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Dean Foods Company. (NYSE:DF)

Q2 2014 Results Earnings Conference Call

August 11, 2014, 08:30 AM ET

Executives

Tim Smith - Head of Investor Relations

Gregg A. Tanner - Chief Executive Officer

Chris Bellairs - Chief Financial Officer

Analysts

Chris Growe - Stifel

John Baumgartner - Wells Fargo

Amit Sharma - BMO Capital Markets

Alexia Howard - Sanford Bernstein

Akshay Jagdale - KeyBanc

Brett Hundley - BB&T Capital Markets

Robert Moskow - Crédit Suisse AG, Research Division

Eric R. Katzman - Deutsche Bank AG, Research Division

Operator

Good day ladies and gentlemen, and welcome to your Second Quarter 2014 Dean Foods Conference Call. My name is Stephanie and I’ll be your operator for today. Throughout the conference you will remain on listen-only mode. (Operator Instructions)

And now, I like to hand the conference over to Mr. Tim Smith, Head of Investor Relations. Please proceed.

Tim Smith

Thank you, Stephanie, and good morning, everyone. Thanks for joining us on our second 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 Form 8-K, which is available on the SEC's website at sec.gov.

A slide presentation, which corresponds with today's prepared remarks, is also available during this call at the Dean Foods website.

Gregg A. Tanner

A replay of today's call, along with the slide presentation, will be available on our website beginning this afternoon.

Throughout today's call, the earnings per share, operating income, interest expense and free cash flow information that will be provided are from continuing operations and have been adjusted to exclude expenses and other gains or losses related to facility closings, reorganizations, realignments, asset write-downs, litigation matters, integration and separation costs and other non-recurring items, including the 2013 spin-off and disposition of our remaining investment in WhiteWave common stock, the Morningstar divestiture and other 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 the Private Securities Litigation Reform Act of 1995.

These statements will include, among others, disclosure of earnings targets, as well as expectations regarding anticipated cost savings, network optimization plans, dairy commodity pricing, the payment of any future dividends, potential 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 these 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 today’s prepared section of the call are myself, Gregg Tanner, our Chief Executive Officer; and Chris Bellairs, our Chief Financial Officer. I will start this off with a review of our second quarter performance. Chris will then offer some additional perspective on our financial results before turning the call back over to me for comments on the forward outlook and other closing remarks. We will then open the call to your questions.

With that, let me get started with the second quarter 2014 highlights. I also want to thank you all for joining us on the call today. Tim had to step away and so that’s why I jumped in and took this over. So, this morning we reported second quarter results that were below our previously articulated guidance range of $0.02 to $0.08 adjusted diluted loss per share.

For the quarter, we reported a net loss of $0.14 in adjusted diluted loss per share and an adjusted operating loss of $6 million, both were down considerably from year-ago results.

When we spoke to you in May, we indicated that we expected the second quarter to be especially difficult, and it was more challenging than even we had anticipated. Increasing and record high dairy commodity costs have continued to create a very challenging operating environment. In 2014, year-to-date results have been well short of our expectations.

This is by far the most difficult operating environment in the history of the company, reinforcing the importance of the initiatives that we have underway. We believe these efforts are ultimately positioning us for a much better future. Key challenges during the quarter were as follows:

First, the fluid milk category volumes remained soft and infact volume declines have accelerated beyond what we would consider the normal trajectory of the category. As Class I raw milk continue to rise through May, the category continued to weaken. ROI data suggest that year-over-year refrigerated fluid milk in the multi outlet or MULO in convenient store channels were down 4.1%, 4.8% and 4.7% respectively for April, May and June.

This represents further deterioration in the category compared to Q1’s comparable decline of 2.8%. USDA reported 4.5% and 3.5% declines in April and May. Actual category performance quarter to date through May indicates a category decline of 4% which is well above the prior quarters 1.5% decline.

As our volumes soften further than we expected, we experienced increased volume to leverage across our network. We are also concerned about the health of the ready-to-eat cereal category and its impact on fluid milk. Within MULO, total cereal volumes in Q2 were down 5% versus year ago levels which compares to last quarters year-over-year decline of 3%.

Second, very high milk cost and resulting increases in retail prices created incremental volume softness in addition to increased pressure on our margins as pricing and retail was pressured by both price gap and price threshold considerations. In addition, higher raw milk cost raised the cost of Dean Foods of route returns, dumps, production losses and other forms of shrink.

