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Dean Foods (NYSE:DF)

Q3 2013 Earnings Call

November 12, 2013 9:00 am ET

Executives

Barry Sievert - Vice President of Investor Relations

Gregg A. Tanner - Chief Executive Officer, Director and Chairman of Executive Committee

Chris Bellairs - Chief Financial Officer and Executive Vice President

Analysts

Matthew C. Grainger - Morgan Stanley, Research Division

Ryan Oksenhendler - BofA Merrill Lynch, Research Division

John J. Baumgartner - Wells Fargo Securities, LLC, Research Division

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Christopher R. Growe - Stifel, Nicolaus & Co., Inc., Research Division

Farha Aslam - Stephens Inc., Research Division

Alexia Howard - Sanford C. Bernstein & Co., LLC., Research Division

Eric R. Katzman - Deutsche Bank AG, Research Division

Amit Sharma - BMO Capital Markets U.S.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Robert Moskow - Crédit Suisse AG, Research Division

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

Operator

Good morning, and welcome to the Dean Foods Company Third Quarter 2013 Earnings Conference Call. Please note that today's call is being recorded and is also being broadcast live over the Internet on the Dean Foods corporate website. This broadcast is property of Dean Foods. Any redistribution, retransmission or rebroadcast of this call, in any form, without the expressed written consent of the company is strictly prohibited.

At this time, I would like to turn the call over for opening remarks to the Vice President of Investor Relations, Mr. Barry Sievert. Please go ahead, sir.

Barry Sievert

Thank you, Glen, and good morning, everyone. Thanks for joining us on our third quarter earnings conference call. This morning, we issued an earnings press release, which is available on our website at deanfoods.com. The press release is also filed as an exhibit to a Form 8-K, which is available on the SEC's website at sec.gov. A slide presentation, which accompanies today's prepared remarks, is also available during this call at the Dean Foods website. A replay of today's call, along with the slide presentation, will be available on our website beginning this afternoon.

Throughout today's call, the earnings per share, operating income, interest expense and free cash flow information that will be provided are from continuing operations and have been adjusted to exclude expenses and other gains or losses related to facility closings, reorganizations and realignments, asset write-downs, litigation matters, integration and separation costs and other nonrecurring items, including the disposition of our remaining investment in WhiteWave common stock, the Morningstar divestiture and those related to our former subsidiary, The WhiteWave Foods Company.

In addition, certain pro forma adjustments were made to our 2012 results to reflect transactions between our former segments under our current commercial agreements that went into effect upon the completion of the WhiteWave IPO in October 2012, rather than under the intercompany agreements that were in effect throughout the majority of 2012.

We also would 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 anticipated cost savings, leverage ratios, network optimization plans, our planned dividend policy, our pending debt tender offers, anticipated share repurchases 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, as well as in today's earnings release.

Participating with me in the prepared section of today's call are Gregg Tanner, our Chief Executive Officer; and Chris Bellairs, our Chief Financial Officer. Gregg will start us off with a review of our third quarter performance. Chris will then offer some additional perspective on our financial results before turning the call back to Gregg for comments on the forward outlook and other closing remarks. We will then open the call to your questions.

With that, I'll turn the call over to Gregg for his opening remarks. Gregg?

Gregg A. Tanner

Thank you, Barry, and good morning, everyone. Thanks again for joining us on the call today. Today, we reported third quarter adjusted diluted EPS in our guidance range and strong adjusted free cash flow despite a challenging business environment. Before getting into the details of the quarter, however, I would like to take a moment to review the progress we've made so far this year against our strategic initiatives to drive our success and create shareholder value, which we feel very good about.

We have successfully separated the Morningstar and WhiteWave from Dean Foods, including the Q3 disposition of our remaining stock -- stake in WhiteWave, which generated $589 million of proceeds and furthered our leverage reduction efforts.

These separation activities allowed us to deliver over $2 billion of value to our shareholders, while creating a more focused and deleveraged Dean Foods.

At the end of Q3, our leverage stood at just 1.64x net debt to EBITDA on all cash netted basis. We have also made strong progress against the accelerated cost reduction initiatives that are helping to offset the impact of the loss of some private label businesses and continued category softness. To that end, we have announced 8 plant closures over the past 12 months, 7 of which have been completed.

The closures will improve the efficiency of our remaining network and drive increased competitiveness going forward. This bolstered competitive position has already enabled us to add significant business wins this year from both new and existing customers. These wins are beginning to positively impact volumes in the fourth quarter and have started to offset the volume decline related to the previously discussed RFP.

All of these efforts have put us in position for today's announcement, that the Board of Directors has adopted a cash dividend policy with the expectation to begin paying a $0.07 quarterly dividend in the first quarter of 2014, equating to annual payments of $0.28 per share. Dean Foods is a strong cash flowing business, and with our healthy balance sheet, we believe now is the right time to adopt our dividend policy to provide another avenue of value creation for our shareholders.

This initial dividend payout level is a level that we believe appropriately rewards investors, while maintaining our flexibility to also invest to drive value in other ways. Additionally, the Board of Directors has approved an increase in the amount available for share repurchases of our outstanding common stock up to a total of $300 million. This provides an additional tool to drive shareholder value going forward. We plan to be opportunistic in our share repurchase activities.

We continue to take action to further bolster our financial strength and flexibility. This morning, we announced that we are initiating cash tender offer for up to $400 million aggregate principal amount of our 2018 and 2016 bonds, with priority given to the 2018s. The transaction is expected to close before year end, and if successful, should significantly reduce our 2014 interest expense and provide additional free cash flow going forward.

We will fund the tender offer through existing cash on hand and borrowings under our senior secured credit facility. So overall, we have made clear progress year-to-date on several key fronts to strengthen both our financial and our competitive position and to deliver value to our stockholders.

However, as I mentioned, we had a challenging third quarter. Industry volumes remain soft, raw milk cost increased and our transitory costs in production and distribution associated with the loss of volumes and plant closures were higher than we anticipated, resulting in an operating performance that was below our plan.

