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Dean Food (NYSE:DF)

Q2 2010 Earnings Call

August 03, 2010 9:30 am ET

Executives

Gregg Engles - Chairman, Chief Executive Officer and Chairman of the Executive Committee

Barry Sievert - Vice President of Investor Relations

John Callahan - Chief Financial Officer and Executive Vice President

Joseph Scalzo - Chief Operating Officer, Chief Executive Officer of Whitewave Foods

Analysts

Alex Bisson - Northcoast Research

Alexia Howard - Bernstein Research

Judy Hong - Goldman Sachs Group Inc.

Christopher Growe - Stifel, Nicolaus & Co., Inc.

Terry Bivens - JP Morgan Chase & Co

Farha Aslam - Stephens Inc.

David Palmer - UBS Investment Bank

Christine McCracken - Cleveland Research

Operator

Good morning, and welcome to the Dean Foods Co. Second Quarter 2010 Earnings 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. Please go ahead, sir.

Barry Sievert

Thank you, Carin, and good morning, everyone. Thanks for joining us for our second quarter 2010 conference call. We issued a press release this morning, which is available on our website at deanfoods.com. The release is also filed as an exhibit to a Form 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 with the slide presentation will be available on our website beginning this afternoon.

The earnings per share, operating income and interest expense information that will be provided today are from continuing operations and have been adjusted to exclude the expenses related to facility closings and reorganizations, expenses related to closed and expected-to-close acquisitions, and other non-recurring items in order to enable you to make meaningful evaluation of our operating performance between periods. The earnings release contains more detailed discussion of the reasons why these items are excluded from the consolidated results, along with reconciliations between GAAP and adjusted earnings, and between net cash flow from continuing operations and free cash flow from continuing operations.

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 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.

Participating with me today in the prepared section of today's call are Gregg Engles, our Chairman and CEO; and Jack Callahan, our Chief Financial Officer. Also joining the call today for the question-and-answer portion are Joe Scalzo, our Chief Operating Officer; and Tim Smith, our Treasurer.

Gregg will start us off by sharing some background to help put our results into perspective before walking through the performance of the operating units and offering some commentary on forward outlook. Following Gregg, Jack will comment on our financial performance and balance sheet before opening the call for your questions.

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

Gregg Engles

Thank you, Barry. I thank all of you for joining us on today's call.

Looking back over the past six quarters, the business environment has changed dramatically. In the first half of last year, we benefited from rapidly declining commodity costs and posted two of the best quarters in our history. By mid-summer, retailers had embarked on a strategy to drive store traffic through deeply discounting private label milk. This resulted in widening price gaps against our brands and pricing pressure on our Private Label Milk business, which was reflected in our results. Through the first half of this year, retailers have continued to drive this strategy even in the face of diminishing evidence of its effectiveness.

With this in mind, this morning, we announced second quarter net income of $53 million or $0.29 a share. These numbers are well below our very strong year-ago results, but they represent a step forward from the first quarter. At Fresh Dairy Direct-Morningstar, the pressures that have impacted results over the last several quarters remain serious challenges to the business. Incremental pricing and continued progress against our cost reduction initiatives resulted in an increase in segment earnings over the first quarter. At WhiteWave-Alpro, strong volume-driven top line growth continued through the second quarter even as operating profit growth slowed a bit from the previous quarter due to higher marketing spend and supply chain cost, driven higher by surging new product volumes.

Also in the quarter, we completed an important amendment and extension of our bank credit facility that provides greater financial flexibility in this challenging environment and significantly improves the maturity schedule of our debt. With that introduction, let me begin by looking more closely at some of the internal and external factors that impacted our results.

After that, I'll offer some perspective on how these trends played out in our businesses during the second quarter and offer some comments on our forward outlook. Jack will take you through a number of corporate items and discuss the changes to our balance sheet during the quarter. Following Jack, we'll open up the call for your questions.

This is a unique time for food producers. Signs of recovery are beginning to appear across the higher rungs of the socioeconomic ladder, but lower- and middle-class consumers continue to struggle. In the grocery analysis [ph], this has led to weak volumes across many categories and weak comps at some value-oriented retailers in spite of strong promotional support. For example, the cereal category, which drives roughly 30% of milk consumption, was down mid-single digits for the quarter, contributing to a slight decline in industry conventional fluid milk volumes.

In contrast to the challenges confronting fluid milk and many other staple categories, some value-added categories are seeing nice growth. Among these, the Non-Dairy Milk Alternatives category, that includes soy and almond milk, was strong in the quarter. Other categories that WhiteWave-Alpro operates in were also strong, including flavored coffee creamers and organic milk. The divergent results of our two operating segments in some ways reflect these broader economic and category trends.

Looking more closely at fluid milk, category volumes were down slightly in the quarter despite continued deep retailer discounting of private label gallons. Despite the lack of elasticity in the category, retailers continue to offer private label gallons at significantly reduced prices to drive traffic. The margin over private label milk, which is a rough measure of the spread between raw milk cost and retail pricing, remains well below year-ago level and is fundamentally unchanged from earlier in the year.

While the gap has tightened a bit, we continue to outperform our competition on a volume basis. The overall fluid milk market was down slightly in the quarter. Within this, our fluid milk volume was up slightly, while the balance of the market declined about a half a point. Our share expansion slowed a bit in the quarter due largely to the lapping of acquisitions and volume declines across some of our traditional grocery customer base.