On a year-over-year basis, our total shrink cost increased more than 30% in Q2 and north of 25% year-to-date. Third, during the second quarter and continuing into the third, we have been challenged by the rapid and unexpected increase of butterfat prices which pressures our margin across our Class II product offerings, including ice cream in its heavy selling season.

Average Q2 CME butter prices increased 32% versus prior year levels to $2.12 with June averaging $2.26 per pound. After the end of the quarter, CME butter prices continued to rise and hit a peak of $2.62 per pound in late July, which represents an input price we haven’t seen since 1998 when CME butter hit $2.81 per pound.

The same month-over-month Class II commodity increases as we experienced in the quarter can create a pricing lag effect that make it difficult to effectively pass through rising costs fast enough to mitigate the sustained inflation across our Class II product set.

Finally, as expected we experience continued transitory cost in production and distribution associated with plant closures and loss of volumes. However, as fluid milk volumes softness accelerated, our logistics and plant as such have experienced increased deleverage, offsetting some of their end year cost productivity improvements.

While disappointed in our results during this difficult environment, we continue to be focused on driving improvements in our operations and in the business that will make us stronger long term.

Total volumes in the second quarter were 674 million gallons, which represents a 4% decline from 703 million gallons in the second quarter of 2013. This decline was due to the partial loss of private label business with a significant customer combined with the increasing fluid milk category weakness.

In Q2, we began to lap the RFP-related volume losses. Last year in Q2, approximately 80% of the RFP driven net store transitions occurred. Within fluid milk specifically, industry category volumes declined approximately 4% quarter to date through May 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 4%. This quarters volumes continued to reflect a negative impact of the RFP driven volume loss, however, as I stated earlier, we are beginning to overlap last years RFP volume loss excluding the impact of the RFP and another customers decision to vertically integrate last year our fluid milk volumes decreased 0.3% in the quarter, significantly better than the overall categories volume decline.

During the quarter, 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 2% increase versus the prior year. However, sequentially we experienced weakness across all channels with the exception of a slight increase in fluid service.

Our share as a fluid milk category for the quarter to date ending in May was 35.9%, which represents a 0.2% increase from the prior quarter. Since bottoming out in the third quarter of 2013, we have increased our share of the fluid milk category by 1%. We are becoming increasingly focused on improving our margins with better pricing that will deliver an appropriate return.

In terms of our branded versus private-label white milk mix, we ended the quarter just under 36% branded. However, since the third quarter of 2013, when raw milk prices began their steady climb, our brand mix has declined by approximately 1%. This traded down the private-label white milk represents an undeniable headwind to our P&L.

Dean’s share of branded white milk at retail is approximately 60 basis points better than the prior year. However, sequentially our share declined by approximately 30 basis points. We continue to be pleased with the performance of the two new brands and are very excited about its potential for continued line extensions.

During the quarter, within the grocery channel, TruMoo performed inline with the flavored milk category which was down 6%. However, in the convenient store channel, we experienced a 9% increase versus prior year against a flat flavored milk category, and we’re able to increase our share by approximately 2%.

We continue to focus on growing our national distribution beyond our DSD footprint by leveraging extended shelf like products as a result of leveraging this capability TruMoo reached an all times high ACV eclipsing the 70% market in Q2. This is 13 points higher than our branded White milk and approximately 8 points better than prior years ACV.

As we indicated on our last call, we intend to launch TruMoo protein nationally in the second half of this year. Although we are just starting that launch, we already have significant authorizations for some of our largest accounts. TruMoo protein is now the number one protein drink in the dairy case in our West operations which launched this product only one year ago.

Turning to pricing, as Class I raw milk prices continue to move higher, the margin over milk or the spread between Class I mover and the retail price of private label gallons compressed to approximately $1.39 per gallon in Q2 compared to a $1.43 per gallon in the previous quarter and $1.58 per gallon in Q2 of 2013.

During the quarter, the margin over milk bottomed at approximately $1.35 at the end of May before rebounding in June to $1.44 after June’s Class I raw milk price declined. We still expect that when raw milk prices moderate the margin over milk will move back towards the post 2010 historical mean of $1.50 to $1.60 as we expect retailers will restore greater profitability to the dairy case.

As noted, we saw some indication of that behavior in June. Average price gaps between our brands and private label in Q2 were consistent with Q1; however gaps extended approximately 10% versus prior year levels.