In this difficult environment, we generated adjusted operating income of $42 million, compared to $57 million in Q3 2012 on a pro forma and comparable basis. This resulted in adjusted net income of $11 million and adjusted diluted EPS of $0.12 per share, which was within our guidance range of $0.10 to $0.16 per share.

Strong working capital performance drove a solid quarter of cash flow, resulting in year-to-date adjusted free cash flow of $97 million. This compares to our full year guidance for adjusted free cash flow of between $75 million and $100 million. We now believe we will end the year at the top of that range. And as I mentioned, net debt to EBITDA declined to 1.64x in the quarter.

The partial loss of business with a significant customer, combined with our general category weaknesses, resulted in total volumes of 685 million gallons for the quarter. This represents an 8% decline from 749 million gallons in Q3 of 2012 on a pro forma and comparative basis.

Within fluid milk specifically, industry category volumes declined approximately 1.7% for the quarter on an unadjusted basis, which does not normalize for the number and quality of days between periods. On this same unadjusted basis, our fluid milk volumes declined 10%. This quarter's volumes reflect the full negative impact of the RFP-driven volume loss for the first time, but don't yet reflect the offsetting business we are beginning to build with other customers. Excluding the impact of the RFP and another customer's decision to vertically integrate last year, our fluid milk volumes declined 1.7% in the quarter, which is consistent with the overall category.

On a channel basis, weakness in large-format retail was particularly -- was partially offset by continued strength in the school and small format channels. We continue to focus on strengthening our volumes, and recent wins have started to positively impact volumes in the fourth quarter.

The new business wins that are coming online in the fourth quarter of this year equate to roughly 60 million gallons on an annualized basis. However, we continue to expect our volumes to underperform the broader industry in Q4 and through the first half of 2014, due to the ongoing year-over-year impact of the lost business.

On a year-to-date basis, our total milk volumes have declined 7%. Considering category trends in the third quarter and the impact of the lost volume and new business over the rest of the year, we expect our full year fluid milk volumes to decline about 7%. Our share of the fluid milk category was 34.9% in the quarter. We expect our share to stabilize and begin to increase from this level over the coming quarters.

Our national flavored milk brand, TruMoo, lapped the strong 21% growth from the third quarter of 2012 with a 2% volume decline in this year's third quarter, consistent with the overall category decline. Looking at the fourth quarter, we are back on air with television advertising after a break during the traditional summer quiet period. The Halloween season is quickly becoming one of our most important for TruMoo.

We have introduced new seasonal TruMoo products that we've seen deliver a sales lift in our past pilots, including limited edition vanilla milk that's tinted orange for Halloween, a chocolate peppermint flavor that we're introducing in the Northeast this December and a vanilla milk tinted green for St. Patrick's Day in the Northeast. We continue to see opportunities to grow the popular TruMoo brand as we move forward.

We are leveraging some of the learnings from the success of TruMoo to apply to our portfolio of regional white milk brands. For example, we are transitioning these brands to a common graphics look that includes our Purity checklist that assures our consumers that our farmers' pledge not to use artificial growth hormones and that we test all of our milk for the presence of antibiotics, among other important differentiators.

Through robust research, we know that this messaging resonates with consumers. And the conversion of our graphics to a new common look allows us to begin to benefit from our brand equities across our portfolio. At the same time, it opens avenues for us to leverage marketing spend across traditional regional brand borders.

Turning to pricing, retailers continue to price private label milk at levels consistent with historical norms, with the margin over milk or the spread between Class I Mover and retail price of private label gallons at approximately $1.52 per gallon in Q3, compared to $1.58 per gallon in the previous quarter and $1.65 per gallon in Q3 of 2012.

Average price gaps between our brands and private label in Q3 were consistent with Q2 and year ago levels. Class I raw milk prices continue to increase in the third quarter. On average, the Class I price in the third quarter was 5% higher than Q2 and 15% above year-ago levels.

Strong Chinese demand for whole milk powder has helped keep world milk prices stubbornly high this fall. We expect this to continue through the balance of the year, with Q4 milk prices now expected to be above our previous forecast and to top $20 per hundredweight in both November and December. While we remain watchful of our global supply and demand dynamics, as we look ahead to 2014, assuming normal weather patterns, we continue to believe that solid global supply growth will lead to declining prices in at least the first half of 2014.

A major cornerstone of our efficiency efforts in 2013 and '14 includes the planned closure of 10% to 15% of our plant network, or 8 to 12 plants by mid-2014. As part of this initiative, and as I noted earlier, we have announced the closure of 8 facilities, with 7 already closed. Since we began ramping up activities late last year, we have strong momentum behind these initiatives and expect increased savings in the fourth quarter and into 2014 to help to offset the volume deleverage associated with the lost business.

However, with the full impact of the RFP volume declines and associated accelerated plant closure activity in the quarter, production costs declines lagged the decline in volumes, resulting in higher per unit cost in the quarter and lower overall gross profit. Similarly, distribution costs declined $15 million on a year-over-year basis. However, this 5% reduction is behind the rate of volume decline in the quarter, leading to an increase in per unit distribution costs.

While closing manufacturing facilities drives production efficiencies, these are partially offset by increased miles driven by products -- driven, as products are shipped back into the areas surrounding the closed facilities. However, in Q3, with the significant plant closure activity and the full brunt of the volume losses associated with the RFP, the level of additional distribution expense temporarily increased even beyond the normal uptick. We believe the increase per unit production and distribution cost is temporary and that cost will come in line with volumes as we move past this period of accelerated plant closure activity.

Helping to offset this increased cost was a $38 million reduction in SG&A costs in the third quarter from the year-ago period. A major portion of the decrease is attributable to the reduction of incentive compensation expense related to operational performance that is below our targets. As a result of the Q3 headwinds related to the rapid transition of volume due to the RFP and the associated transitory costs, we reported a 27% year-over-year decrease in operating income. Operating income totaled $42 million for the quarter, which is a decline of $15 million compared to the prior year quarter.

As we look ahead to Q4 and into 2014, we continue to see difficult overlaps through the first half of the year, but expect performance to improve as we reach the anniversary of the volume loss, realize the benefit of our cost and interest savings initiatives and accumulate additional new volume wins.

With that, I will turn the call over to Chris for a more detailed review of the financial results. Chris?