Outside of fluid milk, other categories, Fresh Dairy Direct-Morningstar, were also generally soft. Our Creamer, Cultured Products and Juice businesses all had modest volume declines. However, strong quick-serve restaurant demand drove solid growth in ice cream mix and aerosol products. In total, our Fresh Dairy Direct-Morningstar sales volumes were down modestly in the quarter.

While we continue to face significant challenges in the quarter, our teams worked to improve pricing wherever possible to protect overall profitability. Gross profits were down $54 million on a year-over-year basis but improved by $12 million from the first quarter of this year to $584 million even as school milk volumes dropped off in the last month of the quarter.

We continue to work to improve the quality of our data warehouse to better analyze the causes of change in our business. However, the key issue remains our core Milk business, which drove approximately 70% of the decline in the quarter. Within our Milk portfolio, brand pricing and margin improved somewhat versus the first quarter, but lower-branded volumes and continued margin compression negatively impacted the year-over-year results.

In private label milk, pricing pressures increased in the second quarter and contributed more to the year-over-year gross profit decline as retailers worked to leverage excess capacity in the industry. Across the balance of the portfolio, general volume weakness and pricing pressure continued to negatively impact results at the gross margin level. These factors in combination more than offset strong progress in driving down conversion costs on a year-over-year basis.

While our results over the last several quarters have been driven by market forces that primarily affect gross margin, permanently reducing our system-wide cost structure remains our top priority. We are committed to becoming a differentiated, low-cost operation in delivering on our commitment to drive more than $300 million in cost savings at Dean. We've accelerated our efforts in this area and believe we are on track to realize over $100 million in savings in 2010 toward this goal on top of the $75 million achieved in 2009.

As part of these efforts, the headcount reduction we announced last quarter is moving forward. These accelerated efforts to streamline operations and maximize efficiency have resulted in the elimination of over 360 positions across Fresh Dairy Direct-Morningstar so far. When combined with other initiatives, Fresh Dairy Direct-Morningstar headcount is down by more than 700 positions since the beginning of the year.

In distribution, better technologies have led to a reduction of 350 routes over the last 18 months. The volume of fuel used in our DSD operations in the second quarter was 2% below last year, and distribution employee costs were down 5%. All in all, distribution cost per gallon in our DSD operations, excluding fuel, were 2% lower than the year-ago period.

In network optimization, we recently announced an additional plant closure in the Southeast that will improve our asset utilization and reduce overall cost in that region, and we're preparing to launch larger projects over the next 18 months that will create a significant change in our cost structure in several key markets across the country. Accelerated cost reduction continues to be the number one priority for Fresh Dairy Direct-Morningstar. Creating a differentiated cost position is critical to the long-term success of the business.

This continued focus on cost control, combined with our pricing initiatives in the quarter, led to a $20 million sequential improvement in operating income from the first quarter of this year to $147 million. That is still well below our very strong result last year and not where we need to be. But it is also a step forward from the first quarter of this year in what continues to be a very challenging market.

Our WhiteWave-Alpro business is operating against quite a different backdrop. The value-added consumer drove solid category growth in non-dairy milk alternatives, organic milk and creamers. This category growth and a strong pipeline of innovative products drove strong top line momentum at WhiteWave-Alpro.

Total second quarter segment net sales increased 31% over last year to $459 million, reflecting the impact of the Alpro acquisition and continued solid growth at WhiteWave. On a like-for-like basis, both WhiteWave and Alpro increased net sales in the high-single digits in the quarter.

Consistent with last quarter, all of our key brands reported solid volume-driven sales growth in the quarter. Our largest business at WhiteWave is our Silk and Alpro Non-Dairy Milk Alternatives business. This area of the portfolio continues to perform very well. Driven by the continued success of Pure Almond, Silk achieved low-double-digit net sales growth in the quarter. We see the almond milk category as an important product extension for the brand as we expand Silk beyond soy.

Alpro also continued to perform well in Europe, with both high-single-digit volume and net sales growth. Our Branded Creamers business again posted strong growth and continues to be a standout performer in our portfolio. International Delight net sales grew in the mid-teens and Land O'Lakes Half & Half net sales increased in the mid-single digits.

Competitive intensity has increased in the Flavored Creamer category, but we remain committed to driving volume growth through innovation in this important business. In the organic milk category, growth accelerated from the first quarter levels. This help support high single-digit growth in Horizon Organic branded milk sales, again, outperforming the category and increasing share.

I should note that our WhiteWave results do not include the Rachel's business. This small business, which consists of yogurt and other dairy products sold primarily in the United Kingdom, has been moved to discontinued operations as a result of a sales agreement we've entered into. This sale will help us create greater focus on our remaining core businesses, and we expect this sale to be completed in the third quarter.

In terms of operating income, our strong brand growth performance and the benefits of the Alpro acquisition were partially offset by higher distribution costs and the timing of marketing investments on new products. The strong volume growth across the WhiteWave portfolio has driven increases in storage, handling and shipping costs as production capacity tightens. In total, segment operating income increased 18% in the quarter to $41 million. Overall, we continue to be very pleased with the momentum of our Branded businesses and continue to expect solid volume-driven top line growth and strong full year operating income growth for the segment.

Before turning the call over to Jack to discuss corporate and balance sheet-related items, I'd like to offer some perspective on our forward outlook. At a high level, our current outlook for the business is fundamentally unchanged from our first quarter conference call. Consumers, particularly working-class consumers, remain underemployed and over-leveraged. Their economic anxiety is reflected in a highly promotional retail environment for private label milk that is driving negative Private Label versus Branded mix and margin compression for our Fresh Dairy Direct-Morningstar business.

