded a corresponding decrease in its deferred tax assets (relating to net operating loss carryovers) during the three months ended December 31, 2009. The offsetting reduction in valuation allowance resulted in an income tax benefit of $2.5 million in the three months ended December 31, 2009.

During the three months ended March 31, 2010, the Company prepared and filed its income tax return for the period ended June 30, 2009. As a result of the filing, the net operating loss available for carryback increased. The Company increased its income tax receivable to recognize the additional amount of the carryback and recorded a corresponding tax benefit of $1.6 million in the three months ended March 31, 2010.

At March 31, 2010, the Company cannot conclude that it is more likely than not that the remaining deferred tax assets will be realized due to the recent history of losses. A summary of the income tax benefit recorded in the three and nine months ended March 31, 2010 and 2009 follows:

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As of March 31, 2010 and June 30, 2009, the Company had not recognized the following tax benefits in its consolidated financial statements:

The Internal Revenue Service is currently conducting an audit of the Company’s amended federal tax returns filed in September 2009, and California is conducting a state examination of the Company’s open tax return years. The Company believes it is reasonably possible that a portion of its total unrecognized tax benefits will decrease in the next twelve months upon the conclusion of these examinations. However, it is premature to assess the range of the reasonably possible changes to the Company’s unrecognized tax benefits.

Note 10. Net Income (Loss) Per Share

The following table sets forth the calculation of basic and diluted net income (loss) per share:

Forward-Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q regarding the risks, circumstances and financial trends that may affect our future operating results, financial position and cash flows are not based on historical fact and are forward-looking statements within the meaning of federal securities laws and regulations. These statements are based on management’s current expectations, assumptions, estimates and observations of future events and include any statements that do not directly relate to any historical or current fact. These forward-looking statements can be identified by the use of words like “anticipates,” “feels,” “estimates,” “projects,” “expects,” “plans,” “believes,” “intends,” “will,” “assumes” and other words of similar meaning. Owing to the uncertainties inherent in forward-looking statements, actual results could differ materially from those set forth in forward-looking statements. We intend these forward-looking statements to speak only at the time of this report and do not undertake to update or revise these statements as more information becomes available except as required under federal securities laws and the rules and regulations of the SEC. Factors that could cause actual results to differ materially from those in forward-looking statements include, but are not limited to, fluctuations in availability and cost of green coffee, competition, organizational changes, our ability to successfully integrate the CBI and DSD Coffee Business acquisitions, the impact of a weaker economy, business conditions in the coffee industry and food industry in general, our continued success in attracting new customers, variances from budgeted sales mix and growth rates, weather and special or unusual events, the impact of global climate change or legal or regulatory responses to such changes, and changes in the quality or dividend stream of third parties’ securities and other investment vehicles in which we have invested our assets, as well as other risks described in this report, and other factors described from time to time in our filings with the SEC.

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Liquidity and Capital Resources

Credit Facility

On March 2, 2009 we entered into a Loan Agreement with Wells Fargo, as Lender, providing for a $50 million senior secured revolving credit facility expiring in February 2012 to help finance the DSD Coffee Business acquisition and for general corporate purposes. The Loan Agreement contains a variety of restrictive covenants customary in an asset based lending facility, including a fixed charge coverage requirement, and it places limits on capital expenditures and dividends. The Loan Agreement allows us to pay dividends at the current rate, subject to certain cash flow and liquidity requirements.

All outstanding obligations under the Loan Agreement are collateralized by perfected security interests in our assets, excluding the preferred stock held in investment accounts. The revolving line provides for advances of 85% of eligible accounts receivable and 65% of eligible inventory, as defined. The Loan Agreement has an unused commitment fee of 0.375%. The interest rate varies based upon line usage, borrowing base availability and market conditions. The range is PRIME + 0.25% to PRIME + 0.75% or LIBOR + 2.25% to LIBOR + 2.75%, subject to a minimum for LIBOR based advances of 3.25%. The interest rate on the Company’s outstanding borrowings was 3.5% at March 31, 2010. Due to the short-term nature of the credit facility and the variable interest rate, fair value of the balance outstanding approximates carrying value.

On May 7, 2010, we entered into a Waiver Agreement with Wells Fargo pursuant to which Wells Fargo agreed to waive our failure to satisfy the fixed charge coverage covenant as of February 28, 2010 and March 31, 2010 under the Loan Agreement. The foregoing description of the Waiver Agreement is not complete and is qualified in its entirety by the actual terms of the Waiver Agreement, a copy of which is incorporated herein by reference and attached hereto as Exhibit 10.9. There can be no assurance that our lender will issue a waiver or grant an amendment to the covenants in future periods, if we require one.

As of March 31, 2010, we were eligible to borrow up to a total of $50.0 million under the credit facility. As of March 31, 2010, we had borrowed $33.8 million, utilized $3.2 million of our letters of credit sub-limit, and had excess availability under the credit facility of $13.0 million. As of May 7, 2010, there was no change in the balance outstanding under the credit facility.

