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Executives

Barry Sievert – Vice President, Investor Relations

Gregg L. Engles – Chairman and Chief Executive Officer

Jack F. Callahan – Chief Financial Officer

Analysts

Christopher Growe – Stifel Nicolaus

Alexia Howard – Sanford Bernstein

Eric Katzman – Deutsche Bank Securities

Robert Moskow – Credit Suisse

Eric Serotta – Consumer Edge Research

David Palmer – UBS

Jonathan Feeney – Janney Montgomery Scott

Christine McCracken – Cleveland Research Company

Farha Aslam – Stephens Inc.

[Brian Stalange] of Bank of America

Dean Foods Company (DF) Q1 2009 Earnings Call May 1, 2009 8:30 AM ET

Operator

Welcome to the Dean Foods Company first quarter fiscal year 2009 earnings release conference call. (Operator Instructions) At this time I would like to turn the call over for opening remarks to the Vice President of Investor Relations, Mr. Barry Sievert.

Barry Sievert

We issued an earnings press release this morning, which is available on our website at deanfoods.com. The release is also filed as an exhibit to an 8-K available on the SEC's website at sec.gov. Also available during this call at the Dean Foods website is a slide presentation which accompanies today's prepared remarks. A replay of today's call along with the slide presentation will be available on our website beginning next Friday.

The consolidated earnings per share, operating income and operating margin information that will be provided today are from continuing operations and have been adjusted to exclude the expenses related to facility closings and reorganizations, non-recurring items in order to enable you to make a meaningful evaluation of our operating performance between periods.

The earnings release contains a more detailed discussion of the reasons why these items are excluded from the consolidated results along with the reconciliation between GAAP and adjusted earnings, as well as between net cash flow from continuing operations and free cash flow from continuing operations.

We would also like to advise you that all forward-looking statements made on today's call are intended to fall within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements will include among others disclosure of earnings targets, as well as expectations regarding our branding initiatives, expected cost savings, leverage ratios and various other aspects of our business.

These statements involve risks and uncertainties that may cause actual results to differ materially from the statements made on today's conference call. Information concerning those risks is contained in the company's periodic reports on Forms 10-K and 10-Q and in today's press release. We also announced an equity offering this morning and filed related documents.

Securities law limits our discussion of the offering on today's call including our responses to Q&A. The perspective information discussed during this call assumes the successful completion of the approximately $465 million equity offering. This audio-cast may not be duplicated, reproduced or rebroadcast without the consent of the Dean Foods Company.

With those formalities out of the way, I will now turn the call over to Gregg Engles, our Chairman and CEO, who will offer his perspective on the first quarter, our balance sheet strategies and the commodity environment. Following Gregg's comments, Jack Callahan, our Chief Financial Officer, will review the financial results for the first quarter, as well as comments on the forward outlook. Following Jack, Gregg will make a few closing comments before opening the call up to your questions.

With that, I'll turn the call over to Mr. Gregg Engles.

Gregg L. Engles

Clearly the business was very strong in the first quarter and we're off to a fast start in 2009. Both of our operating segments contributed to the strong results and we continue to move forward on our strategic initiatives. The strong performance across the business growth consolidated adjusted operating income growth of 47% in the quarter. DSD Dairy, which has recently been re-branded Fresh Dairy Direct, contributed to this strong result with operating income growth of 39% over the year ago period.

WhiteWave-Morningstar also had a particularly strong quarter with operating income growth of 40% over the year ago period. With the benefit of lower year-over-year interest expense driven by the deleveraging of our balance sheet, adjusted diluted earnings per share were 126% above last year's results, well ahead of our expectations. By nearly all measures the first quarter was a very successful one and another strong step forward for the business.

Two other notable highlights of the year so far include two tuck-in dairy acquisitions further strengthening our core dairy business. Our pipeline of potential acquisitions continues to be strong. Also in the first quarter we hosted our first ever Investor Day in February where we laid out the strategies that we expect to drive strong results for our shareholders over the coming years. It was great to see so many of you at the event and we appreciate the time that you dedicated to learning more about Dean.

I'm glad we were able to showcase the strategies that we expect to drive our success over the coming years, as well as the deep management talent we've assembled to deliver those strategies. These initiatives are already beginning to play an increasing role in driving our quarter-to-quarter results. In that session in February, we laid out a three-part strategy that will drive our initiatives and investments.

First and foremost, we intend to extend our low cost position by driving efficiency across the supply chain in procurement, conversion, distribution and network optimization. This will be the key area of our focus over the next three to five years. We expect to drive over $300 million of productivity over this time through our specifically identified productivity initiatives.

Second, we intend to drive revenue and profit in our core by strengthening our businesses in their segments and expanding to adjacent areas when opportunities exist. Tuck-in acquisitions like the two we've announced so far this year will play an important role in strengthening our core businesses.

Third, we intend to invest for future growth. We're laying the foundation for future growth through many of the investments that we're making today in areas like R&D, innovation, process standardization and information technology. We're making solid, consistent progress against these strategies in 2009 so far.

As we move forward and continue to communicate the changes in our business, I believe you will see these strategies transform Dean into an even stronger company, further extending our advantaged position in the marketplace. Let me provide you one great example of the progress we're already seeing in the business. As we discussed at our investor meeting, driving the business to further extend our low cost position is our number one goal over the next several years.

