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Dean Foods (NYSE:DF)

Q1 2014 Earnings Call

May 08, 2014 9:00 am ET

Executives

Tim Smith -

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

Chris Bellairs - Chief Financial Officer and Executive Vice President

Analysts

Amit Sharma - BMO Capital Markets Canada

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

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

Eric R. Katzman - Deutsche Bank AG, Research Division

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

Robert Moskow - Crédit Suisse AG, Research Division

Farha Aslam - Stephens Inc., Research Division

Brett M. Hundley - BB&T Capital Markets, Research Division

Operator

Good morning, and welcome to the Dean Foods Company First Quarter 2014 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 the property of Dean Foods. Any redistribution, retransmission or rebroadcast of this call in any form without the express written consent of the company is strictly prohibited.

At this time, I would like to turn the call over for opening remarks to the Senior Vice President of Investor Relations and Treasurer, Mr. Tim Smith. Please go ahead, sir.

Tim Smith

Thank you, Mina, and good morning, everyone. Thanks for joining us on our first quarter 2014 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 an 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 a 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 spin-off and disposition of our remaining investment in WhiteWave common stock, the Morning divestiture and the early retirement of debt.

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 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, network optimization plans, dairy commodity pricing, the payment of any future dividends, anticipated share repurchases, leverage ratio and various other aspects of our business. These statements involve risk 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 first 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.

I would expect approximately 30 minutes of prepared remarks, followed by 30 minutes of Q&A. With that, I will turn the call over to Gregg for his opening remarks. Gregg?

Gregg A. Tanner

Thank you, Tim, and good morning, everyone. Thanks for joining us on the call today. As you know, we entered 2014 facing substantial margin pressure in our milk business, as Class I raw milk prices have continued to reach all-time new highs, and for the quarter were 22% higher than last year. This morning, we reported first quarter results that were below our previously articulated adjusted diluted earnings per share range of approximately breakeven, with $0.03 of potential risk or benefit to such guidance.

For the quarter, we reported a net loss of $0.05 in adjusted diluted earnings per share and adjusted operating income of $7 million, both were down considerably from year-ago results.

The first quarter continued to be affected by a challenging environment, which we previously indicated would be the case through the first half of 2014. Key challenges during the quarter included the following:

First, raw milk costs posted all-time highs in February and then again in March, which can create increased pressure on our margins, as pricing in retail can be pressured by price gap and price threshold considerations. In addition, higher raw milk costs raised the cost to Dean Foods of route returns, dumps, production losses and other forms of shrink.

Secondly, fluid milk category volumes remained soft, although consistent with the fourth quarter of 2013. However, as prices continue to rise, we experienced additional softness in our volumes during March and April.

Based on another rise in May's Class I price, we would expect this additional volume softness to persist into Q2.

Continued transitory cost in production and distribution associated with our plant closures and loss of volumes is the third item.

The fourth, we estimate that during the quarter, we had a negative impact associated with winter weather disruptions of approximately $4 million or $0.03 of diluted earnings per share. This impact came in the form of lost school milk volumes and incremental costs.

To address the non-weather-related issues and begin to rebuild our profitability, we will continue to focus on 3 business fundamentals: accelerated cost reduction, price realization to pass-through input cost inflation and volume performance.

While we have a long way to go, I'm cautiously optimistic that the trajectory of our business in the second half of the year is upward and that we are on a path for continued progress as we move through the balance of the year.

During the quarter, we also managed our working capital diligently in the face of continued rise in raw milk costs. As a result, we were able to drive improved performance in our cash conversion cycle on a sequential and year-over-year basis. Despite a 12% sequential quarterly rise in the Class I raw milk price, our invested capital across accounts receivable, inventory and accounts payable were flat at $510 million. Year-over-year, we achieved an improvement of $108 million against the 22% rise in Class I raw milk prices.

Finally, during the quarter, we repurchased $25 million of our common stock or approximately 1.7 million shares at an average purchase price of $14.45.

The partial loss of our private label business with a significant customer, combined with a general category weakness, resulted in total volumes of 685 million gallons in the first quarter of 2014. This represents a 5.9% decline from 727 million gallons in the first quarter of 2013.

While we had not yet began to lap the RFP-related volume losses in the first quarter, our volume growth improved sequentially due to realization of previously discussed new volume wins.

Within fluid milk specifically, industry category volumes declined approximately 2.1% 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 6.7%. This quarter's volumes continue to reflect the full negative impact of the RFP-driven volume loss, but the recent wins we discussed on our last call are continuing to materialize in our volumes and share performance.

Excluding the impact of the RFP and another customer's decision to vertically integrate last year, our fluid milk volumes increased 1.1% in the quarter, significantly better than the overall category and an improvement from last quarter's comparable 0.6% decline.

Year-over-year weakness in the large format channel continued to be partially offset by strength in the small format channel, where we experienced an approximate 7.6% increase versus the prior year. This quarter also marks the 11th consecutive quarter of growth for Dean Foods in the expanding dollar channel.