Liquidity

During the first nine months of fiscal 2010 we made substantial progress and nearly completed the integration of the DSD Coffee Business into our existing operations. This broad based effort required SKU optimization, branch and route consolidation, conversion to the Company’s IT systems, including implementation of our mobile sales software across the DSD Coffee Business sales network, and supply chain and manufacturing streamlining and is expected to be completed by the end of fiscal 2010. We currently estimate that total integration costs during fiscal 2010 will be approximately $13.0 million, of which approximately $5.0 million is expected to be capitalized. During the three and nine months ended March 31, 2010, we incurred and charged to expense $1.9 million and $5.7 million, respectively, in integration costs related to the DSD Coffee Business acquisition and incurred and capitalized $0.8 million and $4.2 million, respectively, in integration costs related to the DSD Coffee Business acquisition. During fiscal 2010 we expect to incur approximately $6.8 million in expenditures associated with the installation of two roasters and other production equipment at our Torrance facility and expenditures to replace normal wear and tear of coffee brewing equipment, vehicles, and machinery and equipment. During the nine months ended March 31, 2010, we have capitalized approximately $19.7 million in total capital expenditures. This included $14.2 million for machinery and equipment, including machinery and equipment for the DSD Coffee Business, and $0.7 million for vehicles.

As described above, we maintain a $50 million senior secured revolving line of credit with Wells Fargo. Although we expect cost reductions and other positive synergies from integrating the DSD Coffee Business with our operations, the timing of these improvements is uncertain. We believe this credit facility, to the extent available, and our other liquid assets, provides sufficient capital resources and flexibility to allow us to make investments in the DSD Coffee Business, fund integration costs, meet necessary working capital requirements and implement our business plan without relying solely on cash flows from operations.

Our working capital is composed of the following:

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As of March 31, 2010, we had no material commitments for capital expenditures other than those described above.

Results of Operations

Our net sales in the three months ended March 31, 2010 increased $25.4 million, or 30%, to $111.0 million as compared to $85.6 million during the three months ended March 31, 2009. Our net sales in the first nine months of fiscal 2010 increased $114.7 million, or 50%, to $343.4 million as compared to $228.7 million in the first nine months of fiscal 2009. These increases are primarily due to the acquisition of the DSD Coffee Business. Although our net sales increased and our geographic reach widened, our net sales for the three and nine months ended March 31, 2010 were affected by the economic downturn. We expect that the ongoing weakness in the economy and reduced consumer spending will continue to impact our sales through the remainder of fiscal 2010, particularly in some of the new regions we now serve, for example Michigan and Ohio.

Gross profit in the three months ended March 31, 2010 increased $6.6 million, or 15%, to $49.3 million, as compared to $42.7 million during the three months ended March 31, 2009. However, gross margin decreased to 44% in the three months ended March 31, 2010 from 50% in the comparable period in the prior fiscal year. Gross profit during the first nine months of fiscal 2010 increased $43.7 million, or 39%, to $154.6 million, as compared to $110.9 million during the first nine months of fiscal 2010. However, gross margin decreased to 45% in the first nine months of fiscal 2010 from 49% in the first nine months of fiscal 2009. As with net sales, the increase in gross profit is directly attributable to the acquisition of the DSD Coffee Business. The decrease in gross margin noted above, is primarily due to the increase in total coffee brewing equipment and service costs in cost of goods sold to $6.2 million and $16.6 million, respectively, in the three and nine months ended March 31, 2010, from $2.5 million and $7.1 million, respectively, in the comparable periods of the prior fiscal year and the addition of a new class of DSD Coffee Business customers who require a different mix of products.

Operating expenses in the three months ended March 31, 2010 increased $14.3 million, or 32%, to $58.5 million, or 53% of sales, from $44.3 million, or 52% of sales, in the comparable period of fiscal 2009. Operating expenses during the three months ended March 31, 2010 include three months of expenses related to the DSD Coffee Business operations compared to one month of expenses related to the DSD Coffee Business operations during the same period in the prior year since the DSD Coffee Business was acquired as of February 28, 2009. In addition, $1.9 million in expenses related to the integration of the DSD Coffee Business and $1.7 million in higher pension expense also contributed to the increase in operating expenses in the three months ended March 31, 2010. During the first nine months of fiscal 2010, operating expenses increased $55.0 million, or 47%, to $171.5 million, or 50% of sales, from $116.6 million, or 51% of sales, in the comparable period of fiscal 2009. Operating expenses during the nine months ended March 31, 2010 include nine months of expenses related to the DSD Coffee Business operations compared to one month of expenses related to the DSD Coffee Business operations during the same period in the prior year since the DSD Business was acquired as of February 28, 2009. In addition, $5.7 million in expenses related to the integration of the DSD Coffee Business and $6.3 million in higher pension expense also contributed to the increase in operating expenses in the first nine months of fiscal 2010.