We're already making solid progress against this objective. One of the key areas we expect to drive efficiency is in the Fresh Dairy Direct distribution network. Our distribution system is the largest refrigerated direct store delivery network in the country with over 5,800 routes serving in excess of 160,000 locations. We've been rolling out new routing and tracking technologies across the network with a focus on reducing costs and improving service levels.

Although the rollout of these technologies is not yet complete and will continue throughout the year, the initial phase of the implementation has already resulted in the removal of excess routes from the road and more efficient routing. As evidence of this, in the first quarter we reduced the gallons of diesel fuel we used by over 5% versus the year ago period in spite of an increase in total gallons of product delivered. And that tight cost control has extended across the rest of the distribution cost base as well.

Even when excluding fuel, distribution costs per gallon were down slightly on a year-over-year basis, highlighting early benefits of our cost control initiatives in this area. Also playing a role in driving our long-term success are the network optimization initiatives that we discussed at our investor meeting in February. We recently announced plans to close two additional facilities this year in addition to the four that we closed in 2008.

While these were difficult decisions to make, one of these facilities was over 80 years old and another was a less efficient plant in an area where we had more efficient facilities to have available capacity. These facility closures helped to drive capacity utilization across our network and lower our total conversion and distribution costs. We're also driving efforts to improve the productivity of our existing facility network. Improved data and measurement tools are helping to better benchmark our production facilities and identify areas for improvement.

While commodities will always play a role, productivity initiatives like these across our business are beginning to play an increasing role in driving our long-term earnings trajectory. As described at our February Investor Day, we believe we're only just beginning to address these opportunities. While our current focus is primarily on driving to lowest costs, we're also taking advantage of opportunities in the market to drive revenue and profit in our core business.

So far this year we've announced two acquisitions in our Fresh Dairy Direct segment. We've acquired dairy processing facilities in Waukesha and De Pere, Wisconsin, from Foremost Farms and have signed an agreement to acquire Heartland Dairy in California. These acquisitions add over $300 million in incremental annual sales to the Fresh Dairy Direct segment and bring considerable synergies to our existing network.

The pipeline for acquisitions continues to be as promising as I've seen in many years, and we expect to take advantage of what we believe is a unique time in the market by making further acquisitions as we move forward. As we said in our investor meeting, our stated goal is to reduce our leverage to below 3.5 times funded debt to EBITDA, while sustaining reinvestment in the business and allowing the flexibility to pursue additional strategic acquisitions during this unique time in the market.

We're committed to achieving this leverage target, as well as to continuing to strengthen and invest in the business. Traditionally, we have relied heavily on the bank lending market as a source of capital. The total lending capacity of these markets has been greatly diminished over the past year as the banking industry has been under considerable stress. We believe it's prudent to realign our balance sheet and increase capital raised from the equity and debt markets over time.

Additionally, having signed seven transactions over the past year with approximately $125 million worth of deals so far in 2009 and the robust pipeline of opportunities, we want to ensure that we maintain an adequate amount of liquidity to continue to participate in these actions while also delevering our balance sheet.

Turning back to the business, our key dairy and energy commodities were very favorable in the first quarter and clearly bolstered our results. Like other commodities, the dairy markets have declined sharply through the early part of this year. The Class 1 mover has declined from the historically high levels we've seen over the last two years to the lowest price in at least the last 30 years in March.

Prices remain at historically low levels with cheese and non-fat dry milk back near government support prices after a brief rally early in the first quarter. These levels are not sustainable over the long-term and we anticipate rising dairy commodity prices toward the back half of the year. To date however, overall, cow herd reductions have been moderate and have not diminished the U.S. milk supply enough to begin moving dairy commodity prices meaningfully higher.

We continue to believe that farmers will step up their efforts to remove cows and reduce supply as the year progresses. A recent look at estimates from three prominent dairy economists supports this view. The average of the forecast yields a full year average Class 1 milk price of about $12.50 for the year, reaching a high in the mid-14's toward the back of the year.

Our current internal forecast is fairly consistent with this view on average, which is why we remain focused on our longer term strategies to build a financial algorithm that is less exposed to the commodity markets and more dependent on continuous productivity improvements in the business.

We will continue to update you on our progress as we move forward. Looking ahead, as I said, we expect the dairy commodity environment to become incrementally more challenging in the second half of the year. We continue to feel confident about our ability to deliver strong growth in this year and are maintaining an annual guidance target for 2009 of at least $1.55 per adjusted share, representing nearly 20% growth over 2008's earnings.

With that, I'll turn the call over to Jack who will give you more detail on the first quarter's performance, our capital structure strategies, and our forward outlook.

Jack T. Callahan

I'll first discuss the first quarter performance for Dean Foods and our two business segments, Fresh Dairy Direct and WhiteWave-Morningstar. I'll close my remarks with a look at the balance sheet and offer some additional commentary on the outlook for the balance of 2009.

As Greg mentioned, the business is off to a very strong start in 2009. A favorable commodity environment and our efforts to lower costs enabled us to deliver an exceptionally strong quarter. The quarter was also balanced as both business segments performed well. A big part of the story in the first quarter was the decline in dairy and energy-related commodities.

In contrast to the perfect storm of commodity inflation of late 2007 and into 2008, the first quarter of 2009 felt more like the perfect sunny day. Fresh Dairy Direct increased operating profits 39% above year ago levels to $182 million. WhiteWave-Morningstar produced 40% profit growth increasing to approximately $63 million for the quarter.