Overall, we continue to expect our unadjusted volumes to underperform the broader industry through the first half of 2014, due to the ongoing year-over-year impact of the lost private label RFP business in the second and third quarters of 2013.

Our share of the fluid milk category was 35.9% in the first quarter. This represents 0.1% increase from the prior quarter, as we continue to benefit from the new volume wins and continued strength beyond large format channels. Since bottoming out in the third quarter of 2013, we have increased our share of fluid milk category by 1%.

In terms of our branded versus private label white milk mix, we ended the quarter at approximately 36.4% branded, which was down about 0.5% versus the prior quarter. Dean's share of branded white milk at retail has increased for 4 consecutive quarters, and we are approximately 130 basis points better than the prior year.

We continue to be pleased with the performance of TruMoo brand and are very excited about its potential for continued line extensions. We are seeing positive consumer and retailer response from our seasonal promotions and flavors. During the month of February, TruMoo Chocolate Marshmallow, in conjunction with our Try it Hot promotion, drove 22% incremental volume as measured by IRI.

Our plan is to continue delighting our consumers with limited time offers during peak selling seasons. We are also focused on growing our national distribution beyond our DSD footprint by leveraging extended shelf life products. In January, a large retailer authorized TruMoo ESL in 1,000 new stores.

In the grocery channel, year-to-date ending March 31, TruMoo distribution is 10 points above the prior year and 15 points above our branded white milk distribution. This is clear evidence that TruMoo continues to win with our consumers and retail customers alike. We are also pleased with the results of our regional launch of the TruMoo Protein and plan to expand distribution nationally later this year.

Turning to pricing. As Class I raw milk prices continue to move higher, the margin over milk or the spread between the Class I mover and the retail price of private label gallons has compressed to approximately $1.43 per gallon in Q1 compared to $1.50 per gallon in the previous quarter and $1.58 per gallon in Q1 of 2013.

Although we are near the lows of late 2010, we would expect that as raw milk prices moderate, the margin over milk would move back toward the post 2010 historical mean of $1.50 to $1.60, as we expect retailers will restore greater profitability in the dairy case. Average price gaps between our brands and private label in Q1 were consistent with Q4, but slightly below year-ago levels.

Since August of 2013, Class I raw milk prices have continued to increase every month, ending the quarter at $23.64 per hundredweight, an all-time high. On average, the first quarter Class I price was 12% higher than the fourth quarter and 22% above year-ago levels. On a comparable March 2013 to March 2014 basis, the Class I raw milk price is 33% higher. As of May 1, the Class I price has increased an additional 4% from March to another all-time high of $24.47 per hundredweight, which is 38% higher than year-ago period.

Obviously, these price levels, both in absolute terms and persistency, from unprecedented in our history. Beginning February, we have had 4 consecutive months of all-time high Class I milk prices, and May's increase represents the ninth consecutive month of higher raw milk prices. I'll come back to this topic in my closing remarks to give you a better sense for our balance of year expectations around raw milk prices.

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, we've closed 8 facilities since we began ramping up activities late in 2012 and have announced an additional 3 closures in 2014, including 2 announced in April. We have strong momentum behind these initiatives and expect increased savings from plant closures into 2014 to help offset the volume

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associated with the lost business in 2013 and the current record high dairy commodity environment.

However, as we have previously stated, with the full impact of the RFP volume declines and the associated accelerated plant closure activity in the back half of last year, production cost declines lagged the decline in volumes, resulting in higher per unit costs in the first quarter and lower overall gross profit.

First quarter distribution costs were flat on a year-over-year basis, which was behind the rate of volume decline in the quarter, leading to a temporary increase in per unit distribution cost.

As we have stated in the past, while closing manufacturing facilities drives production efficiencies, these are partially offset by increased miles driven as products are shipped back into the area surrounding the closed facilities.

We believe the increased per unit production and distribution costs are temporary, and that costs will come in line with the volumes as we move past this recent period of accelerated plant closure activity.

Helping to offset this increased cost was a $12 million reduction in SG&A costs in the first quarter from the year-ago period.

As a result of the record-high raw milk prices, unusually severe weather, the full impact of the RFP volume loss and the associated transitory costs, we reported a $67 million year-over-year decrease in operating income. Operating income totaled $7 million for the quarter versus last year's $74 million.

As we look ahead in Q2, we continue to see difficult overlaps, but expect performance to improve as we reach the anniversary of the RFP-driven volume loss and realize a greater benefit from our cost initiatives. However, we remain concerned about fluid milk category volume weakness and the continued pressures historic high-raw-milk costs are putting on our gross margins. That being said, we continue taking the necessary actions to reduce our cost structure and better position the business to succeed despite the challenging marketplace.

Now I'll 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 results, as well as review the balance sheet and cash flow performance. Starting at the top of the income statement. As Gregg noted, total volumes declined 5.9% 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 cost deleverage within the quarter. This, combined with the margin pressures resulting from record-setting Class I milk prices, drove a Q1 year-over-year decline in adjusted gross profit of $80 million or 16%.