Class I raw milk prices continued their rise in Q2 before slight reprieve in June. On average the second quarter Class I price was 6% higher than the first quarter and 31% above year-ago levels. Unfortunately, after a 6.5% decline in June, the Class I price has resumed its upper trend increasing 4.5% since June to $23.87 in August. August price represents the second highest Class I milk price on record and is 26% above a year ago levels.

Over the past year, we have seen Class I raw milk prices increase 11% over the last 12 months. Obviously these price levels both in tenure and absolute terms continue to be unprecedented in our history.

A major cornerstone of our efficiency efforts in 2013 and 2014 included the plant closure of 10% to 15% of our plant network or 8 to 12 plants by mid 2014. As part of this initiative, we have now closed 12 facilities since we began ramping up activities late in 2012 with four of these closures occurring in June and July of this year. We have strong momentum behind these initiatives and expect increased savings from plant closures in 2014 to defer some of the volume develerage associated with the loss of business in 2013 as well as the current above trend fluid milk category weakness we are experiencing from the record high dairy commodity environment.

As we move beyond our accelerated cost agenda, we expect to return to our normal optimization activities. However, as we have previously stated with the full impact of the RFP volume declines, increased category weakness and the associated accelerated plant closure activities production cost declines continued to lag the decline in volumes, resulting in higher per unit cost in the second quarter and lower overall gross profits.

Second quarter distribution costs were up slightly on a year-over-year basis, while volumes declined leading to an increase in per unit distribution cost. We believe the increased per unit production and distribution costs are temporary, and that costs will come in line as we move past this recent period of accelerated plant closure activity and above trend fluid milk category weakness.

The logistics organization continues to focus on a number of initiatives to drive continued productivity to help offset inflation, volume delevarage and increased miles driven resulting from plant closures.

In the first half of 2014, we executed an RFP for third-party freight services. In doing so, we improved our cost structure as well as reduced our third party providers by approximately 75%. As part of this process, we have also moved to a centralized management and execution of all third party freights via the lean logistics transportation management system, or Lean TMS.

Over 80% of our third party freight dollars and over 90% of our freight lanes are now on Lean TMS. We have also started testing intermodal transportation opportunities for ice cream and cultured products as potential long haul economic plays.

Both of these initiatives highlight the potential to leverage Dean’s national footprint to create a sustainable cost advantage. In addition, the logistics organization has spend several quarters identifying and developing key performance indicators and a tracking score card. They now have in place KPIs around assets, costs, fleet and service metrics that will be vigorously tracked to drive continuous improvement across the function.

Helping to offset this slight increase in logistics cost, was a $9 million reduction in SG&A cost in the second quarter from the year ago period. Excluding the advertising and incentive compensation, SG&A was $3 million below year ago levels.

As a result of the increased fluid milk category weakness, mix shifts record high milk prices, rising butterfat costs, the impact of the RFP volume loss and associated transitory cost we reported $71 million year-over-year decrease in operating income. Our operating loss totaled $6 million for the quarter versus last years $65 million in income.

Before I turn the call over to Chris, I want to take a moment to update you on the extraordinarily challenging and unprecedented dairy commodity landscape. Although prices continued to remain in their record levels it is our and industry experts belief that we are seeing meaningful signs that raw milk pricing may improve as we move into late 2014 and early 2015.

However, to date pricing movements have been difficult to predict. First, the consensus view of the dairy commodity outlook for 2014 is to be significantly more challenging than previously expected. As current dairy commodity prices have moved near or beyond all time highs despite strong global production growth. During the first half for 2014, milk production across the top seven exporters which are the EU, the U.S. Brazil, New Zealand, Argentina, Australia and Uruguay is estimated to have increased 4.9% versus prior year.

Of the top seven, the EU, the U.S. Brazil and New Zealand regions make up 93% of this overall production. Collectively, this group experienced 5.2% milk production growth in the first half of 2014. New Zealand, Brazil and the EU experienced first half growth rates of 19%, 12% and 5.1% respectively with the U.S. lagging at 1.2%. As we move into the back half of the year, it’s expected that overall worldwide milk production growth will moderate to approximately 2%.

However, milk production in the U.S. is expected to increase to approximately 3% in the second half of 2014. This is driven by favorable producer margins and production outpacing the modest improvements expected in local market demand as the impact of a slow economic recovery is compounded by recent retail price hikes.

Even if milk prices move off their highs, projected lower grain prices could bring feed expenditures to a four year low, thus continuing to support favorable U.S. producer economics.