The modest decrease in sales was driven by the pass-through of lower dairy commodities at Morningstar and slowing branded sales growth at WhiteWave, which I will discuss later. Overall, consolidated adjusted operating income for the quarter increased 47% to $203 million the first time Dean Foods has exceeded $200 million in a quarter.

Below the line, interest expense of $68 million was $16 million lower than the year ago period due to the reduction of over $440 million of debt. This reduced interest expense, combined with our strong operating profits, to drive adjusted diluted EPS of $0.52 which is well more than double last year's performance. Obviously, I am very pleased with this strong start to the year.

Let's take a closer look at the performance of each of the business segments in more detail, starting with Fresh Dairy Direct. Overall, fluid milk volumes continue to outpace competition in the market increasing 1.4% over year-ago levels, solid growth in spite of a difficult calendar overlap, which included one less day due to leap year a year ago and a shift of Easter into the second quarter.

The increase in fluid milk volumes compares to the balance of the industry that was virtually flat in the quarter based on USDA and federal milk marketing order data. Similar with the fourth quarter of 2008, dairy, energy, and packaging commodities were down versus the year ago period. The Class 1 milk price averaged $11.96 per hundred weight 37% lower than the $19.12 average in the first quarter of 2008.

Prices appear to have bottomed out in the near-term hitting the low of $9.43 per hundred weight in March. The Class 1 price in April was set at $10.36, a 10% sequential increase. May's price was set at $10.97 up 6% from April. As Greg discussed earlier, we do expect a trend towards higher prices by the end of the year.

The average CME butter price also declined during the quarter down 26% sequentially from the fourth quarter of 2008 to an average of $1.13 per pound in the first quarter, 10% below year ago levels. This decline in the CME markets also benefited the results of our Morningstar segment. We do expect the butter markets to increase moderately in the back half of the year.

Fresh Dairy Direct operating income was $182 million, 39% above year ago levels. In addition to favorable commodities and continued fluid milk volume growth, the performance of our ice cream business continues to improve as an early success story of our productivity and standardization initiatives. Unit sales of our leading ice cream packages were each up double digits in the quarter over last year.

Another notable highlight in the quarter for Fresh Dairy Direct is the flavored milk category where our volume sales were also up double digits. Our productivity initiatives also played an important role in driving our financial results in the quarter. For example, Greg told you about the solid progress we are making in driving down distribution expense through implementing improved technology and focusing on route efficiency.

Turning to WhiteWave-Morningstar, total sales in the first quarter declined 2% to $604 million. Morningstar sales declined 4% in the quarter to $245 million. This sales decline is primarily the result of the pass-through of declining commodities as volume growth across the Morningstar portfolio was up low single digits.

Solid growth in the retail channel and relative strength in quick service dining was offset by continued weakness in casual dining food service channels. WhiteWave posted net sales that were 1% lower than the year ago period to $359 million. This decline in WhiteWave sales reflects two things.

First, consistent with other packaged foods companies that compete in premium product categories, we are seeing material slowdowns in key categories where we compete. Second, as we've talked about previously, we've exited an unprofitable food service business relationship in the Silk line, as well as the Private Label organic milk business in the U.K. Excluding the impact of these business lines we exited, the WhiteWave portfolio increased sales mid-single digits in the first quarter.

Let me provide a bit more color on category sales trends impacting WhiteWave. For example, organic milk has slowed dramatically. Just six months ago, volume growth in organic milk in IRI measured channels was as high as 30% in certain periods. More recently, organic milk category sales growth has slowed to low single digits in the current 13-week reporting period, consistent with the first quarter of Horizon organic milk sales. Overall, Horizon's share of the market remains stable and is now three times its closest branded competitor.

The soy milk category where our Silk brand is the clear leader with over 75% market share has had flat category sales growth. All in, excluding the food service relationship we exited, Silk sales were up mid-digit singles in the quarter. Ahead of the overall category performance in IRI measured channels aided in part by the continued strength in the Silk white product line.

The flavored coffee creamer category is a notable bright spot in the retail space. Consumers are increasing enjoying their coffee occasions at home and the retail flavored creamer category has been relatively strong as a result. International Delight posted only a slight increase in net sales in the quarter, however we expect our improved packaging and the introduction of a new sub line of innovative products will boast our International Delight's performance over the balance of the year.

In the half-and-half creamer segment, our Land O'Lakes business was particularly strong in the first quarter increasing sales in the high single digits. As a whole, favorable dairy and energy commodities, tight overall SG&A expense control, production efficiencies, and increased volumes at Morningstar drove the combined WhiteWave-Morningstar segment report operating income was $63 million for the quarter, 40% above year ago levels.

Over the balance of the year, we have a pipeline of innovative fresh product introductions that we expect to bring consumer excitement to our business. For instance, in the Silk line we have plans to reinvigorate category growth with increased marketing investments in support of our biggest innovation yet, Silk Heart Health, the first soy milk clinically proven to reduce cholesterol by up to 7%.

In our coffee creamers business, we have launched a redesigned package for International Delight and we'll be bringing a new sub line of coffee house inspired flavors to market in the third quarter. These flavors, which replicate the most popular coffee house flavors, will provide the away from home coffee experience to increasing cost conscience consumers.

In addition, we will execute the national rollout of the Fruit Today products in the second quarter. The trade acceptance of this unique innovate product continues to be very strong and we are excited about our partnership with the Hero Company.