Below the gross profit line, total company operating expenses declined $12 million from the year-ago period. In distribution, lower volumes and continued cost productivity reduced expenses $1 million versus the prior year, which lagged our first quarter volume decline of 5.9%. However, as Gregg mentioned earlier, while facility closings drive production efficiencies, they are partially offset by increased miles driven, as products are shipped back into the areas surrounding the closed facilities.

SG&A cost declined $12 million, resulting in an operating income decline of $67 million to $7 million. Adjusted EBITDA for the first quarter was $46 million, a 60% decline versus the prior year's $116 million.

Below the operating income line, interest expense decreased $12 million from the year-ago period. This decrease is a result of significantly lower debt levels and benefits from our successful late 2013 repurchase of a portion of our higher coupon senior notes. This, in combination with our normalized adjusted tax rate of 38%, yielded a Q1 adjusted net loss of $5 million and adjusted diluted earnings per share of negative $0.05.

Turning now to the balance sheet and cash flow. As of the end of the first quarter, total net debt outstanding was $906 million, up from the $881 million at the end of Q4. This increase was primarily related to a $15 million tax payment associated with the Morningstar divestiture and $25 million in share repurchase. On an all-cash netted basis, our Q1 leverage ratio was 2.75x net debt to EBITDA. As we move through Q2, we would expect to hit our peak leverage and then move toward our stated objective of maintaining an average leverage ratio below 2.5x net funded debt to EBITDA.

Year-to-date net cash flow from continuing operations was $33 million. Capital expenditures totaled $28 million, resulting in free cash flow from continuing operations of $5 million. On an adjusted basis, which excludes the Morningstar tax payment and the receipt of a $9 million tax reimbursement from our former subsidiary, WhiteWave, Q1 adjusted free cash flow was $11 million.

Overall, we performed above our going-in expectations, as we were able to drive improved performance in our cash conversion cycle on a sequential and year-over-year basis. As Gregg noted, despite a 12% sequential rise in the Class I raw milk price, our invested capital across accounts receivable, inventory and accounts payable was flat at $510 million. And year-over-year, we achieved an improvement of $108 million against a 22% rise in Class I milk prices.

Finally, effective January 1, 2014, we de-designated all open commodity derivative positions that were previously designated as cash flow hedges. During the first quarter of 2014, we reclassified $200,000, net of tax, of hedging activity related to these commodity contracts from accumulated other comprehensive income into operating income.

As of the de-designation date, all commodities contracts are now marked to market in our income statement at each reporting period and a derivative asset or liability is recorded on our balance sheet. Therefore, going forward, our GAAP versus adjusted earnings will net out the changes in fair value of our commodity derivatives.

With that, I will now turn the call back to Gregg for some commentary on our balance of the year outlook before opening the call to your questions. Gregg?

Gregg A. Tanner

Thank you, Chris. During our fourth quarter 2013 conference call, I noted the following items would drive our 2014 earnings progression: first, a more challenging dairy commodity outlook; secondly, fluid milk category softness; third, shrink costs; and fourth, overlapping of RFP-driven volume loss.

First, as we previously indicated, the consensus view of the dairy commodity outlook for 2014 appeared to be significantly more challenging than expected, as current dairy commodity prices had moved near or beyond all-time highs despite strong global production growth.

Since our fourth quarter call, domestic raw milk prices continue to be meaningfully impacted by global developments, with May's Class I raw milk price of $24.47 being 38% above the prior year and well ahead of our prior expectations for May. Although global dairy prices are moving lower, as evidenced by recent global dairy trade auctions, volatility remains, as evidenced by the recent auction in the cheese markets.

Exceptionally strong demand for U.S. cheese, both domestic and international, coupled with milk production issues in a few important cheese producing states, caused fresh cheese prices at the CME to reach all-time record highs in late March, lending support to the all-time high Class I raw milk price announced for May.

Weak cheese production, a 37% year-over-year increase in March U.S. cheese exports, and depressed cheese stocks continue to provide price support to this market. However, since this all-time high, the spot cheddar markets have moderated 14% to 16%, with the exception of -- with the expectation of additional declines.

Beyond cheese, all major U.S. dairy product export volumes have continued to experience meaningful year-to-date increases, with total dairy exports up 23% compared to a year ago. In March, exports volume across nonfat dry milk, butter and cheese were up 31%, 79% and 37%, respectively.

We also said on our last call that we believe that in order for domestic raw milk prices to experience a noticeable decline in the second half of 2014, there will need to be a significant supply response from both the U.S. and the European Union.

To date, global supplies appear to be meeting those expectations. European output is up 4% to 5% versus the prior year. And it appears as though the way is being paved for 2% to 3% full year production growth, which will be the biggest advance in at least 5 years. New Zealand's production has also been relatively strong with full season production, which ends in May, expected to increase 5% to 7% against last year's weak comps.