Second, international dairy prices have declined dramatically since February. International home milk powder, skimmed milk powder, butter and cheese prices have declined 46%, 31%, 41% and 24% respectively driven by four factors. First, as I previously mentioned production rose at unprecedented rates in export regions as producers responded to record or near record prices. Second, consumption growth in these export regions has been modest with consumers battling disappointing economies and significant price increases for dairy products as processors and retailers pass on rising ingredient cost.

Third, slow domestic demand and a stronger than expected surge in milk production appears to have created a wave of product looking for a home on the world markets. Fourth, China bought more than expected in the first five months of this year, however it now appears as though they brought more than they needed given the apparent stabilization of their domestic supply and slowing of local demand growth.

As we expected, other import buyers who had been sidelined by the prolonged period of Chinese purchases re-entered the market to restock, however, their appetite appears to have ultimately been dampened by lower sales in many emerging markets and the depreciation of many of their currencies, which ensured that prices would need to fall sharply to clear the market. Nonetheless, despite these price falls several export regions appeared to have above normal stock levels to work through.

Finally, U.S. exporters have been able to increase outgoing shipments by approximately 22% for the first six months of the year, therefore strong exports have left little room for domestic stock building and so commercial inventories across cheese, butter and powder have remained below year ago levels, thus the U.S. will enter the second half with low stock levels and unable to repeat the record stock drawn downs of the prior 12 months.

Given the current diverge interaction of dairy commodity prices between the U.S. and the world markets, however the U.S. has now priced this advantage vis-à-vis the world markets which would put considerable pressure on second half export activities. Any slowing of export activity would coincide with an expectation of increased second half U.S. milk production. This should allow for stock rebuilding and a higher likelihood of downward pressure on the prices.

While we remain watchful of global supply and demand dynamics as we look ahead assuming normal weather patterns we continue to be cautiously optimistic that solid global supply growth will lead to moderating raw milk prices in the later stages of 2014 and into 2015. Unfortunately, we and just about every other prognosticator have been too early in our call in predicting the timing of the break.

Until it does fall, these unprecedented raw milk prices will continue to be an undeniable headwind for our business. Now, I will turn the call over to Chris for a more detailed review of our 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 P&L as Gregg noted, total volumes declined 4% in the quarter. Although we are making progress in our cost reduction initiatives, the transition of these volumes out of our network coupled with an above the trend weakening of the food milk category outpaced the impact of our efforts and resulted in fixed cost deleverage within the quarter. This, combined with the margin pressures resulting from rapidly increasing butterfat prices and record-setting Class I prices, drove a Q2 year-over-year decline in adjusted gross profit of $75 million or 16%.

Below the gross profit line, total company operating expenses declined $4 million from the year-ago period. Distribution expense increased $4 million, while SG&A costs declined at $9 resulting in an operating income decline of $71 million to negative $6 million. As Gregg previously mentioned, excluding advertising and incentive compensation, SG&A costs were $3 million below year ago levels.

Adjusted EBITDA for the quarter was $34 million, a 68% decline from $105 million in the prior year period. Below the operating income line, interest expense decreased $12 million from the year-ago period. This decrease is a result of lower debt levels and continued 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 Q2 adjusted net loss of $13 million and adjusted dilutive loss per share of $0.14.

Turning now to the balance sheet and cash flow. As of the end of the second quarter, total net debt outstanding was $927 million, up from the $906 million at the end of Q1. This increase was primarily related to a final $6 million tax payment associated with the Morningstar divestiture and a $19 million Tennessee litigation payment which represents the second of four annual installments through 2016.

On an all-cash netted basis, our Q2 leverage ratio was 3.61 times net debt to EBITDA against our covenant maximum of four times. Today, we announced our intention to further amend our senior secured credit facility and receivables-backed facility to among other things, modify the consolidated net leverage ratio covenant to increase our maximum permitted consolidated net leverage ratio. Pursuant to the proposed amendments, we will also be required to maintain a senior secured net leverage ratio. We expect these amendments to be entered into later this month with effectiveness conditioned on Board approval as well as other customary closing conditions.

Year-to-date net cash flow from continuing operations was $25 million. Capital expenditures totaled $54 million, resulting in negative free cash flow used in continuing operations of $28 million. On an adjusted basis, which excludes the Morningstar tax payment and litigation payment, Q2 adjusted free cash flow was negative $9 million. Year-to-date adjusted pre-cash flow was $2 million, down $23 million versus prior year.

