Analysis Fazenda Diamantina (FD)

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EXECUTIVE SUMMARY

Bruna and Heitor (BH) entered into coffee farming with no previous experience. Fazenda Diamantina (FD) has suffered as a result; cash management was not properly done, diluting owner’s equity and subtracting reserves for future volatility. Nonetheless, the tailwinds of the market are helping FD in regaining profitability. Upon the perspectives of market growth, positive exchange rate trends and coffee prices, I recommend BH to keep investing in EGS and the farm, learn and amend previous management mistakes, and prepare for the future.

Three other options have been assessed. (1) Selling half of their stake to a fund that we already suspect is under greenwashing policies, which is a bad option since BH would lose control over the farm, so EGS standards cannot be guaranteed, and they would not resolve their stability issues for their family. (2) Selling the whole farm, even if it is a better option, it can also be done in the future, BH would recover the investment, yet they would abandon their dream. Being not a bad option for the family, selling the farm is not as good as re-invest and continue with the business from Sao Paulo or Rio. (3) Continue in the business without EGS, even if more profitable, goes against the main objective of the project, thus it has also been discarded.

The weakest points of the decision are the financial risk exposure to external threats, mainly, volatile coffee prices and exchange rates, and the little experience of BH in the coffee market.

First of all, I recommend strengthening the financial status of FD by building a cash cushion of at least 30% of revenues to make front the volatility of the market. Furthermore, the farm should join Fairtrade. Not only Fairtrade guarantees a minimum price of coffee, but also it helps small farmers in hedging strategies against exchange rates. BH shall explore if hedging in the hand of Fairtrade could be a feasible option for them in the short or medium term.

Secondly, I recommend containing the level of investment in EGS. This means conducting a modest investment in the new offices, plus a small business structure, equivalent to 1 million $R investment and 550k $R operating expenses. The ROI on EGS is negative (-1.36 million R$ NPV 5 years, 15% dr), yet it is considered necessary to comply with EGS and BH family needs.

Thirdly, I advise BH to invest in training themselves to be able to compete in the market. They need further knowledge in financial management, hedging mechanisms, and the coffee business.

At last and most importantly, BH should plan the transition to the office management, hiring and shadowing new personnel and review the financial performance of Fadenza Diamantina quarterly. If they detect that the farm could not be financially sustainable at a given point, they should seek support from other business partners or reassess the selling option.

I consider that the current market context is favourable for FD, they should seize this opportunity to build the pillars that will sustain the business upon headwinds. In a realistic scenario, see Exhibit 4b and 4c, the business is profitable with net margins ranging between ~10-20%. As far as I am concerned, this option is the best solution to fulfil Bruna’s and Heitor’s dream, whilst granting stability to their family, since they will not require to live in Diamantina half of the year.

Analysis of the problem

The coffee farming market is very competitive with plenty of small farmers, 80% of the market, with low bargaining power, which negatively affects profitability. Furthermore, profitability is heavily driven by coffee prices set in US and exchange rates, against which small farmers cannot hedge. Coffee prices are very volatile, prices can drop or rise at will in the order of 20-40% per year, ranging between 0.5$/lb and 3$/lb, based on environmental factors and production. This introduces high uncertainty regarding future revenues and profitability, see Exhibit 1.

BH entered into the coffee market, where they had no previous experience, and FD has suffered as a result. They invested strongly from the offset on ESG and left little cash to make front volatility, 75,000 R$ in 2017 (see Exhibit 4b). Coffee prices drop in the following years, forcing a dilution of Owners' Equity by 20%, which injected cash but at a high price in terms of equity with an estimated loss of 1.4 million R$ (see Exhibit 4b).

Regarding the P&L, in 2022 net income was 25% over revenues, from -15% in 2019, yet improvements were not attributable to the operations of the farm, but rather external factors. EBITDA improved from 14% to 46% for the same period.

Coffee prices and exchange rates improved in 2021 and 2022, and BH manage to recover profitability. However, they paid dividends, decapitalizing the company, which reduces its capacity to make front the market inherent volatility. Currently, cash represents only 7% of the revenues, which may not be sufficient upon a significant drop in prices or exchange rates (see Exhibit 1 and Exhibit 2). Analyzing the balance sheet, A/R are approximately 15% of sales, and A/P 10% of expenses, although A/R are more than double than A/P in absolute values, it is unlikely that  BH could push to get extra cash from A/R or A/P.

From an operational perspective, it seems difficult that BH could reduce operating expenses, whilst keeping ESG, and abandoning ESG is strongly against their values^[1]. Furthermore, ESG coffee can be marketed at a fairer price closer to US set prices. The farm is already selling 5% to the Finish market, and there are opportunities to grow this number in the short-term, which may boost the sales up to 10% in the next 5 years (see exhibit 4a).

From a personal perspective, BH felt much more fulfilled in their lives thanks to the project, yet it required their presence half of the year and it was an issue for their children.

In this context, BH had to decide what was best for the family, whether to continue with the farm, and if so, how; including the approach to EGS certification, Fairtrade or Rainforest.

Decision criteria

After the analysis, I have concluded that there are three main drivers for the decision on the future of FD on which BH shall focus:

1. The economics and financial sustainability of the farm (Business and economics)
2. The life plan and stability for Bruna and Heitor’s family (Family)
3. The fulfilment of BH lives on their contribution to a more sustainable world (Values)

Analysis of the alternatives and decision

BH have the following opportunities on the table to decide upon the future of the farm:

1. Selling the whole farm, net of debt, for 30 million R$ to a large agricultural group. This would result in a return of 9 million R$ plus the over 2R$ million already collected.
2. Selling a farm’s major stake to a financial fund, which would reduce their ownership to 27.5% and they would receive a fair compensation of 250,000R$ for 5 years plus 4 million R$. Nonetheless, the fund seems to do greenwashing.
3. Keep investing in ESG until attaining sustainable profitability, which may require extra investment, increasing the risk, but would allow them to operate the farm from Rio or Sao Paulo, solving their concerns on their family.

As a fourth option, the farm could steer away from ESG to attain further profitability, yet this has been discarded since it goes against the owners’ values.

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