Despite aggressive retail pricing, category volumes are soft. As a result, our expectations for Fresh Dairy Direct-Morningstar performance have not changed from last quarter's call.

On the other hand, our more value-added business at WhiteWave-Alpro, bolstered by increasingly confident upper-income consumers, continue to post strong volume, revenue and operating profit growth, a trend that we expect to continue, which should result in very solid annual profit growth for that segment.

Finally, we have put one of the major risk to our business behind us with the successful amendment and extension of our credit facilities. The increase flexibility of loosened covenants and extended maturities came at a cost of approximately $0.06 of additional interest expense from Q2 to Q3.

In keeping with our recent practice, we'll offer guidance only for the upcoming quarter. Given that our view of the business conditions have not materially changed from the second quarter and given typical seasonal weakness in Q3 versus Q2, we expect earnings of $0.17 to $0.22 per share in the third quarter. Adjusting for the $0.06 of additional Q3 interest expense, our range of guidance for Q3 is essentially unchanged from the guidance range we gave you for Q2.

With that, I'd like to again thank you for joining us on the call today and turn it over to Jack for a review of operating expenses and changes in our capital structure. After that, we'll open the call for your questions. Jack?

John Callahan

Thanks, Gregg, and good morning, everyone. I'll take a few minutes to walk through the consolidated financial performance in the quarter and discuss a few corporate items, as well as the important step forward in the highly successful amendment and extension of our senior credit facilities during the quarter before opening the lines up for your questions.

Corporate expense of $54 million was 6% below year-ago level. As we've previously discussed, our period of stepped-up investment and corporate capability is over, and we expect essentially flat corporate expense over the balance of the year. Corporate expense did sequentially increase about $6 million from the first quarter of 2010. This increase was due in part to the timing of consulting expense and the completion of our move into our new headquarters building. Headcount remains effectively flat, and we are working to reduce this expense over time as part of our larger cost reduction program.

Within the consolidated results, total Dean Foods gross profit declined about $10 million from a year ago. Solid gross profit growth at WhiteWave and the acquisition impact of Alpro were offset by the weaker Fresh Dairy Direct-Morningstar results.

Below the gross profit line, total company operating expenses increased $37 million over the year-ago period. However, over 90% of the increase was related to the acquisition of Alpro and Heartland in the second half of 2009.

At FDD-Morningstar, strong expense control resulted in total operating expense growth of less than 1%, which is down considerably when adjusted for higher fuel costs and the acquisition of Heartland Dairy, demonstrate our progress in reducing our cost structure. WhiteWave-Alpro operating cost rose primarily due to the acquisition of Alpro, as well as higher distribution costs and the timing of marketing expense at WhiteWave. We're pleased with the operating costs performance in the quarter, and we will continue to focus on driving SG&A efficiency in the business going forward.

In total, second quarter consolidated operating income was 26% below year-ago results at $133 million but an 8% improvement from the challenging start we had in the first quarter of 2010. Below the operating income line, interest expense declined $11 million from the year-ago period as a result of lower interest rate and the maturity of $800 million of interest rate swaps on March 31 of this year. Interest expense will step up going forward as a result of the amend-and-extend transaction we completed at the end of the quarter, which I'll discuss in more detail in just a moment.

Our tax rate in the quarter was 37.1%. This is down from 37.9% a year ago, aided by an international tax rate and an increase in the U.S. domestic manufacturing deduction. We continue to expect our full year tax rate to be between 37% to 38%.

Net income of $53 million drove second quarter adjusted diluted earnings per share of $0.29. As Gregg indicated, these results are well below year-ago levels but a step forward from the first quarter.

Net cash from operations through the second quarter of this year was $244 million. Subtracting capital expenditures of $113 million from this yield free cash flow of $131 million for the first six months of this year. I will update the outlook for the balance of the year capital spending in just a moment.

To further support the generation of free cash flow and bolster our debt pay-down efforts, we continue to aggressively manage net operating working capital. Our cash conversion cycle was down three days from the year-ago period, resulting in net operating working capital that was essentially flat despite a 35% increase in the Class I Mover.

Total outstanding net debt at quarter end stood at $4.1 billion, down $64 million from the last quarter. As expected, our leverage ratio of funded debt to EBITDA as defined by our credit agreement stepped up a bit this quarter despite continued debt reduction. This was due to the impact of losing the very strong second quarter of 2009 and our trailing 12-month EBITDA. As of the end of the quarter, our leverage ratio stood at 4.68x versus the current covenant of 5.5x.

At the end of the second quarter, we successfully completed an amendment and extension of our credit agreement. We enjoyed very strong support from our banking group, and we appreciate their commitment to Dean. The revised agreement results in a lengthened maturity profile, significantly reduced near-term amortizations and increased flexibility versus our leverage covenant.

From a maturity schedule point of view, we significantly improved our profile with approximately 80% of our total outstanding debt now maturing 2014 or later, a far more balanced profile than before.

Our term loan amortization schedule has also significantly improved, with amortizations between 2010 and 2014 reduced by more than $950 million. We maintained strong liquidity through the transaction, preserving approximately $1.3 billion of currently available liquidity in our AR Securitization and Revolving Credit Facility. Additionally, we successfully modified our covenant structure to allow more flexibility as we invest capital to drive our long-term strategy and to weather the challenging competitive environment. Our revised leverage ratio covenant is 5.5x. The covenant steps down to 5x on June 30, 2011. The final step-down to 4.5x occurs at the end of 2012.