In fresh dairy direct, we are significantly expanding distribution of two very successful regional products, Swiss Tea branded refrigerated tea and Over the Moon Milks, which are fortified with extra protein to offer the same taste and feel of whole milk in a low fat formula. Overall, we are very excited with this line up of new and updated product offerings and we intend to maintain a steady stream of product news to the market.

Now, let me discuss corporate and other costs which increased 11.5% over last year to $42 million in the quarter. This includes the Hero joint venture investment of $1.7 million in the quarter. Excluding the Hero operating costs, corporate expense increased approximately 7% in the quarter primarily due to higher professional fees, increased employee related expenses, and transaction related costs.

It is important to note that due to a change in accounting rules, transaction costs are now required to be expensed to the P&L beginning this year versus the historical practice of capitalizing the cost within deal. For the quarter, almost $3 million of transaction costs hit the P&L that would have been capitalized in the past.

With the robust pipeline of potential acquisition opportunities, our forward outlook includes expectations for significantly increased transaction related expenses over the balance of the year. However, it is hard to precisely predict how these costs will impact the P&L from quarter-to-quarter giving our ongoing acquisition activity.

Over the balance of the year, in addition to these transaction costs, we expect corporate expense to be higher as we continue to invest in strategic initiatives. Our strong performance is leading us to selectively accelerate a number of specific investments.

Now, I'd like to discuss the very strong cash flow performance and our continued focus on deleveraging the balance sheet. The business continues to generate strong cash flow driving continued deleveraging of the balance sheet. Free cash flow from operations in the first quarter was $143 million. Capital expenditures in the quarter were $42 million. We expect this level of spending to pick up over the balance of the year as we continue to invest in the business and to drive long-term productivity. We expect full year 2009 capital expenditures to be approximately $300 million.

Now let me review current debt levels. As of March 31 total outstanding debt stood at under $4.4 billion down close to $1 billion from our peak level in the third quarter of 2007. Our leverage ratio of funded debt to EBITDA, as defined by our credit agreement, declined to 4.45 times at quarter end. Notably this is the below the final year end 2010 final required step down to 4.5 times. We remain focused on deleveraging the balance sheet and are targeting a leverage ratio below 3.5 times funded debt EBITDA over the long-term.

This year we have just over $300 million of scheduled amortizations and maturities. We plan to use free cash flow, proceeds from the offering announced today, and borrowings under our $1.5 billion revolving credit facility as necessary to meet our scheduled maturities over the coming year. As of the end of the first quarter, we had a $1.3 billion available under our revolving credit facility and $178 million available under our receivable securitization.

As we discussed at our investor event in February, we believe reducing our overall leverage to a target below 3.5 times will better align our capital structure with the public debt markets and equity investor expectations. We've already made great progress here reducing our debt levels by nearly a $1 billion since the third quarter 2007, and reducing our debt-to-EBITDA ratio below 4.5 times.

We also need the balance sheet flexibility to continue to pursue attractive acquisitions like the five we closed last year and the two we have already signed so far this year. The two deals in 2009 bring in over $300 million in revenue for an aggregate purchase price of roughly $125 million. Furthermore, our pipeline potential deals remain strong and perhaps even a bit more robust than we last talked to you. It is clear that we need to consider the broad range of financing alternatives to continue the build out of Dean Foods.

To conclude my comments, we have significant momentum in our business with an exceptionally strong first quarter behind us and indications of a solid start to the second quarter. We are expecting adjusted diluted earnings to be at least $0.38 per share for the second quarter. However, I must remind you that deal related costs, which now need to be expensed to the P&L, may impact quarter-to-quarter results.

For the full year, flowing through some of the upside from the first quarter we are maintaining our guidance of at least $1.55 of adjusted earnings per share, which is approximately 20% EPS growth over 2008.

With that, I'd like to thank you for joining us today and turn the call back over to Gregg Engles.

Gregg L. Engles

Before we open up the call to your questions, there is one more item I'd like to address today. Our proxy was filed recently and we're seeking an amendment to our 2007 stock incentive plan to continue to align employee interest with shareholders. Shares available under the plan are less than what is needed to cover one year's growth. We're asking that you vote to approve the amendment, which would provide enough shares to issue equity incentive awards for approximately one year.

As you've seen, we spent the last few years recruiting what I believe to be one of the most capable management teams in the CPG industry. This new executive team is in the process of building out their organizations beneath them. These critical employees and teams will determine our success as we move forward. We have embarked on a major transformation of our company, which we expect to deliver significant value over time to our shareholders. This transformation will require singular focus from our people.

Our compensation practices are a vital tool to align our senior leadership team with our transformation agenda. We've recruited an entirely new management team at Dean over the last few years to drive our transformation agenda. Over that time the equity markets have performed poorly and as a result over 1/3 of our option holding employees and 2/3 of my executive management team is entirely underwater on their equity grants.

It is vital during this time that we have the ability to properly incent or reward our employees at a level that is competitive in the industry, as well as continue to attract new talent of the highest quality to our company. If the amendment is not approved, we will forced to materially realign the compensation program of our top 540 people, perhaps negatively impacting our free cash flow and losing much of our ability to align management interest with shareholders. I urge you to vote as our Board of Directors recommends in favor of the amendment in your proxy.