Loss from operations in the three months ended March 31, 2010 was ($9.3) million as compared to ($1.6) million during the three months ended March 31, 2009. Loss from operations in the first nine months of fiscal 2010 was ($16.9) million as compared to ($5.6) million during the same period in fiscal 2009.

Total other income in the three and nine months ended March 31, 2010 was $2.5 million and $11.3 million, respectively, as compared to total other expense of ($1.3) million and ($9.1) million in the three and nine months ended March 31, 2009. These changes were primarily due to improved results from our preferred stock portfolio which recorded net realized and unrealized gains in the three and nine months ended March 31, 2010, as compared to net realized and unrealized losses in the three and nine months ended March 31, 2009.

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Income tax benefit for the three and nine month periods ended March 31, 2010 is primarily attributable to recent federal legislation allowing a five year net operating loss carryback period for net operating losses incurred in tax years ending in 2008 or 2009. This legislation allowed us to claim additional income tax receivable and resulted in an income tax benefit for the three and nine month periods ended March 31, 2010 due to changes in deferred tax valuation allowances.

As a result of the forgoing factors, net loss in the three months ended March 31, 2010 was ($6.6) million, or ($0.44) per common share, as compared to ($1.4) million, or ($0.10) per common share during the same period in the prior fiscal year. Net loss in the first nine months of fiscal 2010 was ($3.0) million, or ($0.20) per share, as compared to ($7.6) million, or ($0.53) per share, in the first nine months of fiscal 2009.

Interest Rate Risk

We are exposed to market value risk arising from changes in interest rates on our securities portfolio. Our portfolio of preferred securities has sometimes included investments in derivatives that provide a natural economic hedge of interest rate risk. We review the interest rate sensitivity of these securities and (a) may enter into “short positions” in futures contracts on U.S. Treasury securities or (b) may hold put options on such futures contracts in order to reduce the impact of certain interest rate changes on such preferred stocks. Specifically, we attempt to manage the risk arising from changes in the general level of interest rates. We do not transact in futures contracts or put options for speculative purposes.

The number and type of futures and options contracts entered into depends on, among other items, the specific maturity and issuer redemption provisions for each preferred stock held, the slope of the U.S. Treasury yield curve, the expected volatility of U.S. Treasury yields, and the costs of using futures and/or options.

As of March 31, 2010, there were no futures or options contracts in place as an interest rate hedge. The following table demonstrates the impact of varying interest rate changes based on the preferred stock holdings, futures and options positions, and market yield and price relationships at March 31, 2010. This table is predicated on an instantaneous change in the general level of interest rates and assumes predictable relationships between the prices of preferred securities holdings, the yields on U.S. Treasury securities and related futures and options.

Our revolving line of credit with Wells Fargo is at a variable rate. The interest rate varies based upon line usage, borrowing base availability and market conditions. The range is PRIME + 0.25% to PRIME + 0.75% or LIBOR + 2.25% to LIBOR + 2.75%, subject to a minimum for LIBOR based advances of 3.25%. As of March 31, 2010, we had borrowed $33.8 million of this amount, utilized $3.2 million of letters of credit sub-limit, and had excess availability of $13.0 million under the credit facility. The interest rate on the Company’s outstanding borrowings at March 31, 2010 was 3.5%.

The following table demonstrates the impact of interest rate changes on our interest expense under the revolving credit facility for a full year based on the outstanding balance and interest rate as of March 31, 2010:

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Commodity Price Risk

We are exposed to commodity price risk arising from changes in the market price of green coffee. We price green coffee inventory on the last-in, first-out (LIFO) basis. In the normal course of business we hold a large green coffee inventory and enter into forward commodity purchase agreements with suppliers. We are subject to price risk resulting from the volatility of green coffee prices. Due to competition and market conditions, volatile price increases cannot always be passed on to our customers. From time to time we may hold a mix of futures contracts and options to help hedge against volatile green coffee price decreases. Gains and losses on these derivative instruments are realized immediately in “Other, net income (expense).”

On March 31, 2010 we had no open hedge derivative contracts, and our entire exposure to commodity risk was in the potential change of our inventory value resulting from changes in the market price of green coffee. The following table demonstrates the impact of changes in the market value of coffee cost on the market value of coffee forward purchase contracts as of March 31, 2010:

Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the SEC. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information we are required to disclose in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosures. In January 2010, we adopted Disclosure Controls and Procedures that included the organization of a Disclosure Committee designed to enhance our process of documenting our compliance with Rule 13a-15(e) promulgated under the Exchange Act. The Disclosure Committee performed its duties as prescribed by our Disclosure Controls and Procedures in preparing this Quarterly Report on Form 10-Q for the fiscal period ended March 31, 2010.