As you expect, pricing on the extended portions of the facility has been adjusted. The new pricing grids reflect excellent execution, given market conditions, including the absence of LIBOR floors. Given this adjustment, we now expect full year interest expense of between $238 million to $240 million, including approximately $66 million to $67 million in the third quarter. We are extremely pleased with the overwhelming support of our banking partners, confirming their confidence in our long-term strategy.

With this deal in place, we plan to continue on the path toward our goal of deleveraging the balance sheet to 3.5x funded debt to EBITDA, balancing continued debt reduction and selected divestitures, such as the Rachel's transaction, against high-return capital investments targeted at extending our low-cost position.

With this in mind, we are now targeting capital spending at the higher end of our previously discussed $250 million to $300 million range, reflecting spend on high-return investments behind our strategies to drive to absolute lowest cost in Fresh Dairy Direct-Morningstar, as well as investments and additional capacity to support the strong volume growth at WhiteWave-Alpro.

With that, I'd like to thank you for joining us today. We look forward to seeing many of you at the Barclays Back-To-School Conference next month. With that, I'd ask the operator to open up the call for your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Judy Hong with Goldman Sachs.

Judy Hong - Goldman Sachs Group Inc.

Gregg, a couple of questions on the Fresh Dairy business. First, on the Branded side of your business, you've talked about margin getting a little bit better sequentially as you've taken some pricing. But as we look out at the end of the quarter with the raw milk prices rising, it looks like your pricing may be lagging again at least in the measured channel data. But can you just talk about how you see that dynamic playing out in the third quarter? And then I have a follow-up question on the Private Label channel.

Gregg Engles

Yes, on our Branded Milk business, as we indicated on our Q1 call, we intended to take pricing in that business. And I say that we're relatively pleased with the results of the price that we've been able to take. And notwithstanding the retail data that shows up, our pricing, I think, has held relatively well, given the actions that we took during Q2. So part of what you see, I think, is retailers adjusting their relative margins in order to maintain a balance of Branded and Private Label, which, over the long run, they need in their stores. So we're reasonably satisfied with the pricing actions that we've taken in our Branded business. We do, however, continue to see, given the relatively larger price gaps, some volume erosion, although that has mitigated as we came through Q2, in terms of losing brands, mixing out to Private Label. So on the Branded side of the business, I'd say we have seen some improvements over the circumstances that existed in Q4 and Q1. We have been successful in taking some pricing. We continue to see volume erosion albeit at a slower pace.

John Callahan

And Judy, just to add, I think the big move we saw from May to June in terms of the Class I Mover, we anticipate that's the last significant move certainly for the third quarter, since it's largely out there, but also carrying into the fourth.

Judy Hong - Goldman Sachs Group Inc.

And then Gregg, if I look at the chart where you talked about the profit shortfall in the Fresh Dairy business, the Private Label margin seems to be a bigger portion of the profit decline this quarter versus the last quarter. So I don't know if this is because your Branded margins actually got better so that's maybe a less of an issue this quarter. But just can you explain to us what's going on in terms of the Private Label margins? And is this a little bit worse in terms of what's happened in the second quarter versus the first quarter?

Gregg Engles

Yes. I think that's an excellent question, Judy. First of all, the overall level of gross profit compression year-on-year is down Q1 to Q2 from $68 million to $54 million. So the whole chart's gotten somewhat smaller. Within that, the gross profit compression in Branded has basically been cut in half, so against a smaller basis, a smaller percentage. So again, we made progress in reference to your first question in getting Branded product pricing, so that aspect has diminished. On the other hand, we continue to see pressure from retailers as they try and capitalize on excess capacity in the industry against private label pricing, and we continue to respond to that. We're going to defend our share in this environment and maintain a size of our business. The industry is going through, I think, a relatively long-term shakeout of capacity here. Retailers understand that. And the level of pricing intensity in private label has amped up a bit as we've gone from 2009 into 2010.

Judy Hong - Goldman Sachs Group Inc.

So that's the increased cost associated with bidding for new contracts on Private Label essentially?

Gregg Engles

Correct, yes.

Judy Hong - Goldman Sachs Group Inc.

And that stays relatively challenging in the second quarter, maybe a little bit worse?

Gregg Engles

Yes. I think it's just sort of how the individual pieces of the puzzle fell into place from across the retail landscape from Q1 to Q2, a little bit more volume bid in Q2 than Q1.

Operator

We'll move on to our next question from David Palmer with UBS.

David Palmer - UBS Investment Bank

Just a quick follow-up to that previous question, within Fresh Dairy Direct, did Private Label profits decline as rapidly as Branded business? Or are you still seeing the majority of the profit decline still in the Branded side of that business?

Gregg Engles

Ask me the question again, David. I'm not sure I got the question [ph]...

David Palmer - UBS Investment Bank

In the most recent quarters, the Branded side of your business was experiencing more margin compression, faster profit declines than the Private Label side, or at least I thought. Could you perhaps talk about how -- we're talking about how things have sequentially improved, but I want to just kind of anchor the year-over-year numbers. Year-over-year was are we looking at mostly a Branded profit decline here in the Fresh Dairy Direct business?

Gregg Engles

No, if you look at Slide 8, we break down the $54 million of gross profit decline. And really, it splits out about a third, a third, a third. Now this is compared to a year-ago period. So total gross margin decline in that business of $54 million split in this period pretty evenly between: Branded margin decline, that's a combination of price and volume; Private Label decline, that's all price; and then the this's and that's in our portfolio, cottage cheese, sour cream, juice drinks, water. Those sorts of things were in a very soft volume environment, mostly volume in that marketplace.