If you need more information about this proposal, please contact Barry Sievert in our Investor Relations department. This is important to Jack and me, and we intend to devote several days before our upcoming shareholders meeting talking with our leading investors to be sure we can address any questions you may have and gain your support.

Let me summarize the quarter. We had a very strong first quarter and the business carried significant momentum into the balance of the year. The accumulating benefits of our strategic growth initiatives in a favorable commodity environment yield a significant upside in the first quarter. Both business segments are performing extremely well.

We continue to deleverage the balance sheet, while also continuing to build the company for the future through the attractive acquisition opportunities we're seeing in the market and the strategic investments that we're making. The first quarter upside and strength of the business lead us to believe we will grow adjusted diluted earning per share by nearly 20% this year, while continuing to invest in our transformation initiatives and reorder our balance sheet. We are very appreciative of your support as shareholders and look forward to speaking with you again soon.

With that, I'd like to thank you for joining us on this morning's call and for your interest in Dean Foods. I'll now turn the call back over to Barry Sievert for some brief instructions before opening the call to your questions.

Barry Sievert

As a reminder, securities laws limit our discussion of the equity offering on today's call. However, all perspective commentary on today's call assumes the successful completion of the approximately $465 million offering. We will not be able to answer questions related to the offering during today's Q&A session, but look forward to taking your questions related to the first quarter results and our go-forward strategies. Also, we would ask that you please limit your questions today to one question and perhaps one follow up question.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Chris Growe - Stifel Nicolaus.

Christopher Growe – Stifel Nicolaus

I want to ask a question, back at the Analyst Day you did talk about the increasing challenge of using bank debt and clearly there was no discussion of equity. I'd just be curious if something changed because it seems that you've got enough revolver facility, enough receivable securitization it would seem like, to handle these deals coming up. I'm just curious for your perspective on that.

Gregg L. Engles

Well, look we've got an ample revolver available to us today. But, we also have to plan for the expiration of our existing bank deal. And the reality of the markets today are such that we do not have confidence that we could refinance the full amount of bank financing revolver and term loans that we have today into the bank market of the future. Bank capacity has simply diminished greatly.

We're, therefore, going to have to move some of that capital into other market places as we move forward, and over that time period we're also going to have to delever. We believe we should delever into the 3.5 times EBITDA range. So, when you put that all together, you're going to have to have a variety of funding sources over time to replace this bank financing. And equity capital is a necessary component of that in our view.

Christopher Growe – Stifel Nicolaus

Okay. And I then, if I could ask you just one business related question then regarding WhiteWave and the profit increase there was quite strong. And I guess, I had built in some investments there for the GAV, and which I know are now are in corporate. But looking at the underlying businesses was most of the drive in operating margin or EBIT growth from Morning Star because of the benefit from lower input costs or I mean can you talk about maybe how much WhiteWave contributed to that as well, from the [inaudible].

Jack F. Callahan

It was a little more weighted towards Morning Star. But, maybe 60/40, Morning Star verses WhiteWave, but both businesses had very strong flow through on their businesses. Morning Star did benefit with some solid volume growth and improving commodity input cycle verses what we had seen in 2008, and WhiteWave had some very strong flow through particularly on their SG&A line.

Operator

Your next question comes from Alexia Howard - Sanford Bernstein.

Alexia Howard – Sanford Bernstein

We've noticed in the measured channel data recently that there's been a reversal of the share trends between branded and private label in fluid milk. Could you talk about how that's running year-on-year at this point and maybe what it looked like, verses what it looked like in 2008?

Jack F. Callahan

Yes, the branded conventional fluid milk market struggled tremendously over 2008, across the board. Virtually all regional brands, ours and competitor regional brands, driven by the consumers desire for value and our customers, our retailers, desires to highlight value for their customers. So private label significantly took share in 2008. And, we see that continuing in 2009, but at a decelerating rate. So, as price gaps have narrowed, as milk prices have come in, we're seeing some deceleration, but the trend has definitely not stopped. The consumer out there is definitely looking for value.

Alexia Howard – Sanford Bernstein

So, we're still seeing year-on-year mixed shift into private label to look at it that way.

Jack F. Callahan

Absolutely

Operator

Your next question comes from Eric Katzman - Deutsche Bank.

Eric Katzman – Deutsche Bank Securities

One question with one follow-up, okay, I guess the first question has to do with kind of the efficiency gains that you're getting verses what is, I assume, the close to dilutive impact of the struggling dairies that you're buying. I guess how do we judge the efficiency that you're generating internally verses the offset of a stronger pipeline? And how, I guess, Gregg, how do we kind of look at that in terms of your, your willingness to kind of stick with the roughly mid-teens kind of EPS target as you kind of balance the two?

Gregg L. Engles

Well, let me address the pipeline first on the conventional dairy side. I think your observation, implicit in your question, is largely correct that many of the conventional dairy properties that we're seeing in the market and that we've seen over the last year or so have been struggling entities. And so the acquisition of those entities often is not immediately accretive to our earnings.

The flipside is that the purchase price for those entities tends to be quite moderate. However, over time we believe, and it's based on a tremendous amount of experience in acquiring conventional fluid dairies over time, that we can move those margins to our margins by operating those properties better and integrating them into our existing network.

So make no mistake about it, we believe that over the intermediate term, those dairy acquisitions are significantly accretive to our performance in the fresh dairy direct segment. The issue of our compound earnings growth rate, and I'm going to say it that way because it is important for you to remember that our earnings growth rate expectations and guidance are compound rates and not discrete year-to-year rates.