During the quarter, we also managed our working capital diligently in the face of continued dairy commodity increases. As a result, we were able to drive improved performance in our cash conversion cycle on a sequential and year-over-year basis driven by improved DSO and DIO performance.

Despite a 6% sequential rise in the Class I raw milk price, our Q2 invested capital across accounts receivable, inventory and accounts payable was down $14 million to $497 million. Year-over-year, we achieved an improvement of $70 million against a 31% rise in the second quarter’s Class I milk price.

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

Gregg A. Tanner

Before we open up the call for questions, let me give you some perspective on the forward outlook. The balance of the year appears rocky, with continued unpredictable and volatile dairy commodity environment. That makes it difficult to provide guidance beyond the immediate quarter.

Therefore for the time being, we are going to provide specific guidance only for the next quarter, where our visibility is better. In this case, we expect a net loss of between $0.05 and $0.15 per adjusted diluted share in the third quarter.

While we hope to see a more positive environment later in the year, the uncertainty surrounding whether or when that will occur leads us to withdraw our full year guidance for the present time.

Processors are under pressure in ways that we have not experienced before. The longer these challenges persist, the more difficult it becomes for cost-disadvantaged competitors to survive.

We would expect that this extremely challenged operating environment may cause some higher-cost firms to fail resulting in long-term opportunity for Dean to service additional customers at competitive prices.

We believe we are the cost leader in the industry today. Our size and scale afford us opportunities to meaningfully extend our cost leadership position and we are aggressively attacking these opportunities and extending our lead.

We now expect CapEx to be at the low end our original $150 million to $175 million guidance. So in summary, we are clearly disappointed with our second quarter results. We were challenged by record high diary commodity prices, softening category volumes, mix shift out of our brands, and significant cost friction. This is the most difficult operating environment we’ve ever experienced as a company.

However, we continue to focus on the three things that we can control, price realization, cost productivity and volume at margins that deliver an appropriate return. Looking forward, we’re cautiously optimistic that we will see some commodity cost stabilization in the fourth quarter, and are cautiously optimistic about declining raw milk prices in 2015.

We continue to drive improved efficiency and capability across the organization with a view toward positioning the company for long-term success. I also want to again thank our employees for their hard work, focus and discipline as we navigate our way through a very difficult operating environment.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from the line of Chris Growe with Stifel. Please proceed.

Chris Growe - Stifel

Hi, good morning.

Gregg A. Tanner

Good morning, Chris.

Chris Growe - Stifel

I just had a quick question -- two questions for you, if I could, a quick one on just how you are approaching retail pricing in this environment. And we’ll hope, obviously we’re headed for a lower milk price going forward. I am just curious to the degree to which you are holding back on pricing on your branded products and the degree to which retailers may be observing some of that increase in price as well. Is that helping volumes a bit at least, in relation to where it could be?

Gregg A. Tanner

Well, it’s tough to say, Chris, we’re in an environment right now where its -- we’ve never seen this before. So, we have no data to support what those price thresholds should look like. We believe that the retailers are absorbing some of this. If you look back at our margin over milk, in the second quarter was at about $1.39 I think, and got as low as $1.35 coming out of May.

But if you look at what happened in June with the price decline in Class I, it jumped back up to a $1.44. That tells us that they are absorbing some of the margin now. But they’re also going to put some of that margin back in their pocket as milk prices start to come back up.

As far as our pricing from a brand perspective, we are at some price thresholds and I can’t tell you across the country in every region what that looks like, but we know that there’s been some price thresholds that we’ve hung on to trying to avoid going above some of those. But yeah, trying to maintain the volume, find that right balance between volume and price.

Chris Growe – Stifel

Okay. And then I guess sort of in relation to that you talked about the amount of branded volume you sell being down a percentage overall. I'm just curious did you outperform the industry then on that basis? Are you seeing less volume weakness on the branded side versus private label? And I guess, I'm just trying to get sort of elasticity here for the consumer?

Gregg A. Tanner

Yeah. We did outperform the rest of the category. Our share of branded products is up 60 basis points on a year-over-year basis and we have lost about 30 basis points in the last few months, but year-over-year our branded volume continues to outperform on the rest of the brands.

Chris Bellairs

Internally within Dean’s Foods, Chris, there was a -- there is a negative mix shift taking place. So, our business transitioned about 1% of volume from brand to private label. So that’s a headwind for us as we experience that mix shift. But to Gregg’s point, brand versus brand, our brands continue to win in the marketplace versus competitive brand.