David Palmer - UBS Investment Bank

You mentioned that milk discounting is showing less evidence of traffic benefits. Is there any evidence in the recent retailer behavior that there is a buy-in to that thinking or even there are communications about the future when talking with Dean's about how they behavior will be with regard to this category?

Gregg Engles

Yes, there is some. Now I wouldn't say it's category-wide. We definitely have some retailers who have abandoned the low-price strategy. They basically said, "We're going to price this at a reasonable gross margin return. We're going to live with the volume declines. This is not going to last forever." You clearly have some retailers who have taken that approach. I'd say the principal players in the marketplace, however, had not yet taken that approach, at least not country-wide. And so in fact, we do see volume softness in some of our customers as a result of their pricing strategy. So we do see signs that some customers are wearying of the strategy. Whether that continues, how that ebbs and flows, I think that's going to be a function of what the economy looks like. What I would say, I'd reiterate my comment from my prepared remarks, that despite what is still a pretty promotional environment, we see volumes down in the category. And I think that is a little bit disconcerting.

David Palmer - UBS Investment Bank

We keep on talking about the retailers sort of driving this whole thing. Is there any influence? I mean we're hearing about aggressive behavior by some dairy competitors, such as Grupo LALA, which bought National Dairy Holdings last year. How much of this might be competitor dairy, perhaps, upping the ante a little bit?

Gregg Engles

You really can't separate out the chicken and the egg here. Retailers respond to declining margins in their business by seeking lower prices. And frankly, processors respond to volumes moving around in the category and soft volumes by seeking volume, and they do that on the basis of price. So what actually started the ball rolling down the hill is sometimes hard to parse out, but the fact of the matter is, the balls are rolling down the hill here. And there is pressure on private label price.

Operator

Moving on to Alexia Howard with Sanford Bernstein.

Alexia Howard - Bernstein Research

Speaking with Fresh Dairy Direct and then a quick follow-up on Horizon, you mentioned that retailers are addressing pressure based on excess industry capacity. And I imagine that, that means, or I think you commented, that they are basically going out some re-tendering their private label contracts. Where do you think we are on this? I mean, I think a lot of it started in Q3. Are we in one of the later innings? Are you seeing some light at the end of the tunnel on that sort of re-tendering process from the retailers? And are you seeing capacity rationalization in the industry? And if so, how much?

Gregg Engles

Well, what I would say, yes, this has been going on really now for probably more than a year in terms of the re-tendering of the business, to use your phrase. And so I would say, it swept through much of the industry. And so you would hope that you've seen the bottom of it, but it's hard to say that they won't come back to the well, depending upon how category volumes and the category performs. So again, in the prepared remarks, we focused on the fact that we have got to, over the long term, structurally reduce our cost structure and make sure that we're the surviving players as the industry consolidates here, and the winning player as the industry consolidates, because in a soft-volume environment and an environment where consumers continue to be pressured, I'm not sure that I would want to forecast that this process was going to stop. So yes, it swept through most of the industry. And that was largely complete coming into the second quarter. But I'm not prepared to predict that we won't have another round of it at some point in time. And you had a follow-up question?

Alexia Howard - Bernstein Research

Yes, quick one on just are you seeing industry capacity rationalization at this point? And then just very finally, have we got to the point where Horizon's profits are now sort of where you'd expect them to be over time?

Gregg Engles

At the industry rationalization in capacity, yes. It continues to come out of the marketplace I would say, slowly. We're taking capacity out. We announced on Monday another plant closure within our systems. Some of our competitors are also taking capacity out as volumes move around the systems. So I think that's all healthy behavior. And I think it will continue to happen over an extended period of time. I think you'll continue to see capacity come out of the industry because it makes economic sense for it to come out of the industry. As to Horizon, Horizon is clearly improving. There is no question about that, and the category is back to growing at a pretty healthy pace. So category volume's up mid to high-single digits over the past quarter. So very reassuring and encouraging developments in the category. While we are in a greatly improved financial position in Horizon compared to where we've been in the last year and half or so, we are not anywhere close to being back to what our level of profitability was going into the sort of tectonic shakeout in the industry that started in 2007. So we still got a long way to go in Organic. Frankly, we think that's encouraging because we think it raises the prospects of continuing profit growth in WhiteWave above and beyond perhaps volume growth in that category. But we're going to have to wait and see how that plays out over time. But we're encouraged by the changes in Organic milk.

Operator

We'll move on to our next question from Farha Aslam. [Stephens Inc.]

Farha Aslam - Stephens Inc.

Gregg, when you talk about overcapacity in the industry, about how much capacity needs to come out for the fluid milk industry to be healthy?

Gregg Engles

It's hard to say on an industry-wide basis, Farha, because it's really still -- you have to think about it regionally in terms of where the milk moves. If say, you have to put a number on it, I think the industry could operate with 30% or 35% less capacity than exists today. Best guess, I'm just pulling that number out of thin air to give you an aggregate number. But that feels about right to me.

Farha Aslam - Stephens Inc.

How much is coming out a year, would you estimate, with your closures and what the competitors have shut down?

Gregg Engles

Not a rate nearly fast enough to get to that number any kind of time horizon, pure investors would be interested in. I mean, it's coming out in small single-digit percentages, to date, today.