So, we feel confident in the long-term earnings growth guidance that we gave you at Investor Day of sort of double-digit EPS growth rates. The implication of that is that years where we have very high earnings growth rates won't always be followed by years where we have very high earnings growth rates. We showed you a chart at that Investor Day that showed our EPS oscillating around a rising trend of double-digit EPS growth. We believe that is in fact the sort of earnings progression that you will see over time.

Eric Katzman – Deutsche Bank Securities

Okay, my follow up has to do with this incentive plan. I guess, just so I understand it, you're saying that 57% of the key employees their options are under water and you want to kind of like, in essence, reset that?

Gregg L. Engles

Oh, absolutely not. No, no, no. What we are saying is, our long-term incentive plan, our stock option plans, are important to the compensation scheme that we have at Dean Foods. We go to our shareholders they have to approve the shares available for grant to our employees.

We are out of options in the plans that have been approved by our shareholders, and if we are going to make grants in the normal course next year, we have to re-up that plan. That's all we're saying. The commentary about being underwater is just to highlight the importance of the plan going forward. There's absolutely going to be no reset, no re-pricing, no amendment to prior grants.

Operator

Your next question comes from Robert Moskow – Credit Suisse

Robert Moskow – Credit Suisse

Greg and Jack, is this the last equity offering you're going to do? You have more maturities coming up in 2010 and 2011.

Gregg L. Engles

Well, let me just say this, Robert. This puts us on a path to, by the end of 2010, be below that 3.5 times debt to EBITDA test or threshold, which we believe is important to the ultimate refinancing of our facilities that begin to mature at the end of 2011. So, all things being equal, that puts us in a very good position. I don't think I can make an unequivocal statement around what our capital raising activities will be because I frankly can't tell you what M&A activities are going to look like.

Robert Moskow – Credit Suisse

But if the underlying business performs up to your expectations over the next year or two, it's not like more earnings [beats] will be met with more equity raises. It's just this is the step you're doing to get more in line with what your 3.5 target is.

Jack F. Callahan

It's consistent with that long-term strategy of getting to 3.5 times and not associated with a good quarter.

Operator

Your next question comes from Eric Serotta – Consumer Edge Research.

Eric Serotta – Consumer Edge Research

First, wanted to touch upon the pacing of your investments this year, Jack, you made a comment that the favorable environment has allowed you to accelerate some of those investments. I'm wondering did any of the acceleration of those investments occur in the first quarter. Where was your overall investment level in productivity programs and the like in the first quarter relative to the year ago period?

Jack F. Callahan

There was some investment versus year ago as was built into our plan, but there was not a lot of what I would classify as sort of out-of-plan investment in the first quarter. We are considering to have made a couple selective decisions in places to step up our investment. It will largely flow through corporate expense. It is considered in our full year outlook, and we are selectively using this very strong operating performance to accelerate a number of discreet initiatives.

Eric Serotta – Consumer Edge Research

You talked about some of these decisions being sort of in-progress. Is that more of a second half event or second quarter that we should see the investments?

Jack F. Callahan

I think it should start to step up over the balance of the year.

Gregg L. Engles

Including some in Q2.

Eric Serotta – Consumer Edge Research

And Greg, wondering whether you could give us a little bit of perspective as to why you think the dairy herd liquidations and reductions in milk production have been less than what many market observers have been looking for?

Gregg L. Engles

I'll give you two perspectives on that. First of all, I think the market under appreciates how much a fixed-cost business dairy farming is. So, while you may look at the total cost of producing a hundred weight of milk as, let's say, $11.00 or $12.00, the incremental costs of adding a cow to your farm or keeping a cow on your farm and producing the last hundred weight of milk is meaningfully less than that, much, much less than that.

So, I think farmers are making their decisions over the near-term on the marginal economics of producing a hundred weight of milk. And I don't think at the levels that we're seeing today, we're below the marginal cost of production. Right, so farmers in fact lower their profitability by shrinking their herd at these price levels.

And particularly, as they look at the forward curve as to where price levels are going over the next few months, they're saying I'm going to hang on and have a bigger business when prices move up than if I reduce the size of my herd, because, growing the size of your herd is a difficult exercise, right? You have to produce a cow. Getting rid of a cow is a lot easier and a lot faster than producing a cow. So, that dynamic I think is less well-understood than it needs to be in the industry.

I think there is another factor which is the details of the CWT auction have not yet been ironed out, what the level of the bid is going to be. And I think that is causing people to sit on the sidelines to some degree, waiting to see what the CWT bid is going to be before they decide whether to just reduce their herd or tender into the bid. So, I think those two factors are driving the stickiness of the herd on the downside.

Operator

Your next question comes from David Palmer – UBS.

David Palmer – UBS

The question that will maybe help us with the model, and then a follow-up, how much of your profit growth do you think, or if you want to describe it another way like basis points, was driven by the sequential move-down in dairy prices?

In other words, did you have a significant lift from having a lag in your prices passed along versus the input cost relief, or is this simply just the shrink costs that we've talked about in the past? So put another way, will your year-over-year gross profit increases diminish if prices just simply remain at these low levels?