Production in the U.S. continues to grow at a slow rate, largely as a result of harsh winter weather conditions in the Midwest and Northeast through March. U.S. milk production increased approximately 1%. However, sequential production improvements are being forecasted by the USDA. Overall, U.S. milk production is expected to increase 4.9 billion pounds or 2.4% in 2014, which is a slight increase from the prior USDA forecast of 2.1%.

Based on current Class I raw milk forecasts, we anticipate the second quarter of 2014 will be the highest quarterly average on record, exceeding the first quarter's average of $22.38 by approximately 6%.

The result of this continued upward movement in raw milk prices has increasingly moved us into uncharted territory with respect to price elasticity within the fluid milk category. As I previously mentioned, we continue to work to pass through the increasing raw milk costs to our customers. However, in doing so, volume softness has begun to manifest itself in both March and April. We would expect to see that continue through Q2, given current raw milk price levels.

While we remain watchful of global supply and demand dynamics, as we look ahead, assuming normal weather patterns, we continue to believe solid global supply growth will lead to moderating raw milk prices in the second half of 2014.

These historically high raw milk prices continue to be an undeniable headwind for our business.

Second, the fluid milk category continued to show weakness, with industry volumes down 2.1% in Q1. We continue to keep a watchful eye on the impacts associated with the higher dairy commodity prices and the late 2013 reduction in SNAP benefits. We are hopeful that our recent new volume wins and increasing share gains will partially offset the asset deleverage that soft category volumes create. However, soft volumes, coupled with historic raw milk inflation and price gap and threshold pricing decisions can negate some of the impact of our cost reduction efforts and make it harder to take those savings to the bottom line.

Finally, as raw milk costs rise, so does our cost to shrink. To help offset a portion of this cost, we have recently implemented a per gallon price increase to our customers. Even so, at current forecast dairy commodity levels, we expect shrink costs to continue to be a headwind for us in 2014.

As you can tell from my commentary, we expect Q2 to be particularly difficult, given the unprecedented level of raw milk costs, continued overlaps of the RFP-driven volume loss and category declines that may be worse than recent run rates, given our current price elasticity concerns. However, as we lap the most difficult challenges of our cost reduction efforts continue to take hold, we expect results to strengthen in the back half and exceed 2013 performance in third and fourth quarters.

Taking all of these factors into account and looking ahead to the balance of the year, many challenges remain, and thus, our forward guidance will reflect a cautious tone. All told, we expect a second quarter adjusted diluted loss per share of $0.02 to $0.08.

Based on our performance in the first quarter, as well as our expectations for the second, we are lowering our full year guidance to at least $0.60. This full year guidance is predicated on a moderation of Class I prices beginning in June, with an end of the year assumption of $20 to $21 per hundredweight.

Beyond the Class I milk assumptions, there are a number of additional interdependencies embedded in our full year guidance as we begin to decline from historic raw milk cost levels. Key interdependencies would include a return to the mean around a number of factors including: the elasticity of the category and a reinflation of the margin over milk, allowing for the maintenance of appropriate price gaps between private labels and brands. We remain comfortable with our prior adjusted free cash flow guidance of at least $125 million, with our full year capital expenditure forecast unchanged at $150 million to $175 million.

In summary, we believe the market environment continues to be a difficult one with several factors continuing to impact our earnings progression, particularly over the first half of 2014. However, later in the year, we expect earnings to improve, as we -- as the overlaps become less difficult and the full benefit of our cost reduction efforts take hold. We are currently operating in a very difficult environment. However, we remain confident the right steps are being taken to build a strong foundation for future success.

Before I turn the call over to the operator, I want to acknowledge a couple of recent awards. First, Dean Foods was recognized with the 2014 Best of Sustainable Supply award in the category of Animal Health and Wellness (sic) [Welfare] by the McDonald's Corporation. We were 1 of 4 company's granted this award globally. Second, we received the Dairy Category Supplier of the Year Award from Target Corporation. Both of these awards reaffirm our commitment to quality, safety and service. And the aforementioned awards are not possible without our great employees. Therefore, I want to thank them for their hard work, focus and dedication.

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

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Amit Sharma from BMO Capital Markets.

Amit Sharma - BMO Capital Markets Canada

Gregg, I'm sorry, I jumped on the call a little bit late, so forgive me if you have answered this already. When we look at the milk price environment and the moderation coming back in the back half, what sort of impact -- or in what ways will it impact Dean's operating performance in the back half? And then I have a follow-up.

Gregg A. Tanner

Well, I mean, I think in general, it starts to put us back in historical places that would get us back, from a cost perspective, back more in line with where we should be. So I think we'll see the -- overall, as it comes down in that $20 to $21 range, it allows us then to get back to where we've been in areas where we've seen. Like I said, this $24.47 is uncharted for us. We have no -- we've never seen it work in this manner.