Farha Aslam - Stephens Inc.

And so as we're seeing this intense competition and capacity is not coming out really quickly, a lot needs to come out. What types of things are people doing to secure volume? Are they signing long-term contracts that are going to be tough to get out of? Or are they -- is it something that can be fixed fairly quickly, if retailers start to change how they go to market?

Gregg Engles

The industry still operates largely on an at-will basis. So people tend not to sign long-term agreements. They may have at-will arrangements that have time horizons on them, but they tend not to sign contracts that are classic supply contracts. So we can change relatively quickly as industry conditions begin to improve. Back to your question of what needs to happen to really get a lot of capacity out. Frankly, it's going to take one of two things to get a lot of capacity out, and we're clearly on one of the paths. In order to get meaningful capacity out of our system, we're going to have to step up our level of capital spending in order to create modern facilities that can supply broader geographies than our existing legacy, smaller, more fragmented facilities can supply. You're seeing us start to step up that level of capital spending. So within our own system, we've got a lot of stranded capacity out there in the 100 plants that we have in FDD, and we need to reconfigure that capacity and ultimately, the amount of capacity we've got dedicated to these individual product lines is going to have to go down, although, our business is not going to get smaller. So we're going to take our own excess capacity out. And you see us probably working more steadily at that than anybody else in the industry. And I think that's why our cost structure is today, lower than anybody else in the industry. So that's the plan that we're going to be on. The rest of the industry remains very highly fragmented. And I think, in order to enable capacity come out of the rest of the industry, it needs to consolidate in terms of an ownership consolidation. And whether one of the existing participants or a new participant is going to come in to drive that is an open question, and one that we don't have a lot of visibility into. But I think for a lot of the stranded capacity and the other 60% of the industry to come out, it needs to have a more consolidated ownership structure.

Farha Aslam - Stephens Inc.

Just one final housekeeping, what tax rate should we use for the rest of the year, Jack?

John Callahan

For the full year, Farha, I'd just point to between 37% to 38%.

Operator

Moving on to Terry Bivens with JPMorgan.

Terry Bivens - JP Morgan Chase & Co

Gregg, just on this capacity thing, I guess, one reason, since it does seem to be such a concern, I just don't know how you square that with the fact that milk production continues to be up from where we sit. It looks like farmers are making money. So I mean, isn't that going to significantly impede rationalization for a certain period at least?

Gregg Engles

Well, I wasn't talking about capacity rationalization at the farm level. I was talking about at the processor level. So milk production is up, but again, you've got declining volumes of Class I products. So that milk's going somewhere else, alright. That milk production is going into cheese or powder or butter. Some of it's going into the domestic marketplace, increasingly, more of it's going into exports. So the milk that shows up for Class I processing is flat to slightly down. And frankly, that flat-to-slightly-down trajectory exacerbates the excess capacity issue within our segment of the industry. So I really don't see other than the period-to-period volatility that's created by what happens in raw milk. I don't see what happens in raw milk as influencing that capacity issue at Class I.

Terry Bivens - JP Morgan Chase & Co

On the fluid side?

Gregg Engles

On the fluid side.

Terry Bivens - JP Morgan Chase & Co

As you look at your branded shares, and we do our best to try to track those through Nielsen and the Wal-Mart panel data, do you think, the private, the branded/private label mix, does it appear to you now to have stabilized and maybe getting a little better? That's what we see.

Gregg Engles

I would say that it's stabilizing. We have yet to see it getting better because we still have pretty big gaps. And some of the customers where we over-index in terms of share of volume are still highly promotional. And so within that, those costumers sets, we continue to see pretty big price gaps to private label, so it's getting better. It has not turned around yet. Again, back to my answer to one of the earlier questions, I do think you're seeing now a divergence of views within the retail community as to the profitability of this price promotional strategy. So hopefully that's the beginnings of a turn, which will lead to improving brand volumes. But we're not ready to call that yet.

Terry Bivens - JP Morgan Chase & Co

And we also see in some of the syndicated data that pricing appears to be better in terms of fluid milk. I think in response to maybe the first or second question, are you saying that you are getting some share of that incremental margin as the retailers do move pricing up?

Gregg Engles

Well, within the retailers that are moving pricing up, our brands are doing better, obviously, in that environment, where the price gaps are lower. But I'll tell you, there doesn't appear to be any private label pricing that's positive going on in this environment. You can see that from our result that's posted on Slide 8.

Terry Bivens - JP Morgan Chase & Co

Was there any hit of a meaningful nature from Class II in the quarter?

Gregg Engles

Yes, we did struggle with Class II in the quarter. Now that's now within our FDD-Morningstar business. But where we struggled with Class II in the quarter was really two fronts. First of all, you have high and rising butter prices. Those high and rising butter prices were reflected in some margin pressure in our Cream business, driven more by the fact frankly, that we were unable to supply all of our needs internally, and we had to go to the external market to acquire cream in a lot of those businesses. That's somewhat offset by the fact that one of the reasons we had to go outside is we were fulfilling our contracts to sell cream to third parties that we sell cream to externally, and the pricing on that cream was pretty attractive. So our net cream sales were positive. Our external cream purchases were slightly negative in the quarter, I would say, on balance.

John Callahan

Yes, we're probably buying more cream on the outside than average, Terry. And that was a bit of a factor as we ended the quarter, and it's probably going to be an issue we're going to live with for the third quarter.

Terry Bivens - JP Morgan Chase & Co

So it would more than offset, Jack, your excess cream sales by -- I guess, it sounds like a little margin but not terribly much?