Jack F. Callahan

On the commodity side, David, I probably would put it into two different areas. I think, as you correctly point out, there is what I would classify in the first quarter of 2009, particularly when compared to the first quarter of 2008 which was still very challenging, we would have what I would call maybe sort of recovery normalization of sort of profit growth from two things.

One, the sale of our excess cream, which a year ago was largely close to breakeven, this year it's back to making what I would classify as more as its normal profit contribution. So, on a go-forward basis it probably won't be as great a contributor to growth, and a little similar to shrink. Shrink is not quite the drag this quarter as it was a year ago. Again, but that started to normalize on a run rate basis as we went through '08.

So, we're back to what I would classify as more normal levels, particularly in terms of excess cream sales, and it won't contribute quite as much to growth going forward. The other commodity input that was significant though, beyond just the dairy cycle, was some of the declines in the oil-related commodities, particularly diesel fuel.

Gregg L Engles

Yes, I think, David, to really understand what's going on here and to think through the model, you have to look you really have to start looking beyond the milk commodity. I'm not going to say that milk is not important, it is. But, it is I think less important than the external community views it as being. So, by that I mean we, as a company, are highly efficient at passing along to our customer's changes in raw milk, both on the way up and on the way down.

So, while there is some compression month-to-month or expansion month-to-month as the milk price changes that washes out as soon as the trajectory of milk stabilizes. So, in this quarter we had a big drop in January, but then milk stabilized in February and in March. Following that dropping, you see the effect of milk kind of wash out in the quarter.

But what the quarter, the last two quarters, really highlight is first of all, the tremendous cost pressure we had as the entire commodity complex rose and started doing strange things in 2007 and 2008, so not just milk, but energy, packaging, ancillary food inputs, sugar, electricity, all of those things putting tremendous pressure on the P&L, and then in Q4 and Q1 those pressures reversing and abating, right. So those are the things driving the P&L over the last three or four quarters if you go back and you look at.

The other thing that Jack mentioned, which is something that really only 2007 and 2008 would have highlighted, is the importance of the traditional relationship between the cost of milk protein or non-fat dry milk and the cost of fat. And the traditional relationship between those two components of milk is such that fat is the higher value component than non-fat dry milk.

And that heavily influences the recovery that we get from all the cream that we sell into the market place. And when that relationship got inverted in the back half of 2007 and the first two or three quarters of 2008, that had a material negative impact on our margins. That relationship has returned to normal. That is helping refill the profit pool at the company.

And as long as that relationship remains normal, which the excursion from normal has been a very brief period during a very long period of time, you'll see the sort of profitability related to that that you've seen in the last couple of quarters, right, so it's a meaningful impact in our profit algorithm.

I think the bottom line that you should take away from this is great pressure on the P&L starting in mid 2007 and continuing through the third quarter of 2008, underlying that excellent work and progress on the underlying cost structure and management infrastructure of the business. As those cost pressures have abated, you are seeing that substantial improvement in our management and understanding of the basic business and our focus on our costs flow through the bottom line.

Operator

Your next question comes from Jonathan Feeney – Janney Montgomery Scott.

Jonathan Feeney – Janney Montgomery Scott

Gregg, I wanted to ask a bigger picture question. You made an excellent point I think about the fixed versus variable cost of the farm producers, but we've learned from time to time that's somewhat true of the dairy processors as well.

And I think as you embark on this long-term improvement of your economics through higher returns, it seems to me if volume growth is flat due to sort of the demographic pressures against them, just talking about fluid, I guess newly renamed Fresh Dairy business here, you'll be pushing on a string if you're continually improving your return yet competitors are getting pushed further and further into their sort of less efficient operations and it was a tremendous story when it worked, when you were able to buy more things and make them more rational by actually taking out capacity.

How are you going to deal with over the long run that continual pressure of less efficient competitors maybe losing market share as you out execute them and then under pricing you down to the point their margins are flat to negative? How is Dean sort of going, I'm talking five, ten years, maintain the growth given that competitive dynamic?

Gregg L. Engles

Well, I guess first of all the observation that I'd make is that it's the other guy who has really got to deal with, right, I'm going to serve it up and they're going to get to deal with it. I think the way that they deal with it is I guess the punch line to the herd reduction question is, in many ways herd reduction comes from farmers exiting the business, right, when the marginal cost game runs its course. And that's what you're seeing happening in the fluid dairy segment, right.

There are fluid dairy processors out there we bought five of them last year. We've entered into a couple of transactions this year. And in many cases, it's not in every case, but in many cases the strings just run out on how far they can go because they're not getting their cost structure down and building their capabilities to the point where they can survive and thrive in the marketplace. And it has a consequence that you're pointing out of the occasional episode of highly unsustainable behavior in a marketplace over time, but that story always has a pretty similar ending.

Jonathan Feeney – Janney Montgomery Scott

Just as my follow up, I know you've made some acquisitions, but is this financing environment caused anybody who may have had a situation like brewing for some time now to exit the business? Have you heard about that? Are people close to exiting the business? I mean what's the chatter out there?

Jack F. Callahan

I think while we're seeing maybe perhaps more opportunities to day than two years is it's been really a series of two shocks. First it was the commodity shock that started in 2007 and as maybe they're starting to get a little bit a recovery there, they're hit with this financing shock in both in terms of access to capital, which we think also is creating some [inaudible] out there. So I think it's the combination of the two over a sustained period of time I think has led to some situations where people are considering other options.

Operator

Your next question comes from Christine McCracken – Cleveland Research Company.