Chris Bellairs

Thank you, Gregg, and good morning, everyone. I'll walk through the Q3 results, as well as review the balance sheet and cash flow performance in the quarter.

Starting at the top of the P&L, as Gregg noted, total volumes declined 8% in the quarter. Although we are making progress in our cost reduction initiatives, the transition of these volumes out of our network outpaced the impact of our efforts and resulted in fixed asset deleverage within the quarter. This drove a year-over-year decline in adjusted gross profit of $67 million or 13%. Lower volumes and cost productivity drove a $15 million net reduction in distribution costs.

SG&A cost declined $38 million, in large part due to reduced incentive compensation expense. This resulted in an operating income decline of $15 million or 27% to $42 million.

Adjusted EBITDA for the third quarter was $81 million. Year-to-date adjusted EBITDA through the third quarter is $301 million. Interest expense came in at $24 million for the quarter, in combination with our normalized adjusted tax rate of 38%, yielded adjusted diluted EPS of $0.12 for the quarter.

As of the end of the third quarter, total net debt outstanding stood at approximately $671 million. Our net debt to EBITDA leverage ratio on September 30, was 1.64x, a significant decline from the 3.52x at the end of the fourth quarter of 2012, with all cash netted against outstanding debt.

This sharp decline is predominantly a result of the debt reduction driven by the proceeds for the Morningstar sale and the July disposition of our investment in WhiteWave common stock, offset by nonrecurring cash outlays associated with our separation activities, including the Q2 and Q3 payments toward the tax bill associated with the gain on the Morningstar divestiture.

Our objective remains to maintain a leverage ratio below 2.5x net funded debt to EBITDA. With the disposition of our remaining WhiteWave stake, we are now comfortably below that level. Following our Q4 Morningstar tax payment and the increase in total debt associated with the bond tender, we expect our net debt to EBITDA leverage ratio to be approximately 2x at year end.

Year-to-date net cash used in continuing operations was $259 million. Capital expenditures totaled $90 million, resulting in free cash flow used in continuing operations of $349 million. Negative free cash flow has been primarily driven by the $315 million tax payment associated with the Morningstar sale, the $35 million impact of moving WhiteWave and Morningstar to external accounts receivable and accounts payable, the $28 million interest rate swap termination fee associated with our Morningstar sale-driven debt reduction, approximately $31 million of deal costs, a tax payment of $15 million associated with certain tax obligations recognized upon completion of the WhiteWave spinoff and our $19 million litigation payment, as well as other onetime items, primarily associated with the separation of Morningstar and WhiteWave from the business.

On an adjusted basis, which excludes the Morningstar tax payments, other onetime uses of cash associated with our strategic activities this year, litigation payments and certain other items, we have generated approximately $97 million in year-to-date adjusted free cash flow. We expect to end the year at approximately this level.

We believe we will be able to substantially accelerate our free cash flow generation before dividend payments from this level over the coming years through decreased interest expense and capital expenditures, as well as operating income growth. These expectations and our strengthened financial position give us the confidence to adopt a dividend policy, initiate a cash tender offer for up to $400 million of aggregate principal amount of our 2018 and 2016 bonds and increase our available share repurchase authorization to a total of $300 million.

With that, I'll now turn the call back to Gregg for some closing remarks and a review of our forward outlook. Gregg?

Gregg A. Tanner

Thanks, Chris. In summary, notwithstanding the challenges of the third quarter, we continue to feel confident in our long-term trajectory. We are actively working to extend our competitive advantages through aggressively reducing costs and enhancing our strengths and capabilities. We continue to work through the impact of the significant volume loss we experienced due to the customer RFP by closing excess production capacity in our network and targeting new business. At the same time, we have put the pieces in place to enhance shareholder value by utilizing our strong balance sheet and growing free cash flows.

That said, over the near term, the external environment remains challenging. With soft industry volumes and persistently high milk prices, additionally, with approximately 8% of Supplemental Nutrition Assistance Program, or SNAP benefits, spent in the dairy category, we're cautious about the impact that the recent 5% reduction in those benefits related to the expiration of the 2009 American Recovery and Reinvestment Act will have on industry and broader grocery volumes.

The dairy commodity environment looked more challenging than previously expected, as prices remain stubbornly high despite strong global production growth. Industry volumes remain soft. We expect to continue to have temporarily high cost in Q4 related to the plant closure activities. We expect this to be partially offset by our recent new business wins that will begin to improve our volume performance in the fourth quarter.

All told, we expect Q4 EPS of $0.17 to $0.23 per share, resulting in full year earnings per share of between $0.85 and $0.91. Additionally, we now expect full year adjusted EBITDA to be between $391 million and $400 million, and for adjusted free cash flow to end the year at approximately $100 million.

As we look ahead, difficult overlaps will make the first half of 2014 challenging, and we would expect volumes and operating profit to continue to trend below year-ago levels through the first half of next year.

To wrap up, although Q3 was more challenging than anticipated, we believe many of the factors impacting our performance were transitory as we move toward a more efficient cost structure. We are excited about today's dividend policy announcement, bond tender offer and share repurchase authorization, and believe these will be important tools for bolstering total returns for our stockholders in the future.

We remain confident we are taking the right steps to build a strong foundation for future success, and I'd like to recognize and thank our employees for their very hard work toward that goal.

With that, I will ask the operator to open the call to your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Matthew Grainger with Morgan Stanley.

Matthew C. Grainger - Morgan Stanley, Research Division

Gregg, you gave us a sense that raw milk costs could be down year-on-year during the first half of 2014. Assuming that does hold, should we -- I guess, does the continued impact of the private label contract loss and then, as you mentioned, the potential for volume pressure from the reduction in SNAP benefits, limit your flexibility to potentially see some upside to mid-single-digit EBITDA growth even if we're looking at a deflationary environment?

Gregg A. Tanner

I think it will depend, Matthew, to some degree on what level of deflationary environment we see. Right now, as we look at the first half of next year, we see that being difficult, and I think that, that's going to continue to play out with our higher prices.

