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Company overview:

Dean Foods (NYSE:DF) is a leading food and beverage company in the US and a European leader in branded soy foods and beverages. The company is organized into two segments, Fresh Dairy Direct-Morningstar (84% of sales) which is the largest US processor and distributor of milk, creamer, and cultured dairy products and White Wave-Alpro (16% of sales) which produces and sells branded diary, soy, and plant based beverages and foods. Fresh Dairy Direct-Morningstar sells products under more than 50 local and regional brands (ex: Country Fresh, Dean’s, Garelick Farms, Mayfield) as well as private label. White Wave-Alpro offers only branded, value added dairy and soy-based products such as Horizon Organic, Silk, and Land o Lakes.

Investment Thesis:

DF is currently trading at $7.26, which is a 10yr low as a result of several disappointing earnings reports and the departure of their CFO. DF has seen profit margins squeezed over the past few months as there has been a divergence in the relationship between the retail price of milk and input costs. Historically, the two have moved in tandem, when input costs go down, the price of milk goes down and vice versa. However, the current macro economic weakness has caused retailers to use milk as a promotional item to drive store traffic, which has depressed the retail price of milk despite the fact that input costs have been rising. Further compounding the problem for DF, is that the retailer promotions have been using private label milk which has widened the price spread versus branded milk, which has pressured DF’s higher margin branded product line. Eventually, the pricing environment will normalize and the price of milk will reflect the input costs. Over the past 20 years, DF has earned an average operating margin of 5.8%; this year, I expect operating margin to be 3.6% which is the lowest since 1993. The stock’s sell-off appears to be extremely over-done at this point, even if 3.6% operating margins are the new normal (which I don’t believe they are) the stock is still cheap at 88% of book value. I think the appropriate way to evaluate this opportunity is to take a longer perspective on the business (selling milk is not a new concept) and see that if DF can return to the profit levels seen last year or in 2008 the FCF% would be ~30%, P/E of 6x, EV/EBITDA 6x. I see fair value for the equity at $15.

· Stock at 10 yr low as milk retail prices diverge from input costs, CFO resigns

DF has seen a brutal 2010, the stock is down -60% from its high this year following several disappointing earnings reports as well as the departure of the CFO last month. The CFO change does not strike me as a big deal given that he left to become the CFO at McGraw-Hill (MHP), which is a much bigger company and likely a better career opportunity. The new CFO is Shaun Mara (age 45) who was previously the Chief Accounting Officer.

click to enlarge

Earnings have disappointed, the last Quarter in particular, due to a divergence between the retail price of milk (blue line) and the cost of the inputs (orange and pink line) needed to produce said milk. Using data compiled from the USDA, BLS, and University of Wisconsin, I charted the trend below, which shows the recent divergence; the wider this spread becomes, the worse profit margins will be for DF. The driver behind this is that retailers have used milk as a loss leader promotional item to drive store traffic; in doing so, they have dramatically deteriorated their margins at the retailer level which has resulted in them asking for (and getting) pricing concessions from the producers. Eventually, retail prices will normalize to properly reflect the level of input costs, which will allow profit margins to recover for DF.


History suggests retail prices will normalize, leading to margin recovery

Historically, input costs and the retail price of milk have moved in tandem. When input costs go down, the price of milk goes down, and vice versa. However, the combination of macro economic weakness and commodity inflation stemming from a weak dollar/QE 2.0 have caused a divergence in this relationship. I pulled data from the USDA and BLS from 1996 (as far back as I could find) and over time this relationship has held very much in lockstep. If you look at the past few data points, however, you see that input costs are rising while milk retail prices remain flat. Eventually, this will prove to be an untenable position for the industry as a whole and will result in higher prices from more rational competition by producers or the failure of smaller less-capitalized players, which will decrease supply and then result in higher prices. The economic laws of supply and demand are on our side here. Although not pretty at the moment, DF is best suited to weather this storm as the clear dominant player. DF has 38% of the total US fluid milk market share and is 5x the size of the next largest competitor. DF also has $1.4 B of undrawn credit capacity that provides further flexibility.

DF has been selling milk for a long time and over the past 18 years they have been able to do so at a 5.8% operating margin. I argue that the fundamental drivers of supply and demand for milk and the economics of production have not materially changed in the past 12 months to suggest that the industry should expect lower profitability into the indefinite future. Our margin of safety with DF is that we do not need the company to necessarily return to 5.8% operating margins (although I believe they will) for the idea to work. If DF is just able to maintain current profitability (which is at a 17 year low) the stock is still attractively valued.

· DF has ample liquidity to ride out this rough patch

Longer term, I expect rationality to return to the dairy industry as retail prices will need to track input costs. However, until that happens, DF is well suited to ride out the storm. DF will generate ~$150m in FCF this year and has $102m in cash on the balance sheet. The business is levered, however, they have a substantial amount of undrawn capacity ($1.4B) on their line of credit. DF has no significant debt maturities until 2012 and even then they will not necessarily need to refinance anything until 2014 when their term loan and credit revolver mature. The only issue with the balance sheet is that DF will probably trip their debt/EBITDA covenant in Q2 2011 when the leverage ratio steps down from 5.5 to 5.0. Given that DF is an otherwise healthy company (profitable and generating FCF despite the situation described above), I expect DF will be able to adjust this covenant. Judging by the recent string of lenders willing to negotiate covenant flexibility for companies in much worse shape, I do not foresee DF having a problem negotiating some breathing room.

· Structural cost reduction initiative to remove $300 in annual expenses

DF announced a structural cost reduction initiative earlier this year that is targeting $300m in annual cost savings. So far in 2010, DF believes they are on track for removing $100m in costs this year. DF expected to complete the entire $300m in 3-5 years, however, with 1/3 already complete they believe they are ahead of schedule. I put little weight into this promise, however, if it does prove to be true it will provide incremental upside/profitability. At the current stock price, I do not believe we need any restructuring cost savings for the stock to work.

· White Wave-Alpro a bright spot overshadowed by industry dynamics

The White Wave-Alpro segment has been performing well, but given that it is only 16% of sales, this performance has been masked by the larger issues facing Fresh Dairy Direct segment. YTD sales for White Wave-Alpro are up +34% yr/yr and operating income is up +35%. White Wave-Alpro is benefiting from demand growth for soy milk, almond milk, and organic milk. There have been rumors that DF could spin-off White Wave-Alpro, which on its own would most certainly garner a higher multiple than is currently being awarded by the market.

· Risks

o Milk industry pricing does not rationalize. Longer term, this is impossible, but the industry could remain challenging for a very long time. With DF’s resources and position as dominant leader, they are in the best position to ride this out.

o Some type of food outbreak related to milk, which hurts demand. I’ve never heard of anything related to milk in particular so I’m not overly concerned. Scientific research indicates that mad cow disease cannot be transmitted via cow’s milk.

o DF is unable to amend their covenant terms for their credit agreement; if the banks refuse to work with DF then DF would have a few alternatives, such as scaling back CAPEX for a few quarters to pay down debt, or even in the worst case, raise equity. I think the risk of an equity raise is remote.

Disclosure: Long DF

Source: Dean Foods: Holy Cow, This Stock Is Undervalued