Chris Bellairs

So you may -- you've heard us talk about at $24, certainly, and even at levels below that. We think we're kind of faced with 2 awfully equally unpleasant choices. One is to pass through that high milk cost of $24 and run the risk of destroying demand. The other is to not pass it through and sort of try to maintain historic price levels that we have and destroy margin. And neither one of those options is particularly palatable. So to your question, if the milk curve in the back half of the year follows our forecast, comes down, we would expect relief on that dynamic.

Gregg A. Tanner

And that will be either the margin or the volume.

Amit Sharma - BMO Capital Markets Canada

And the guidance of at least $0.60 for the full year, that implies a pretty substantial recovery in the back half. We have seen, at least in the first and second quarter, milk prices overwhelm some of estimates and expectations that we had. How much comfort do we have about the back half guidance at this point?

Gregg A. Tanner

We're cautious, obviously. I mean, we believe that we've got a plan that delivers that. But we've tried to project these milk costs over the last 9 months, and it's been difficult.

Chris Bellairs

We and other industry experts have really struggled to be able to forecast over the past, like Gregg said, 6, 9, 12 months.

Amit Sharma - BMO Capital Markets Canada

Sure. And one more on the volume side. I mean, clearly, you guys are doing very well in terms of gaining some of the share back that you lost last year. And the other thing that you're seeing a lot more visibility on TV and other avenues, Milk Board spending a lot of money. Kellogg talked about spending a little bit more money in promoting milk. What's your outlook on milk volume for the overall category and your ability to continue to take share here?

Gregg A. Tanner

Well, we believe we'll continue to take share. As far as the work that MilkPEP is doing with Milk Life, we're obviously highly engaged in that process with MilkPEP and feel very confident in the new program that they're rolling out with. So I think that's going to help the category in general. But I think the second quarter is going to continue to be tough for the category. I think we're going to see -- it was down 2.1% in the first quarter. I think it's going to be more than that in the second quarter, just because of the higher prices. And then I think you'll see it start to come back in the third and fourth quarters.

Chris Bellairs

Yes. We might have thought that the 2.1% in the first quarter category decline was, in some respects, a little bit of a bright spot and a silver lining, because you had the very difficult weather that we talked about that likely took some wind out of the sails of the category. And you had, recall, you had 3 full months of reduction in SNAP benefits, not the 2 months that you had in the fourth quarter, when we also logged a 2.1% category decline. So going into the quarter, I might have thought that the category will be down even more in the first quarter than it was. Now to Gregg's point, then you have sequentially higher prices in the second quarter. So do we see continued softness? That would stand to reason.

Amit Sharma - BMO Capital Markets Canada

In the back half, we should see better trends, as milk prices come down and some of these promotional activities also take some impact on consumption.

Gregg A. Tanner

Correct.

Chris Bellairs

Yes.

Gregg A. Tanner

That's our expectation as well.

Operator

Your next question comes from the line of Akshay Jagdale from KeyBanc.

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

So first question. I mean, your results are obviously being negatively impacted, it seems like, from a number of factors that are out of your control to a large extent. I would call out the 2 main ones, obviously, milk prices and the other being category weakness. So I know you baked in, to the best of your ability, projections for milk prices. But what if -- can you give us a sense of what the back half would look like if milk prices stayed where they are today and also if category volumes remained as weak as they are today? What's the downside to your earnings outlook if those 2 situations come to be true?

Chris Bellairs

Yes. Akshay, the piece I would take you back to in the prepared remarks, the part of Gregg's script where he talked about uncharted waters. I think it's difficult for us right now to wrap our minds completely around what that downside scenario looks. Because unfortunately, there's just not a good data set to pull from. We're really making up the data that suggests how the category performs and how the Dean Foods business performs at $24 a hundredweight milk as we go. So that's why you've heard that cautious tone, that's why we set guidance of at least $0.60, assuming a number of things take place, largely the initial catalyst being the reduction in milk cost in the back half of the year. To the extent that doesn't happen and then other things don't follow on from that, continuing to provide the range around the downside below $0.60 is a challenge for us.

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

And so that same challenge obviously applies to us. But can you give us a sense of just roughly how much of the underperformance, let's say, this quarter was related to milk prices.

Chris Bellairs

The amount would be tough for me to tease out, actually, with everything else going on. And there -- it would be tough for me to say. So if -- in hypothetical, if milk had been $22, not $24, or $20, what would our EPS have been? That would be a tough piece of math to do.

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

So just roughly, I mean, I guess, the way you're thinking about milk prices is if milk prices return to historical levels, I don't know what that level is, but maybe let's call it $17, $18 a hundredweight over the next year or 2, your general sense is that your EBIT per gallon should return to more historical levels of $0.07, $0.08, $0.09, right? Is that a good way to think about it?