Matthew C. Grainger - Morgan Stanley, Research Division

Okay. And Chris, just on the balance sheet, you mentioned where you expect to be at year end, but assuming some level of ongoing borrowings from the senior secured facility to fund buybacks or to fund the ongoing dividend, what should we consider sort of a steady-state level of leverage going forward? And should it be slightly above 2x or do you see that 2x holding? And then with respect to share repurchases, can you give us a rough sense of the level of buybacks you'd expect on a run-rate basis?

Chris Bellairs

Yes, so I think the right way to think about that, Matthew, is for leverage, kind of at that 2x to 2.5x that we've set as the ceiling. We certainly have no expectations of going above, but we think the 2% -- the 2x that we're at now is the level going forward that makes sense. We wouldn't think to fund the dividend out of borrowings. We'd think to fund the dividend out of free cash flow. And as far as repurchases, as Gregg said in the prepared remarks, we are thinking about that opportunistically. So it's not really so much about kind of having a vision today of how much we would dedicate to that, but more how those opportunities to buy back Dean Foods shares might present themselves.

Operator

And your next question comes from the line of Ryan Oksenhendler with Bank of America.

Ryan Oksenhendler - BofA Merrill Lynch, Research Division

Just on the dividend, I guess, can you talk about what the outlook is in terms of what the growth potential of that is and is there like a target payout ratio or will it grow in line with earnings?

Gregg A. Tanner

Yes, I mean, I think it's one where any board -- we will continue to look at this on an annual basis and see what we should do with it. But right now, we're seeing it as a payout of between 30% and 35%, and we would expect that to continue to be somewhere in that range.

Ryan Oksenhendler - BofA Merrill Lynch, Research Division

Okay. And then just quickly, on the business in terms of, I guess, a follow-up on Matt's question, looking out for next year. I guess, I thought -- you had a transition services agreement at WhiteWave that would roll off. It would be a pretty significant impact to the P&L, that should help you, I guess, grow next year. And then just thinking about the business longer term, in terms of you're growing mid-single digits. I guess, is that -- what does that assume in terms of volumes? Is that just the category declines 1% to 2% a year and you guys are in line with the category, or do you take share to get there? Can you give us, I guess, maybe some parameters around that as well?

Gregg A. Tanner

Yes, I'll -- let me start with the $20 million to $30 million in stranded costs associated with the Morningstar and the WhiteWave businesses. So if you think about those, those are coming off. We're continuing in removing these costs as we speak. But some of those transition costs will continue for the next 3 to 9 months. So as we work off the transition services agreements, we'll take those costs out of the system. Second part of your question, can you remind me the second?

Chris Bellairs

Do you want to say the rest of your question again?

Ryan Oksenhendler - BofA Merrill Lynch, Research Division

Yes, just in terms of thinking about getting back onto track of growing EBITDA mid-single digits, what does that imply in terms of volumes, you guys versus what your outlook is for the category and kind of what your share gains are relative to that -- to get to that number?

Gregg A. Tanner

Basically, Ryan, all -- we have to maintain basically flat volume. So we'll have to continue to outperform the category, of which we're very confident we can do. We think our third quarter was our low point. We have gained share 14 out of the last 16 quarters, and we expect to get back on that trend here in the fourth quarter of this year and as we go into 2014. But to be able to deliver the algorithm, we have to be able to maintain about flat volume.

Chris Bellairs

And I really would -- I think about the same way Gregg answered the first question, think about next year in terms of kind of half 1, half 2. So throughout the first half of the year, while we're still overlapping the volume loss from the private label RFP, that will continue to create challenges. Now even though our accelerated cost reduction program will start to contribute more and more to that offset, the first half of the year, with that tough half volume overlap, and even though we do have -- we expect to have some favorable tailwinds from lower milk cost, I don't think it will likely make up the total difference between the volume loss on the RFP. Then you get into the back half of the year, now we've anniversary-ed the volume loss, and at that point, we feel like that, that mid-single-digit operating income growth target that we talked about, at that point, we're kind of into the future state for Dean Foods and where we've got that volume loss fully behind us.

Ryan Oksenhendler - BofA Merrill Lynch, Research Division

Got it. And just to be specific, the volume loss started in the middle of the second quarter? I'm just trying to think of when you lap it.

Gregg A. Tanner

It was towards the end of the second quarter. It was right towards the end that we started losing big pieces of it.

Chris Bellairs

I'd kind of characterize the second quarter as being about half of the ultimate run rate, and then the third quarter, we were at run rate. So throughout the second quarter next year, we'll be anniversary-ing the loss.

Operator

And your next question comes from the line of John Baumgartner with Wells Fargo.

John J. Baumgartner - Wells Fargo Securities, LLC, Research Division

Gregg, thinking of the cost savings here, you're already working through 8 of these 8 to 12 facilities, I guess. Are you seeing anything out there that may lead you to either stop the program here or would you anticipate hitting the full 12 or going further from there?

Gregg A. Tanner

I don't see anything that would stop us where we're at. We're continuing to look at our network to see where we have additional opportunities. We think -- we've closed 7 of the 8 so far, and we anticipate that there will be additional announcements coming.

John J. Baumgartner - Wells Fargo Securities, LLC, Research Division

And then, I guess, maybe second generation savings. Is there a way to think about packaging opportunities or centralized sourcing or even the direct store delivery fleet and better monetizing that going forward?

Gregg A. Tanner

P

I think there continues to be opportunities on both those fronts, whether it be in the indirect procurement side of things or whether it be in what we call purchase for resale. We think there continues to be opportunities in that arena on the procurement side to leverage our scale. On the distribution side, I think we just -- we have continued opportunity on multiple fronts. I think there's the optimization of just our current fleet. I think there's ways that we can take miles and optimize our routes that will allow us to take money out. So I'm confident in our cost reduction efforts over the next 2 to 3 years, that we'll maintain close to the levels that we've seen in the past.