Chris Growe – Stifel

Okay. That’s very helpful. Thanks for your time this morning.

Gregg A. Tanner

Thanks, Growe.

Operator

Your next question comes from the line of John Baumgartner with Wells Fargo. Please proceed.

John Baumgartner - Wells Fargo

Thanks, good morning. Gregg, when you look at the Q3 environment, how much of a factor on the profit drag there is the ice cream business? I guess in the sense that as we get out of the peak season that drag becomes much smaller into 2015?

Gregg A. Tanner

Yeah. I think that’s true. I think as we start to see some relief from these prices too that we’ll see that play out larger. If I was to categorize the four items that we’ve talked about as being drags, I think the two big ones are obviously the volume itself from a category perspective in Class I prices. And then I would probably go to deleverage and then probably the Class II issue.

John Baumgartner - Wells Fargo

Okay. And then, just a follow-up for Chris, in terms of Morningstar having been sold, is there anything seasonally in the back half of the year in Q4 in terms of being a net seller versus buyer of cream that we should consider in terms of looking at the cream market prices going forward?

Chris Bellairs

No. I think our relationships there continue. The people that we’re selling to today whether its people that previously were third-party customers or Saputo diary foods its kind of I’d say mix, and so the sale of Morningstar doesn’t affect that as much as the volatility of fat prices will. And that’s the piece that will be difficult to predict out into the fourth quarter.

John Baumgartner - Wells Fargo

Okay. Thank you.

Chris Bellairs

You’re welcome.

Operator

Your second question comes from the line of Amit Sharma with BMO Capital Markets. Please proceed.

Amit Sharma - BMO Capital Markets

Hi, good morning, everyone.

Chris Bellairs

Good morning, Amit.

Gregg A. Tanner

Good morning.

Amit Sharma - BMO Capital Markets

Gregg, understanding the unpredictability of Class I prices at least in the near term, and if we look at a little bit longer term, longer term being six months here, and you outlined some of the reasons why there is still expectations as prices are going to come down later this year and early next year. So if you are thinking about 2015, which is where I think the stock is sort of getting valued at, as we think about 2015, apart from milk prices I think there are a number of other things that are going to impact your 2015 operating performance. If you can talk about that a little bit and how what is happening today impacts your 2015 performance, I think that will be helpful? Then I have a follow-up on balance sheet.

Gregg A. Tanner

I have been saying for almost 18 months that here’s what’s going happen in the dairy Class I commodity and I have missed every one of them. So, trying to prognosticate Class I at this point, all the data shows you that it should start to come down. All the fundamentals of the market say it should start to come down. But those fundamentals have been in place now for probably five to six months and we have not seen it come down. So, we got to stay worried about the things we can control and the things that are going to impact 2015 from our perspective are the things that we can control. We’ve to get -- we got to continue to work on our cost structure and continue to make sure that we’re doing the things we can to extend our cost advantages.

We have to stay focused on pricing realization and making sure that we’re working on pricing to make sure our pass-through mechanisms are right. And then we have to make sure that we’re focus on volume that makes sense from a margin perspective. So those are the things that are going to impact 2015. Do I think Class I should come down? Yeah, I do. But I can’t predict that at this point. That’s why we basically said, it wouldn’t be responsible for us to even try and project forward, because we have been so far off on this.

Amit Sharma - BMO Capital Markets

And I agree. What I’m really trying to get to is, of the factors that you do control, your brand mix, your TruMoo penetration, the plant closures and what kind of contribution we going to get from that, we talk about lower shrinkage cost. Is there any reason to believe that your ability to execute on those is impaired by what is happening in this quarter or in this environment?

Gregg A. Tanner

No. I don’t think there’s anything that impairs us. The one thing that continues to be a drag is the category. And the category is the biggest one. I think I continue to look at this and say, I’m confident the things that we’re doing are the right things to get us where we need to go. The category -- if the category were to get back to normal 2% than I would be very pleased with that. But right now, we got to deal what we have in front of us. And that’s about the best I can give you at this point. But I don’t -- there is nothing that tells me that the things that we’re working on are not going to allow us to deliver on what we’ve told you all along.

Amit Sharma - BMO Capital Markets

And then one quick follow-up on the balance sheet, Chris, could you talk about what kind of interest expense impact will we have from this amendment? And the thinking behind it is that it's more of a backward-looking amendment like what has happened this first half and likely to happen in third quarter that you want to build some flexibility, rather than a view on what is going to happen in 2015?