Chris Bellairs

Yes, absolutely. That's -- so if you go back to where I started. If we are back in charted waters, if we're back in kind of a $17, $18 range, we think our historical models apply. We have good data sets to go on. And we think nothing has changed in the fundamental P&L algorithm of the Dean Foods business that would change that operating income per gallon performance. The difficulty is where we are today at the historic highs, predicting that. And in some respects, that transitional period. So from $24, back to $18, which we think will be the back half as we move from $24 to possibly $20 in the back half of this year, that's where the difficulty in putting a particularly fine estimate on the outcome is hard for us.

Gregg A. Tanner

So, Akshay, the thing we run into here is not -- as Chris said, it's uncharted waters. But the elasticity of the pricing and volume correlation is almost impossible for us to try to get our arms around right now, just because we have no data. So to say, if it wasn't at $24, would we take more pricing and what would be the volume destruction that we would see from that? And we just don't know those numbers.

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

Okay, that's helpful. So let me go to the side of the business that you do control, right? Obviously, there's -- in my estimation, the biggest cost bucket that you can attack and which you're in early stages, are the distribution costs. So can you give us a sense of what are the distribution costs per gallon? What's the long-term sort of trajectory that you can get to on those? And then why not -- there's been other companies that are in tough categories that have done sort of accelerated cost reduction programs, et cetera. So why -- is there a possibility of that happening at Dean Foods? And if not, why?

Gregg A. Tanner

Yes. Well, I mean, you look at our -- you look at the work that we currently have underway in the logistics organization, and I believe we're making great progress. We are a bit behind the curve as far as the volume decline and being able to take out cost at that rate yet. But we think that as we go through the rest of this year, that our logistics costs will definitely come out at a rate faster than the volume has declined. So I'm very confident in the work that Tony Brooks and his team are doing in the logistics side to take those costs out. I think the same goes on the plant side. So both of those are, in my opinion, in relatively good shape.

Operator

[Operator Instructions] Your next question comes from the line of Judy Hong from Goldman Sachs.

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

So just on, obviously, a pretty tough environment from a high milk-price perspective. I'm just curious to hear your perspective and in terms of what you're seeing with how retailers are dealing with this, the category and the elevated milk prices. Both from the effort that you have to obviously stick to the pass-through, for the milk cost, as well as, I think you've said, you try to take pricing on -- to offset some of the shrink cost increases. So just wanted to see what the reactions that's been from the retailers. And then related -- I guess, somewhat related to that, you've seen some consolidation among some of your key customers, Safeway and Albertsons, for example. Just wondering what the implication there is. Is that an opportunity as potentially to get more business? Or are they looking to other avenues of sourcing?

Gregg A. Tanner

Okay. Well, let me start with the customers and where they're at. We talked about it in our prepared remarks, where the margin over milk is coming down. So I think the retailer today is absorbing some of the cost increases that are coming across, as you can see in the $1.43 from $1.50. And we've seen that, Judy, as we've seen through April as well, we're down in $1.39 range currently. So I think we're going to continue to see them absorb that until the prices start to fall. And then my opinion is and I -- in discussions with other retailers, is you'll see that margin over milk start to come back to more historical levels of $1.50 to $1.60 range. So I think they understand the environment today. Everybody is really price sensitive in the market because we know that there are certain price thresholds that we can't cross or it starts to -- start to impact the demand more so than others. So I think the retailers are responding well. And yes, they clearly know that we're all kind of in this together as far as the high milk prices. On the Safeway, Albertsons, I can't speculate what that may mean. It's obviously going to consolidate on the retailer side. And I think -- every change out there, I think, provides us an opportunity. I just don't know what that opportunity looks like as I sit here today.

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

Okay. And if I can just follow-up on your comment about the retailers. So they're absorbing some of the cost pressure right now. If in the back half, you do see milk prices moderating, is there a risk that they try to recoup some of the margins that they lost in the back half and push the manufacturers, to some extent, for some of that margin give-back? Or you think that the relationship is pretty rational right now?

Gregg A. Tanner

It feels rational, Judy. I think it's one where I don't know that they'll put any more pressure on the manufacturers than what they put on today. I mean, it is an extremely competitive environment, and that pressure will continue. But I think on the -- I think where we'll see it is, is they probably will recoup it more on the pricing side within their stores. So they'll probably hold prices as it comes down. So it may not help us on the volume front, as much as it may help them on the margin front.

Operator

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

Eric R. Katzman - Deutsche Bank AG, Research Division

I guess, let's switch -- quick question, given the Q on the balance sheet cash flow and use of that. I guess, I was initially concerned that the board had not implemented a dividend that was high enough. But given what's going on in the market, it seems like the board was correct in giving a relatively modest dividend. But where -- at the same time, you had announced a pretty big share repurchase program. Are you kind of inclined to hold back on that, given what's going on in the market? Or do you still feel comfortable enough in that $125 million of free cash flow that aggressive repo is likely to continue?

Gregg A. Tanner

I think there's 2 things there, Eric. One is I think from a -- we'll continue to be opportunistic in our purchases. I think we can continue to create shareholder value at certain levels. I think I would also tell you that our long-term target is to be at 2.5x net debt to EBITDA. And we're currently above that, so we'll watch ourselves as we go through this process.