Operator

Your next question comes from the line of Judy Hong with Goldman Sachs.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

I guess, first, I wanted to just go back to the volume trajectory. So the industry kind of declining at about 2%, the RFP loss is about 8 points, and then the new business wins are about 2 points. So I guess, really, in the first half of next year, assuming that the industry kind of still down a little bit and you still have the impact of 8 points or so, it sounds like the first half volume's going to be still pretty challenging. And I'm just wondering if there is any other, number one, other business opportunities that you can win to offset some of the volume loss that you're looking actively at? Secondly, the volume deleveraging that you're experiencing at this point, can you just help me understand sort of the phasing of how that gets impacted as you get into the first half? Have we seen really that the most negative impact from a profitability perspective, do we start to see that flow more positively in the first half?

Gregg A. Tanner

Okay. Let me take the first part of that. There continues to be opportunities as we continue to drive our competitive side of our business, that we think there's volume out there to be had. So I am confident that we can -- we'll continue to chip away at the 180 million gallons that we have lost. So I think that's the big piece that we continue to have. Is there any one customer who can make that up? Absolutely not, so we're going to have to continue to go after multiple customers to try and offset some of that volume. And our expectation is, is we'll do that over some period of time. I don't know if that's a couple years or 3 years, or what period of time that is, but we will continue to work towards that. On the second part of that, I think we have reached the low point from a transition -- a transitory cost perspective. The biggest thing, Judy, as we have transitioned out of the plants, has been the kind of the lingering cost structure. So you have severance that goes on for 2 or 3 months. You have multiple other, as long as you're maintaining the security of the facility, until you can dispose of it, so there's a number of costs that continue on. Those will start to fall off as we come out, and we will then start to pick up more of the cost savings that we've delivered this year and get the full year effect as we move into 2014.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Okay, got it. And then, Chris, just on -- I know you talked about the share buyback being more opportunistic. But as I think about next year, your free cash -- adjusted free cash flow probably would step up with the lower interest expenses. You'll be ending the year sort of 2x net debt to EBITDA leverage, and the dividend is probably about $27 million, $28 million per year. So it sounds like you do have flexibility, $80 million-plus sort of flexibility to the buyback next year. Is that kind of how we should think about just in terms of what you can do from a buyback capacity perspective in 2014?

Chris Bellairs

Well, first, I'd say Judy, kind of the way I'm thinking about it is, the lower interest next year, about $20 million after tax benefit of the lower interest payments, that feels pretty close to the amount of the dividend that we're talking about. So those feel in a similar range, you have the ability essentially to fund the dividend, most of the dividend, through the lower interest expense that we'll enjoy next year. Then on share repurchase, you could look at it in terms of what's free cash flow leftover at that point, whether it's kind of in that same $75 million to $100 million range as this year, or you can say, hey, we just have a lot of dry powder on the balance sheet and if the opportunity presented itself, you could actually buy back, since the authorization is now increased to $300 million. I wouldn't think of it as being limited by free cash flow so much as by our -- the capacity of the balance sheet. But it's really limited by how we and the Board of Directors assess the opportunity to go out and opportunistically buy those shares back.

Operator

Your next question comes from the line of Chris Growe with Stifel.

Christopher R. Growe - Stifel, Nicolaus & Co., Inc., Research Division

So I have just 2 questions for you. I want to make sure I was clear on, as you're closing these plants, and obviously, you've already lost the volume from Walmart, are you still in a position where that, obviously, is a drag on profitability such that as you get to 2014 and you have sort of the full run rate of savings, and of course, you've lapped the volume you've lost this year, should we see an acceleration in operating profit growth just due to the timing factor around those 2 items?

Gregg A. Tanner

Yes, I think, Chris, I think it goes back to what Chris talked about earlier, Chris Bellairs talked about earlier. And that is this kind of half 1, half 2. I think you'll see that in the second half of '14. I think in the first half of '14, it will continue to be tough just because of the volume lap.

Chris Bellairs

And I wouldn't think of half 2 as being acceleration beyond our mid-single-digit rates that we've talked about in the past. The first half is challenging and the second half starts to look more like what we think the long-term trajectory looks like.

Christopher R. Growe - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then I want to ask, as you're seeking new business and new volume, presumably you have a margin target -- or should we think about this new business being at least neutral to accretive to your margins in the dairy business?

Gregg A. Tanner

Well, that's really a tough one to call, Chris, because it's going to be very dependent upon channel, geography, customer. So it depends on where that gets, obviously, if it's in the outside of the large-format retail, it's going to be a higher margin. If it falls within the large-format retailer, it's probably going to be pretty weak margins.

Christopher R. Growe - Stifel, Nicolaus & Co., Inc., Research Division

Okay. I guess, kind of related to that or a follow-up would be, I understood -- you seem to be less volume-focused than you have been historically. And I guess I'm just trying to understand, are you looking just to add volume, I won't say at any cost, but basically trying to add volume, or is there sort of a return threshold maybe within each segment, which you're trying to hold?

Gregg A. Tanner

I don't think there's -- I think what we're trying to do is make sure that we're pricing competitively and that we're pricing prudently, to make sure that we do have margin that's appropriate for our returns. And I think that's what we'll continue to do. We're not going to chase volume just for volume's sake. We're going to make sure that we're going to make money at it.

Chris Bellairs

Yes, I think that business you see coming on in the fourth quarter is a good example of the team doing a nice job of kind of striking that balance between pricing to win the bid, but also pricing to deliver a fair return to the business, and I think we're putting some pretty good processes in place to strike that balance.

Operator

Your next question comes from the line of Farha Aslam with Stephens Inc.

Farha Aslam - Stephens Inc., Research Division

You do anticipate getting $120 million of cost savings in 2013, and are you still expecting to get sort of 75% of those here in the second half of '13?

Gregg A. Tanner

We continue to believe that we're on track for our $120 million. I'm not sure where the 75% in the second half comes from, Farha. But we do anticipate that we'll be on our $120 million in cost savings for the year.

Farha Aslam - Stephens Inc., Research Division

And then for next year, you're going back to your normalized rate of $80 million?

Gregg A. Tanner

Yes, $80 million to $100 million. $80 million to $100 million, maybe a little higher than that.