John Callahan

I would say we're probably losing a bit of margin, Terry right now, just given the amount of cream we're buying on the outside. Part of it is growth in certain product lines. But it's also -- it appears that there's a little less average butterfat available coming out of the system right now on a per-hundredweight basis. We've been struggling to get enough internally.

Gregg Engles

Yes, it's hot. And so we're getting a little less fat for every hundredweight we buy. So there's a little less fat to either sell or more fat you got to buy on the outside in this environment.

Operator

We'll take our next question from Chris Growe with Stifel, Nicolaus.

Christopher Growe - Stifel, Nicolaus & Co., Inc.

The first is that, and I'm just trying to kind of go back to some of the things you said, Gregg, about volume and market share. And I see, excluding acquisitions, I don't have the raw numbers, if you give it I can get it, but your core volumes, x acquisitions would have been down on the quarter, and just curious, is that because of kind of the change you made on some of the branded side of your business? Or what could be driving that marketshare loss on the quarter?

Gregg Engles

Yes, if you take acquisitions out, first of all, volumes in the category are down in the quarter, right? So I'd say that we're sort of holding our own in terms of share x acquisitions. So acquisitions have driven any kind of share we picked up in this period. There is no one identifiable factor to drive our like for like volume declines in liquid milk. A number of things that are happening that I've mentioned, one, some of our customers are taking a high price as opposed to a promotional price approach. So we're getting some mix out of our customer base on volumes. But aside from that is category weakness. So that would be the drivers of the slight volume decline on a like-for-like basis.

Christopher Growe - Stifel, Nicolaus & Co., Inc.

And just to clear that up then, one further question would be because you did indicate a higher percentage of your gross profit hit in dairy came from more of the private label pricing, which just sounds like you wanted to defend your share there. We should expect your share, going forward, at least be in line with the category or above, you're basically drawing a hard line there on shares. Is that correct?

Gregg Engles

Yes, we're going to defend our share position, absolutely. But I don't want to mislead you and say, that there aren't going to be period-to-period fluctuations when you're at sort of a flat share level. What our customers do will also drive our share. So I wouldn't tell you that every share, every quarter, we're going to be positive 1/10 of a share point to the category or anything that precise.

Christopher Growe - Stifel, Nicolaus & Co., Inc.

And to be clear on the MorningStar division, would that have been a benefit in the quarter sequentially? So did that business get better in terms of your pricing algorithm?

Gregg Engles

The MorningStar business within FDD-Morningstar is performing relatively better than our Liquid Milk business. On a year-over-year basis, last year, we had a fantastic year in MorningStar because of decline in commodities. So year-over-year, the MorningStar division is slightly down for last year. But it's performing very, very well and in Q2, was up from Q1.

Christopher Growe - Stifel, Nicolaus & Co., Inc.

So it's sounds you got sequentially better in MorningStar. It's part of what made Fresh Dairy Direct-MorningStar look better this quarter.

John Callahan

It made a contribution to the improvement in Q2 relative to Q1.

Gregg Engles

On the flip side, it will probably struggle in Q3 in response to the fat issue that rather discussed in response to Terry's question.

Christopher Growe - Stifel, Nicolaus & Co., Inc.

On cost savings, and I got the sense from last quarter that you're going to be more aggressive. I think you've confirmed that on terms of getting extra cost-reduction efforts. Should we expect to be hearing more, even though the plants close on Monday, more of that kind of activity this year whether if a few charges or announcements, you'll have more activity there that we should be kind of looking forward to? Or is this more like a 2011 in going-forward basis?

Gregg Engles

I think that over the next few quarters, you will hear -- I alluded to them in my prepared remarks, about some very significant projects that we're undertaking to move big hunks across out of our system. These are projects however that will require investment and will take time to play out. So we will begin to tell you about them in the upcoming quarters. But unlike the closure of a single plant, where we can reallocate the volume around a region, these will be more sweeping moves, and they will require more capital and time to put into effect.

Operator

Moving on to Alex Bisson with Northcoast Research.

Alex Bisson - Northcoast Research

I guess, first, if I look at your selling and distribution expense on a sequential basis, it was down about $17 million. I guess, two things, one, is that a result of the actions you're taking? And is it sustainable that we see lower selling and distribution throughout the rest of this year?

Gregg Engles

Let me take a stab at it and then Jack will backfill with any detail or correct me with anything I get wrong here. Yes, a meaningful part of that reduction is a function of structural cost that we're taking out of the business. So as I mentioned in my prepared remarks, over the last year and half, we've taken 350 routes off the road, and that's an ongoing exercise. And frankly, you'll see as we drill into product line profitability in our business, maybe some stepped-up efforts in that regard. So yes, there are ongoing structural aspects to the reduction. There's also a bit of seasonality that works in our business as schools go out of session and come back in. So you should typically see a decline period-to-period, Q1 to Q2 in distribution expense, because we're not going to a lot of the places we go to the rest of the year. So it wouldn't be surprising to see that step back up to some degree as schools come back into session in Q3.

John Callahan

We also, I mean, we are kind of ending a period, if you would, in terms of, one, we're sort of with the second quarter, ending the overlap of the Alpro acquisition, which has always sort of impacted the year-over-year comparison. But also more broadly, I think as we've communicated earlier this year, our period of buildout and investment of capability at the center is largely behind us. And that will impact distribution, G&A, to a degree selling, that we are now, we believe, in the position to start to begin to drive more overall productivity out of the total operating expense line. I think the results in the Q2 start to point us in that direction, and it's really we're going to focus on the fourth.