Operator

Your next question comes from the line of Mr. John Baumgartner from Wells Fargo.

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

Gregg, in this higher milk price environment, what are you seeing in terms of the financial stress on your smaller competitors? Have you seen much of an uptick in those competitors closing their doors at all?

Gregg A. Tanner

John, no. I can't -- I mean, I can't speculate on what the impact is on them. I got to believe it's tough. I mean, it's tough on us. It's tough on everybody. But I don't -- I can't speculate on where it's at.

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

But you haven't really seen any reports of an acceleration of people exiting at all at this point?

Gregg A. Tanner

No, no. I mean, we keep our eyes and ears out. But no, we haven't really seen anything.

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

Okay. And then just in terms of a follow-up. In these price increases you put through, have you seen your competitors also putting through surcharges as well from some of these shrink costs?

Gregg A. Tanner

I haven't heard, so I don't know. I know -- we've put it out there. We believe that it's effective for us. I haven't heard whether or not they did or didn't.

Operator

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

Robert Moskow - Crédit Suisse AG, Research Division

Really, just to follow up to Akshay's question about the distribution costs. I didn't feel like you gave us much in a way of details as to what steps Tony is taking to optimize the cost structure of distribution. And I was hoping, since this is such an important issue for the company, that we could get kind of a little more color on how you're looking at it. And maybe also, do you -- have your cost per gallon gone up a lot over the last 4 years? Because I remember at your Analyst Day in 2009 that this was a big issue then. You felt like your costs were too high then. And I imagine, with all the volume coming out of the system, have the costs gone higher since then?

Gregg A. Tanner

Yes. The costs are up a bit over the last 5 years, 4 to 5 years. A lot of that due to just consolidation and volume deleverage of the system. To give you a little bit more color on the logistics side of it, as far as the things that we're doing: the big thing is around driving all of the appropriate performance indicators. So we bring in a logistics professional in to get us focused more on the logistics side around what are the right key performance indicators, the same thing we did on the supply chain side and the operations side. And they're in the midst of rolling that scorecard out as we speak today. But the key cost drivers beyond just driving productivity through their KPIs is really coming out of 2 fronts. One is what I would characterize as load factors. So how do we make sure that when our trucks are going out that their load factors are at the levels that we would expect them to be at. So that means that they're redoing routes, they're rerouting and optimizing our routes to try to get the load factors to a much more acceptable level. The second thing is putting a lot of our third-party freight out for bid. We had not put our third-party freight out for bid in our history that I'm aware of. So we have put our freight out for bid, consolidated all of our third-party freight, put it together into a bid and put that bid out earlier this year, and should be finalizing some of those over the next couple of months.

Robert Moskow - Crédit Suisse AG, Research Division

Gregg, what about just the number of DSD routes? Like does that -- does the number of routes come down?

Gregg A. Tanner

They're coming down. Yes.

Robert Moskow - Crédit Suisse AG, Research Division

Coming down?

Gregg A. Tanner

They come down. As you start looking at your load factors and you try to get your load factors up, the number of routes will start to fall. Yes, I mean, we're taking assets off the street.

Robert Moskow - Crédit Suisse AG, Research Division

Okay. And do you foresee a restructuring program that would have to pay for all of that in terms of severance and everything? Or is it too soon to talk about that?

Gregg A. Tanner

No, I don't think it's going to be a -- it's not going to be a big bang like that. I think it's going to be one that we'll continue to just take them out as the routes come out because we're also -- we'll also be looking at branch consolidations along the way. So I don't think there's going to be any big restructuring. Chris, do you...

Chris Bellairs

Absolutely.

Gregg A. Tanner

And I don't see anything, anyway.

Operator

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

Farha Aslam - Stephens Inc., Research Division

When you look at volumes, looking into the second quarter and going into the rest of the year, how do you think about Dean Foods volumes for the quarter and the year?

Gregg A. Tanner

Well, I mean, if I look at -- as we've said in our prepared remarks, I think the second quarter is going to be tough volume-wise. I think we will continue, as we did in the first quarter, to continue to take share. I think we'll continue to get as much as we can, from a volume perspective, out of the RFPs that are currently out there. And then full year, low single digits would be my guess.

Farha Aslam - Stephens Inc., Research Division

So second quarter decline similar to what we saw the first quarter and then low single digits for the year?

Gregg A. Tanner

Yes. I would even say second quarter may be a touch worse than the first. I mean, just because we're up at $24 a hundredweight.

Chris Bellairs

So a low single-digit decline for the full year. And keep in mind, Farha, as we get in the second quarter, we do have the tailwind that we begin to overlap the Walmart loss from last year. So it's sort of 2 different counterbalancing factors, where we're worried about the health of the category as prices climb to all-time highs and we're worried about our own volume within the category as we try to strike the right balance on that price-volume equation. But then on the counter side of that, in the second quarter, in the third quarter, we start to get the benefit from lapping last year's volume loss. But all that netted together takes us to our expectation that the full year will be low single-digit decline.