Chris Bellairs

There's 2 components, Farha. There's 2 components to next year. Obviously, there's the benefit that we'll get from the accelerated cost reduction activities from this year, so those are really just now ramping up. As we talked on the call last quarter, we got and we expected to get fairly little benefit from the accelerated cost reduction in the third quarter. That will ramp up some in the fourth quarter. And then throughout next year, you get an accelerated benefit from that -- from the positive overlap. The other component, though, is kind of our base cost savings that will result from our annual planning process. And so that's still playing its way out. So I think Gregg and I are a little reluctant to commit too much to the cost savings algorithm for next year until we put the planning process to bed here in the next few weeks.

Gregg A. Tanner

But I would think there is nothing that would keep us from believing that we would stay on a similar trajectory to past years.

Farha Aslam - Stephens Inc., Research Division

That's helpful. And then just on the category, with the SNAP programs being cut and commodity dairy prices being high, what do you look for in terms of 2014 volumes for the industry? And are you seeing increased competition for volume in the industry given that volumes are contracting?

Gregg A. Tanner

We're in an extremely competitive industry, so I expect that competitiveness to continue. I don't think -- we'll continue to fight for volume the same as we have all along. I like the hand we have and I think we're going to -- we're in a competitive position to be able to win the majority of those fights. So I think from that aspect, I don't see that changing. As we look at commodity prices and the SNAP program moving into 2014, I can't really speculate on SNAP at this point. It will be very dependent upon what our representatives do. And then as far as the commodities, we believe that we're going to see it start to fall off in the first half of next year. It's going to be well over somewhere around the 20-plus in the fourth quarter, and we expect that to start to decline in the first and second quarters of next year, as we think milk supply around the world will continue to pick up.

Operator

Your next question comes from the line of Alexia Howard with Sanford Bernstein.

Alexia Howard - Sanford C. Bernstein & Co., LLC., Research Division

Can I start with the retailer environment? You mentioned that the price gap between private label milk at retail and Class I Mover have compressed sequentially over the last little while. Are you seeing more pressure from the retailers as general II [ph] prices have come down that might cause you some problems going forward?

Gregg A. Tanner

No, Alexia, I don't think so. I think what we're seeing is that the reason that starts to compress to some degree is that as prices get so high, there's thresholds and price points that retailers don't want to go beyond. And I think that, that's really what drives that compression more so than anything that would tell us that they are trying to reduce their margin over milk.

Alexia Howard - Sanford C. Bernstein & Co., LLC., Research Division

Okay, great. And then just as a quick follow-up, the volume decline in the -- although the volumes were obviously coming through a little worse than expected in the third quarter, I just wanted to get clarity. It sounds as though that was more to do with weaker-than-expected market share. Was it the category that was also a little weaker than expected? And was it branded that came through -- for you, was it branded volume that came through a bit worse than expected, not just the private label RFP that we -- you'd already lost?

Gregg A. Tanner

All right, on the first part of that, it was really more the category. I think our volume was pretty much what we had anticipated, with the loss of the RFP and the other changes in our business. But the category was softer than what we had initially anticipated. As far as where that came out of, our brand share, actually, was at an all-time high in the third quarter. We were up 120 basis points versus the second quarter. And that -- so we're happy with how our brands are doing. It's just that we got to get the category going.

Operator

Your next question comes from the line of Eric Katzman with Deutsche Bank.

Eric R. Katzman - Deutsche Bank AG, Research Division

Well, I don't know, you're probably in a room, so you may not be aware, but your stock is down about 7% to 8%. And so I think it's probably fair to then ask, with the market not particularly happy today, maybe you can kind of go into the decision to offer what I would say is a relatively modest dividend and dividend yield payout ratio versus a more significant authorization? Maybe you could kind of walk us through kind of the decision between those 2?

Gregg A. Tanner

Well, let me -- first of all, I will tell you that I believe, and I think our Board of Directors believes, that when we were evaluating options for returning value to shareholders, we wanted to be very comfortable with the amount of the dividend we launched when we launched the program. And we think that, that provided investors with a market competitive yield. It's about at the average of the S&P 500. So I'm not sure why anybody would be disappointed with where that would come out. And then I think beyond that, we believe that we preserve the flexibility to invest in the business and return capital to shareholders through other share repurchases in an opportunistic basis and other opportunities that we may have. So I don't -- I'm not sure there's a need to apologize to anyone for the dividend rate.

Eric R. Katzman - Deutsche Bank AG, Research Division

Okay. Second question, I guess, this is maybe a little bit of hindsight's 20/20, but it seems that with all the cost savings efforts that you are making and plant reductions, et cetera, but the overhang of the Walmart account loss is now -- it sounds like the battle to offset that is going to essentially last into the, let's say, middle of 2014 before kind of shareholders see the benefit of the cost savings effort. So I guess, Gregg, if you had to go back, would you have bid more aggressively for that and not have to deal with so much reduced fixed cost absorption? And maybe it's more appropriate to ask then, is with your new cost position, is there really accounts that you could see are vulnerable or you would not go through this kind of exercise again?

Gregg A. Tanner

Eric, I often looked in the mirror many times over the last year to figure out if we would have or should have done something different in that process. And I still come to the same conclusion. We were, I think, prudent with the shareholders' money, in what we thought was right for Dean Foods Company. So I wouldn't have necessarily bid it differently. I think we are -- we did what we believed was right. And I think in our trying to take our fixed cost and the volume out or the capacity out of the system now is going to serve us better when this is all said and done. So I don't -- I wouldn't say that I would probably have done it differently. There may have been geographies that we may have looked at differently, but other than that, I think we did what was absolutely right.

Eric R. Katzman - Deutsche Bank AG, Research Division

Last question, and I'll pass it on. Just looking -- there's been some, obviously, some questions about 2014. And Chris, I'm trying to kind of think about the bridge here. Let's kind of start at the bottom. So given the stock's weakness, I assume you're going to be more aggressive and there'll be some share repo benefit to 2014. You've got maybe $0.20 benefit from your lower interest expense, roughly, and you're talking about maybe $80 million of savings, maybe even higher than that relative to, call it, I don't know, $220 million, $230 million of EBIT, wherever you're going to end this year. So I'm kind of having a tough time -- unless the fixed cost absorption is so severe, I'm kind of having a tough time seeing why EBIT in the second half is really only up 4%, 5%, which I guess would lend itself to being a 2014 EBIT growth rate of just very modest. Am I just thinking about that incorrectly or...?