Christine McCracken – Cleveland Research Company

Just if you could provide a little bit more color around the competitive environment in organic milk and you talked about the low single-digit growth that you guys saw, obviously. I'm wondering if you could just provide a little more color in terms of how much of it was volume versus price?

Jack F. Callahan

There has been a step up in pricing on all the branded players versus certainly the year ago period so some of the sales growth is price related. Right now the branded players are all around that same approximately $4 half gallon pricing, are all out there about the same level. And it's really sort of the branded players versus private label right now, and our branded share has remained within that very stable.

Christine McCracken – Cleveland Research Company

Just as a follow-up then, in terms of what you're seeing in that competitive environment, is private label gaining share similar to what we're seeing kind of in the traditional conventional milk category?

Gregg L. Engles

Absolutely, private label has gained share over the last year in organic milk. Horizon has largely held its share and the other brands have suffered share declines. So I think our view of this business as [Joe Scalzo] said in February, is that this category is moving to resolve itself really to one significant branded player, Horizon and private label.

Operator

Your next question comes from Farha Aslam – Stephens Inc.

Farha Aslam – Stephens Inc.

Could you just share with us the difference in profitability between branded retail, private label retail and food service in your DSD Dairy business?

Jack F. Callahan

Within our DSD business?

Farha Aslam – Stephens Inc.

Within DSD.

Jack F. Callahan

Farha, I think we'd have to get back with you offline to try and give you a real meaningful accurate information on that.

Gregg L. Engles

Yes, we don't have it at the tip of our tongues.

Jack F. Callahan

Our information systems are really built up around a lot of the legacy business units, which were acquired over a period of time, so we can give you great insight as to particular profitability in a certain region, but this sort of product mix on a nationwide basis is sort of a project that we're working on right now and we're not quite all the way there.

Farha Aslam – Stephens Inc.

So could you breakdown sales in terms of acquisition, price mix versus volume growth in each of your two divisions?

Gregg L. Engles

The Q was filed this morning. It's broken out in fairly fine detail.

Farha Aslam – Stephens Inc.

Okay that's in the Q?

Gregg L. Engles

It was filed this morning so it's out there.

Farha Aslam – Stephens Inc.

And then my final question is with these acquisitions are you basically saying that you're seeing some sort of capitulation in competition in that DSD Dairy versus the intense competition you were facing about a year ago?

Gregg L. Engles

I wouldn't describe it that way broadly, Farha. I would just say that capitulation or the decision to exit the business is a unique decision for any given player. There are clearly players that are exiting the business. Back to Jack's comment, they've been hammered by the very difficult commodity input environment that we had up through Q3 of last year and then coming out of that facing an extraordinarily changed and difficult financing environment.

So there are definitely players out there who are who decided an exit is better than the alternative, but I wouldn't make a sweeping comment about the rest of the industry. There're still strong capable fluid milk players out there that we compete against all across the country.

Operator

Your last question comes from [Brian Stalange] of Bank of America.

[Brian Stalange] – Bank of America

I guess just a follow-up on Jon Feeney's question regarding M&A. In terms of pacing, I mean I understand fixed cost structure and financing might hasten the pace of M&A or move some the marginal players out. I guess the cost environment getting better I would think that might cause some players to pause only because now their cost structure is looking a little bit better.

Is there anything else that might hasten the pace including like taxes moving up potentially? I'm just trying to get a sense for whether or not there's something else that's driving maybe a more accelerated window in terms of getting potential sellers motivated to sell sooner?

Jack F. Callahan

Well, again the motivation of sellers is as numerous as sellers themselves, so all these guys have somewhat different perspectives on it. But let me give a little different take on margins expanding. If you were close to the precipitous in 2007 and in 2008, you really didn't have anything to sell but you saw the possibility of it going to zero. All of a sudden your margins expand and now maybe you do have something to sell and that causes you to think, boy maybe it's better to consider a sale in this environment than in an environment where I can't show a buyer any profitability.

Particularly in light of a world in which you've seen rules of thumb go out the window and traditional paradigms of managing and running these businesses start to change very rapidly. So, I can't speak to the individual motivation of everybody out there who's thinking about this, but I'll just tell you this, there're an awful lot of people thinking about it.

[Brian Stalange] – Bank of America

Okay. And just if I can one last follow up to that is it fair to say the level of capital you might need to put into some of these acquisitions, some of these properties may be higher than what you had to do in the past? Maybe there hasn't been as much maintenance CapEx done to these properties or is that not right?

Jack F. Callahan

Yes. I mean in some circumstances that's right and in some circumstances it's not. Again, they're all unique and the amount of capital that's required is a function of both of the assets that you're buying, but also how they fit into your broader network of assets that's around these properties.

Operator

That concludes the question and answer session today. At this time Mr. Engles, I will turn the conference back over to you for any additional or closing remarks.

Gregg L. Engles

Well, thank you all for joining us on the call this morning. We appreciate your attendance and your very good questions. We will look forward to talking to many of you on the road show over the next few days as we get out and talk to the marketplace. And we will look forward to talking to again at the time of our annual meeting and for our next quarterly conference call. So thank you again. We appreciate your interest in Dean Foods and we look forward to speaking to you soon.

Operator

Ladies and gentlemen that concludes today's call. Thank you for attending.

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Source: Dean Foods Company Q1 2009 Earnings Call Transcript
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