Alex Bisson - Northcoast Research

Gregg, last quarter, you said, you thought $100 million of gross profit was at risk in the last three quarters. Given a roughly flat gross profit performance on a sequential basis, would you be willing to update the amount that you view with that risk?

John Callahan

I think we commented the sort of -- we're thinking specifically really, commenting that around the FDD-Morningstar business. And I would say consistent with our view of that business that, that's unchanged, that for the full-year risk we do believe would be about $100 million, inclusive now obviously, of the Q2 result.

Alex Bisson - Northcoast Research

And then my final question, the major cost-reduction efforts that you'll be launching over the next year or so, were these incorporated in your $300 million cost-reduction guidance that you gave a year or two ago? Or are these above and beyond that?

Gregg Engles

Some of them were. But as we mentioned on our Q1 conference call, we're going to be taking this $300 million number up. And in our view, up meaningfully as we move forward out of 2010 and into 2011. So the reservoir of potential cost reductions was never limited to $300 million. Frankly, the more that we learn and the more capability we built at the center to attack cost, the more confident we become that there is still a very, very large pot of opportunities to take cost out of the system. So as we move into these larger projects we'll be announcing over the next few quarters, I think we'll move well beyond the $300 million cost target that we initially rolled out in 2009.

Operator

We'll take our last question from Christine McCracken with Cleveland Research.

Christine McCracken - Cleveland Research

Just on a couple of housekeeping issues. First on the $100 million, I guess, in cost savings that you've identified. You had I think earmarked about $75 million in Fresh Dairy Direct earlier. I don't know if -- I'm wondering if now that you've raised it to the $100 million, if most of that $10 million additional cost saves are going into the Fresh Dairy business, or if it's kind of equally divided.

Gregg Engles

No, it's pretty much Fresh Dairy Direct.

Christine McCracken - Cleveland Research

And then just another follow-up on the Horizon business. You talked about the improvements that you're seeing, I think, in the profitability there, but was it actually profitable in the quarter?

Gregg Engles

It was actually profitable in the quarter, modestly so.

Christine McCracken - Cleveland Research

It sounds like you're doing something maybe to reduce your exposure on the production side or at least lower your cost there. Hearing a lot about, I guess, the production industry changing quite a bit, I think, with some changes in terms of ownership. I'm wondering, from your perspective, you own some farms, is there any way that you could maybe limit your exposure and move supplies around? Or is there anything underway there to lower costs?

Joseph Scalzo

Yes, Christine, the issue with Horizon has been, if you just step back to the period where the industry was profitability challenged, it was a time at which demand was growing in big double digits and people were scrambling to satisfy demand. In and of itself, that creates a lot of supply-chain efficiencies. So as that demand, as we moved into the recession and the growth in the industry mitigated to basically being flat, we focused on our supply chain. So where we source milk from, the distances it moves from getting more efficient in conversion and distribution. And that's been one of the big drivers of improved profitability in the business. And frankly, we're pleased with that progress, and we believe there's still more cost that we can get out in that area.

Christine McCracken - Cleveland Research

And you talked about better sales trends in Horizon as now conventional milk prices are moving up. You think that gap would narrow, it would actually probably benefit Horizon even more maybe than the growth that you've seen already. Is that something that you're anticipating?

Joseph Scalzo

Yes. I mean, there has been, as pricing has moved upward in conventional, there's been an improvement in organic milk growth. And I think as Gregg mentioned in his prepared comments, we do see, to some degree, bifurcation of our categories. Our more premium categories are growing. Our more value-oriented categories seem to be flat. And so I think, we're going to continue to see that as we move forward. I think the recession has affected different classes of folks in different ways.

Christine McCracken - Cleveland Research

Just finally, I think, Gregg, you highlighted your concerns about the lack of volume growth, I think, in the category overall. I'm just wondering, you highlighted use in cereal and the challenges there. Is there anything else that -- is it a change in taste preferences? It doesn't seem like consumers are reacting maybe to the low prices the way you think they would.

Gregg Engles

Yes, I'll give you what is an anecdote. But it is one of the things frankly, that I am somewhat worried about. And that is if you go back and you look at our fluid milk volumes several quarters ago, and you track them on a weekly basis, we used to see, as you would expect, was a truly stable category with complete household penetration. You used to see very flat volumes week to week, right? So very little change in average daily sales. We're now seeing a different pattern. And that pattern is at the beginning of the month, we're seeing sales rise above the trend line. And by the time that you get to the end of the month, sales are down in what are meaningful percentages for a category like this, that's flat, it has been for 30 years. So you're seeing inter-month volume volatility, or a volume pattern emerging. And the only conclusion, I think, you can draw from that is there are people who are big consumers in this category, they're just running out of money, starting at the end of the month. And you'll recall, during the month of June and in part of July, the Congress stalemated over extending unemployment benefits for a large number of people. We saw that in our business in soft volumes. So that's really my concern about the category is that there are still a very large number of households in the U.S. who are very constrained in terms of disposable income, and they're cutting back wherever they can. And they're not cutting back just one category, they're trimming around the edges everywhere. And we see soft category volumes.

Gregg Engles

Thank you all for joining us on today's call and we look forward to seeing you at the Back-To-School Conference in Boston in about a month and after that on our November call. Thank you all very much.

Operator

Ladies and gentlemen, that does concludes today's conference. Thank you for your participation.

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