Chris Bellairs

I'll start at the beginning. First, I'd just caution you on the share repurchase piece, because we haven't laid any plans in place on that yet and the board and management will continue to look at that. So I just -- before you go down the path of assuming share repurchase for next year, I would advise caution. On the operating income algorithm, I think kind of the way we talked about it in the call several times already, with the first half being challenging and then the second half starting to improve from there, as we anniversary the volume and then also have the sort of the final benefit of the cost savings, I think you do see an improvement sequentially. But I think you're thinking about it right. I think next year, with the slower start that we're expecting, coupled with a back half that starts to get back towards the longer-term algorithm we described, feels like the math that we're looking toward. But again, not having put the 2014 plan to bed yet, it's premature for us to have that conversation and we will be back in 3 months to walk you through our guidance for 2014.

Operator

Your next question comes from the line of Amit Sharma with BMO Capital Markets.

Amit Sharma - BMO Capital Markets U.S.

Gregg, can you talk about the raw milk environment? Clearly, we talked about it a couple of times already, that prices are a little bit higher than what we would have expected going into, or what you expected going into the quarter. What's the outlook look like in the first half, 1Q and 2Q sequentially, and then now, year-over-year for the rest of the year?

Gregg A. Tanner

I mean, if you just kind of think about our forecast anyway, I would probably call you -- sometime -- somewhere in the mid 18s as you think about the first quarter of next year. And then probably getting down in the mid 17s sometime in the second quarter. I just think it's going to be very dependent upon on the powder demand in China. I mean, that's probably the single biggest driver we have right now of the global demand, is whole milk powder and skim powder going to China.

Amit Sharma - BMO Capital Markets U.S.

Got it. And then looking forward, if we look at your cost-saving initiatives and you've certainly made some changes to your management team, your reporting lines, is the trajectory still the same what it was last year or earlier this year? Or you feel like you're getting to the point where some of these contributions are going to start to show up a little bit more in the back half of this year -- or 2014, I mean?

Gregg A. Tanner

Well, I think the changes we made in the third quarter were really more focused on the commercial and the growth side of this business, and the desire to get more focused on the commercial and growing the business. So that was why we made the change. I think from a cost perspective, Tony Brooks and Shay Braun, who lead our logistics and our operations team, are on track to do what we need to do as we finish this year and go into 2014.

Operator

Your next question comes from the line of Jonathan Feeney with Janney Capital Markets.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

I just wanted to clarify about the front half guidance for next year. Are we talking about on an EPS basis, you expect the entire front half or each of the 2 quarters of the front half to be down year-over-year? Just a clarification on that, please?

Gregg A. Tanner

Yes, I think it's an overlap. We haven't done our 2014 plan. So anything that we're talking about, all we're trying to say is that we know that the overlap in the first half of next year, because of the volume loss, is going to be tough. I mean, that's just, that's the given part. I don't think it's a quarter-to-quarter as much as it's just -- we don't want to -- we can't get into 2014 guidance because we have...

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Got you. So it's really premature to say?

Gregg A. Tanner

Yes, we'll put the plan together now and we'll be back to you.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Great. And on the adjusted cash flow, looks like you came in at the high end -- you're going to come in at the high end for the full year. You were talking $75 million to $100 million, I think, on the last call. On an adjusted basis, I know what the puts and takes are on a pre-adjusted basis, but on an adjusted basis, what sort of -- clearly, the results this quarter were in the middle, and now, next quarter is looking to be a little bit disappointing. So what's the big delta on an adjusted basis in terms of cash flow?

Chris Bellairs

What's the big delta in the fourth quarter or...?

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Yes, in that fourth. It looks -- it seems that -- in that fourth quarter, yes.

Chris Bellairs

Yes, so we still have one more of the Morningstar tax payments to make in the fourth quarter. We still have $100 million of the Morningstar tax payment that falls into the fourth quarter. So we think after getting to the full year on -- getting to year-to-date, where we are at the high end of the range and with the Morningstar tax payment in the fourth quarter, and it's kind of the normal seasonality for our business, a very large portion of our full year CapEx will get spent in the fourth quarter. So those 3 factors kind of conspire to suggest to us that we'll finish the year about where we are now, at the high end of the range.

Jonathan P. Feeney - Janney Montgomery Scott LLC, Research Division

Got you. Okay. And just finally, I know you haven't committed to a level of share repurchase or anything like that, and the board has to discuss that. But could you talk about when you think about the other things you could do with cash, I mean, clearly, you've talked about a 2 to 2.5 range. You told us you'll finish the year at 2, so there's cash there potentially to use. What sort of hurdle rate do you think about or use as you apply to areas of the business, whether it's an incremental plant closure or something else, an acquisition, something else you might do besides share repurchase. Just what number do you use philosophically to think about your rate of return?

Gregg A. Tanner

I think it's going to be that there's 2 different ways that I think about that. And one is what do we do with that money from an investment back into our business locally. And much of that is around how do we improve our own internal capabilities and drive cost reductions. So there's a certain part of that, that I would expect. We're trying to drive 25%, 30% returns on our cost reduction efforts. And we continue to drive -- other alternatives would be is there any other ways to figure out how to grow the business. So is there M&A opportunities or other opportunities that may allow us to grow the business. But all of those should be coming in that same vein of similar types of returns.

Operator

Your next question comes from the line of Robert Moskow with Credit Suisse.

Robert Moskow - Crédit Suisse AG, Research Division

Gregg, I was interested in your comment that your brand market share was up sequentially 120 basis points versus second quarter. And I wanted to know, was that a pleasant surprise? And if so, why would that not have helped your profits more? I think you've said in the past that your branded businesses is much more profitable than your private label business, and I wanted to make sure that, that's still true and maybe you can give me an order of magnitude, and why didn't it help third quarter more?

Gregg A. Tanner

Yes, I mean, I think it's one where -- first, let me clarify, the 120 basis points is over prior year, not over the previous quarter. But I think it's our brand volume, as a share of brands out there, we're in the 44 range from a share perspective. And that -- but it's tough to offset when the category itself has declined at the levels that it has. I don't think our profitability on our brands have changed dramatically from what we've talked about in the past. So Chris, you have any...?