Chris Bellairs

Amit, I’ll let Tim talk to the details of that.

Amit Sharma - BMO Capital Markets

Okay.

Tim Smith

Hey, Amit. So, the amendment that we’re considering and that we outlined in the press release, you can see it both revolver as well as the AR securitization. So the revolver, the grid and so forth that we have in that facility today is the same grid that we had in July of 2013. What we’re proposing to do here is add two grid -- two price points on top of that, which would be incremental price increases of 25 basis points when you’re above 3.5 times leverage and another 25 basis points on top of that when you’re above 4 times leverage.

With respect to AR securitization, that facility was priced at 80 basis points flat. So we’re working today towards a scenario that would provide a grid that would range anywhere from 20 basis points to 30 basis points above that current 80 basis points assuming where we were on grid with respect to our leverage. So I would characterize interest expenses changes as relates to Q3 and what we’re guiding to as minimal.

Amit Sharma - BMO Capital Markets

Got it. Thank you very much.

Chris Bellairs

Amit, it’s really that change on the balance sheet that I think might be the only thing that would have been answer to your question on what would impair our potential for execution in 2015. Dean Foods were still operating at the levels of leverage that it existed at a few years ago, then you might see a different situation. But this is really kind of now a testament to getting the balance sheet right, setting up the new Dean Foods the way we did a year, year and a half ago with a very strong balance sheet, means that you really don’t have any risk of that kind of impairment going forward.

Operator

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

Alexia Howard - Sanford Bernstein

Good morning everyone.

Gregg A. Tanner

Good morning, Alexia.

Alexia Howard - Sanford Bernstein

Can I ask about the annual run rate of cost reductions here? You’ve obviously got the big plant closure program going on this year, but how do you add up like how much you are going to save year-on-year this year and then what’s the ongoing run rate that you expect on more of the ongoing activity? And then I have a follow-up.

Gregg A. Tanner

I mean, I think if you look back during the accelerated process and I think what we had said in years past was that it was going to around $125 million range. But we have no reason to believe that we’re not – we don’t continue to be on track with that. And then our ongoing would be somewhere around $80 million to $100 million and we think that’s still on track as well.

Alexia Howard - Sanford Bernstein

Great. Okay. That’s great. And then the volume on new contracts, I seem to remember that you picked up a few additional contracts I guess either late last year, early this year I think it was actually. Is it possible that we might see volume actually start to improve or could you tell us how much the volume of those new contracts is likely to be and have you picked up any additional ones at this point?

Gregg A. Tanner

Well, as we said in our prepared remarks, our share continues improve. So we were up 20 basis points in the quarter and up over 1% since we hit bottom back in 2013. So yes we continue to pick more volume. The other point would be the point that we made in our prepared remarks and that is that if you look at the RFP lost volume and you include the volume from the supplier or the customer in the upper Midwest who went vertical last year, our volume was actually only off by about three tenths of a percent, which is considerably better than the category. So, we believe we continue to pick up volume. We think we continue to take advantage of our cost structure and see where that takes us.

Alexia Howard - Sanford Bernstein

Great. Thank you very much. I’ll hop.

Operator

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

Akshay Jagdale - KeyBanc

Good morning.

Gregg A. Tanner

Good morning, Akshay.

Akshay Jagdale - KeyBanc

Hi. My first question is on your cost to serve and it's two parts, so what -- you have mentioned the timing lag between your initiatives on accelerated plant closures and its impact on your P&L basically or cost to serve. Can you talk about once that timing lag -- when will that timing lag end and what impact on a per gallon basis that could have on your cost to serve? That's the first one.

And then secondly, talk a little bit about your distribution costs, basically your [DSD] network. I think it's about $0.43 a gallon to start off and you are in the early stages there. What’s the opportunity there to lower your cost per unit? Are there some comparisons that you look at across other industries where you get confidence that that number can be lowered significantly? So those are my first two questions on cost to serve and then I have a follow-up?

Gregg A. Tanner

Okay. Let me start with the -- what we see as that the -- what we call transitory costs as we transition out of some of these plant closures. All of them will play a bit differently as far as timing. But I would guess in most cases that if you look at the timing of the transitory costs, they typically over 60-day to 90-day period depending on how long you’re holding the property and what costs remain to maintain or hold the property from a security and maintenance perspective. So, in most cases the majority of that probably goes away over some 90-day period.

Our expectations as we’ve said is that both our distribution and our conversion cost will go down in the second half of the year. Now that’s all assuming that the volume doesn’t accelerate -- the volume decline doesn’t accelerate, but it’s our expectation that they will continue to go down.