Farha Aslam - Stephens Inc., Research Division

Understood. And if we go to the full year -- or sorry, pricing, has -- you're right now bidding for milk business for next year, that school milk business, are you bidding for it any differently because it is fixed price and you have seen such volatility this year? And just an overall question about pricing going forward. Are you changing your pricing contracts and the methodology to be more flexible, more real time, not just this sort of onetime surcharge for shrink?

Gregg A. Tanner

Well, I'll talk to the first part of that, as far as the school milk bids and the RFPs that are currently out there. Obviously, in this environment, we're working those contracts much more than probably we have in years' past. And so far this year, we have been fairly successful with our school bids, and we'll know more of that as -- because it's still early on in the school bid season. But we feel confident that our school bids are going well. And then I'll let Chris talk more to the mechanics of our pricing and whether he sees any changes coming with that.

Chris Bellairs

Yes. So far, also just before we leave the school topic. Just to clarify, we actually believe that -- well, we know, it's our data, that a fairly small portion of our total school business is on a fixed bid program. Most schools actually follow kind of the same methodology of allowing us to flex our price up and down to follow the milk commodity. It's a fairly small slice of that business that actually likes to be on a fixed bid. So -- and then -- and on to the price mechanics piece. We still do feel very good about our overall. When milk prices are kind of in their historic range, if you call that a $15 to $20 band, we think our mechanics of pass-through work pretty well. At the $24 hundredweight level, the notion that perhaps a surcharge was the right piece for us to move toward, if that means that we need to reconsider the mechanics when milks -- when milk moves back to its historic levels, I don't see that. Probably, I think I lean back on the notion that our pricing methodology has always served Dean Foods pretty well. And as we move back to normal levels, that will continue.

Farha Aslam - Stephens Inc., Research Division

And just as a follow-up. Do you think normal is now $15 to $20? Because exports are now a much more significant part of the U.S. milk pie and can vary much more than just sort of U.S. consumption, which is much more stable? And given this new variance of demand, which is largely dependent on weather in New Zealand and Australia, that volatility in milk should be expected much more going forward. And so those pricing contracts, which assume normal, might not be right going forward.

Chris Bellairs

Yes. So to put maybe a slightly finer point on it, I would have said that historically the mean was kind of more in that $15 range, so to the low end of the band that I just described. I do believe that the new mean going forward is probably more like $18. Now those are point estimates. But I do believe that the mean has moved higher as the U.S. markets have become more exposed to global dairy commodity movements. Will volatility also be higher? Perhaps. And that then gets to the root of your question, if we do see spikes in the future back above $20, even up into the mid-20s, do you handle that via a surcharge? Or do you handle that via a change to the price mechanics? I think that's something for us to consider.

Operator

We have time for only one more question, and that comes from the line of Brett Hundley from BB&T Capital Markets.

Brett M. Hundley - BB&T Capital Markets, Research Division

So Gregg, just want to go back to a comment that you made on retailers potentially holding pricing as raw milk comes down in an effort to recapture some margin. Does that make you more optimistic on maybe margins hanging in there better than you would have originally anticipated in any type of deflationary market? In other words, that as raw milk prices come down, the pass-through may not be as great as it traditionally would. Does that make sense?

Gregg A. Tanner

Yes. I mean, I think what you'll see is, is we'll see it, hopefully, in the volume side versus the margin side for us. That if they maintain and take their prices down, we would see it on the volume front. If they maintain their prices and put the margin in their pocket, I think we'll get hurt a bit on the volume side. Does that make sense, Brett?

Brett M. Hundley - BB&T Capital Markets, Research Division

That makes sense, that makes sense.

Chris Bellairs

It's a complicated set of factors. Because if they maintain private label and don't take the prices down consistent with the decline in Class I cost, that actually could help our branded products. So if they were to dramatically reduce their private label cost, then you have an expanding gap to our brands. So there is no one -- kind of what we've been trying to communicate both in the prepared text this morning and in our answers to your questions has been it's just complicated. There isn't one simple answer because there are a number of factors and they are interdependent.

Brett M. Hundley - BB&T Capital Markets, Research Division

Totally makes sense. The -- my second question just kind of goes to what Farha was asking, Gregg. Does it give you any comfort at all that cheese dynamics have kind of driven the mover price higher over the short term here as opposed to powder, just given some of the demand differences historically between cheese and that of powder since maybe '07, '08, '09? Or you really remain cautious either way?

Gregg A. Tanner

No, I think cheese gives me more comfort than the powder side because it's not as heavily impacted, I think, by some of the developing markets. So yes, I -- but either way, you have to be cautious in this environment.

Operator

Thank you. I would now like to turn the call over to Mr. Gregg Tanner for closing remarks.

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 next quarter. Thanks.

Operator

Thank you, sir. Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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Source: Dean Foods' (DF) CEO Gregg Tanner on Q1 2014 Results - Earnings Call Transcript
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