Chris Bellairs

No, I think that's exactly right. I think the profitability, the incremental profit that we enjoy on the branded business is about what it's historically been. It's a good premium, and it was in the third quarter. But as Gregg said, we've gained that share over the last year, not over just one quarter. So the effect of kind of the quarter-over-quarter increase, or even the increase over the prior year, is in our P&L. It just does get sort of overwhelmed by the soft category, by high milk prices, by the lagging cost takeout relative to volume. So it's definitely in there, but it gets a little bit lost in the noise of all the other things that are sort of working against us right now.

Robert Moskow - Crédit Suisse AG, Research Division

May I ask, is there anything you're doing operationally to push your brands a little harder and is it getting any traction with retailers? Or like, I don't get -- I don't ever get the sense that when you talk about your brands, that you're really -- that there is any initiatives to extend them further versus private label?

Gregg A. Tanner

Well, I think if you think about our brand, we talked a little bit in our prepared remarks about moving towards a more consistent type of brand with our dairy pure initiatives. And I think that's one thing that we try to do, is to take advantage of the scale across buying our advertising and other things on a national basis versus a regional basis, which comes at about 1/2 the price. So there's things like that, that we're doing, Robert. But as far as major innovation on the brands, we continue to do our consumer research to find out where the consumer believes there's value to be had. But I feel confident in our regional brands, and we have some very, very strong regional brands. We continue to look at opportunities to consolidate those regional brands to try to get more scale.

Chris Bellairs

And our real success in the branded environment -- our real focus in the branded environment over the past couple of years hasn't been on white milk so much as it's been on the flavored milk. So TruMoo is the huge success that it's been within the branded consumer packaged goods environment, not just in milk, but I think we've demonstrated, begun to demonstrate that there is an opportunity, there is an avenue for relevant brands with consumers via the TruMoo successes that we've had.

Operator

And your final question comes from the line of Akshay Jagdale with KeyBanc.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

So first question is, in terms of your EBITDA guidance and it coming down relative to the preliminary number, can you tell us what the main drivers of that were and in terms of -- and if you can rank them too, that would be great.

Chris Bellairs

So I think it's kind of across the entire portfolio of our P&L, Akshay. I think it starts at the top of the category, throughout this year has been a bit softer than we expected going in. I think milk prices, raw milk prices, have been a bit higher than we expected them to be, and that results in both the softer category, has an impact on the category. Gregg talked earlier about kind of high price points on average for milk out in the retail environment. And it has a cost drag on our P&L, as milk is more expensive, that does flow through our P&L in areas like milk shrink. So if we spill more expensive milk on the floor, there's no way to get around that, that has a drag on our P&L. And then you continue down through the P&L, I think that the cost savings that we plan for this year for both the accelerated cost reduction program that was in response to the RFP loss and just the base cost savings that we churn out every year, that kind of $80 million to $100 million run rate that we've been on for the past several years, I think both of those have lagged a bit versus our expectations. So really, whether it's the top of the P&L category, our volume, pricing as it relates to the raw milk cost environment or our cost savings initiatives, each one of those has probably been just a bit off of where we expected it to be. And the convergence of all of those factors results in that lower EBITDA number that we're guiding to now. It's not really one thing. It's a portfolio of things that has sort of broken against us throughout the year.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

Okay. And then when I just think of sort of gross profit or EBIT per gallon, I mean, first of all, what's the -- which is a better number to look at as a base starting in 3Q? That's point number one. And number two is, shouldn't that number sequentially just continue to get better? And what is a normalized number that you think you can get to, either on gross profit per gallon or EBIT per gallon?

Chris Bellairs

Feels like we're back into the 2014 AOP question again. So first, on your first question, I'm not sure which is the better number. I mean, are they different? We look at both and we think they're both valuable. And they kind of -- they probably end up taking you in about the same direction, whether you're looking at OI per gallon or EBITDA per gallon. And then on the sequential aspect, yes, we do believe that from this point forward, whether it's on an absolute volume or kind of a cost structure as it relates to any deleveraging that we've experienced, we think we are at or near the bottom of that, now that we're in the third quarter, at the full run rate of our volume loss. We think in the fourth quarter, we're beginning to see the benefits of the volume that we've gained as a response to that. So we think going forward, other than the normal seasonal flows that you experience on our business, so when you say, sequentially, every quarter, no. When we get to the third quarter next year, we think that like the third quarter of this year, our business deleverages as the school business is lighter. And we think we'd see a reduction in profit per gallon sequentially or seasonally. But as a general trajectory from here forward, yes, we're going to head back to that same path that Gregg talked about earlier, that from the period from 2009 to 2012, over those 16 quarters, we gained share in 14 of them. We're right back on that path from this point forward, and we think that whether it's 2014 or 2015 or 2016, we're looking at a P&L algorithm that will lead to sequentially increasing OI per gallon. Exactly what number that gets to over time, I'm not ready to tell you yet, but I will tell you it gets higher.

Akshay S. Jagdale - KeyBanc Capital Markets Inc., Research Division

And just one last one on capacity utilization. So what was roughly the utilization rate in your plants this quarter? And after you finish closing the 7 plants that you've announced, where will utilization be and what quarter will we be at that run rate, assuming the volumes are what you think they're going to be?

Gregg A. Tanner

Well, I -- that's a really tough one to answer because I think if you look at our overall capacity, you would think about our capacity being somewhere around 6% to 7% volume decline. And we're telling you, we're taking 10% to 15% of our capacity out -- or our plants out. So my expectation is you're going to get somewhere around 5% to 7% improvement in our asset utilization, assuming that the category continues on the trajectory that it's at today.

Operator

Ladies and gentlemen, we thank you for your questions. I will now turn the call over to Mr. Gregg Tanner for closing. Please proceed.

Gregg A. Tanner

Great. Thank you, again, for joining us for the call this morning. We appreciate your continued interest in Dean Foods, and we'll look forward to talking to you in 3 months.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect, and have a great day.

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Source: Dean Foods Management Discusses Q3 2013 Results - Earnings Call Transcript

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