As far as that and how it impacts our cost to serve, the incremental miles that we drive because of these plant closures. As we look at our supply chain, we look at it from what we call our total supply chain costs or our total landing costs. That will be what our total -- what we’ll look at is, are we driving down our total landing cost from the facilities all the way through to our customers. And our belief is that’s what we will be doing as we come out of these plant closures. Does that answer your first question?

Akshay Jagdale - KeyBanc

That does help, but what when I'm really trying to get is get some color on magnitude of this. And perhaps you can comment on sort of how much of this is being -- if any of your progress it's being masked by higher milk prices and the margins on butterfat and on ice cream specifically. So if you exclude milk costs and that stuff, which is not really in your hands, do you feel like you've already lowered your cost to serve? I mean, bottom line is we are trying to figure out when will this come -- flow down to your EBIT per gallon?

Gregg A. Tanner

Yeah. I mean, you should see in the second half of the year. We believe that it would show up today if it weren’t for some of the other headwinds that we have.

Chris Bellairs

That cost performance isn’t being masked Akshay today so much by milk input costs or Class II fat prices. It’s being masked by masked sort of in the sense by the more rapid deceleration of the category. So we had as you know a very aggressive cost productivity plan in place to respond to the volume that we lost last year to Walmart and also sort of 2% decline that was taking place in the category that we were largely offsetting our share gain to the extent that their category has now move to a different level.

And if we’re not able to accelerate our share gains to make up for that, then you’re seeing that new sort of deleverage that wasn’t in the P&L before will have an effect on both distribution cost and plant operating cost, so lowest landing cost the way Gregg just describe them will be fighting a big of an uphill battle if the category has gotten worst than run rate.

Akshay Jagdale - KeyBanc

Can you just comment a little bit on the branded margins as well as the mix shift -- that seems to be a relatively new phenomenon in terms of percentage of your volumes coming from branded; it seems to have come down, and what impact that has on margins? Can you help us a little bit there from what I understand, the branded margins per gallon are significantly higher than private label, so if you can help us there, that would be good? Thanks

Gregg A. Tanner

Yeah. I think what we have said in the past is that our branded margins, I think run at about $0.60 -- $0.60 to $0.65 depending on the part of the country, higher than the private label margins. So as you lose volume from a branded perspective it obviously has a drag on your P&L.

Chris Bellairs

Akshay, it kind of goes back to Chris’s first question that if you go back to a year ago, if we had a brand sitting out there and it was in a higher cost geography and it was perhaps already in a 499 threshold versus another brand that was out there at 449 a year ago, as Class I prices have increased over those 12 months by $0.50 to $0.60 a gallon. We were reluctant to take pricing on the brand that was at 499, because we didn’t want to breach that $5 threshold on the brand that’s started at 449.

We would have had more flexibility and that brand may have taken the full amount of price increase, the full amount of cost increase and may now today be sitting at 499 as well. But it’s hard to -- because each of those regional brands had its own kind of starting place and its own profile relative to competition and private label. It’s a little tough. Other than to say, as you can see in the P&L, there has been margin compression on our branded white milk products particularly on large format, and then coupled with the mix shift that we described that creates that -- it certainly contributes to that gross profit headwind that we’re fighting against.

Akshay Jagdale - KeyBanc

And just one thing that intrigued me in just your commentary was you still expect to return to more of a normalized cost savings initiative or run rate. Given the sequential worse than expected deterioration and volumes, shouldn't you accelerate your plans even more to lower your costs? Perhaps I think what I am reading in there is some optimism in terms of these cost savings flowing through at some point in the next six months and perhaps you see that better than us. Is that the right way to read that?

If the volumes are getting worse, branded margins have worsened; we would expect perhaps you to double down even more on your cost savings initiatives. So why still say that after an accelerated period on cost savings you're going to return to a more normal rate? Thanks.

Gregg A. Tanner

Just keep in mind that the category data that we’re talking about that to extent the category has now move to a new lower level that it had been for the prior two or three years is only two months old, so we’ve got April USDA data. We’ve got May USDA data. And in fact May got better than April, April was down 4.5%. May was down 3.5%. So it might be premature for us to sit here today based on 60 days worth of data and announce a reacceleration of that program.

We have to see where the category is going to settle out. If no prices come down and that’s a big headwind for the category today, then you may see the category rebound to that minus 2% level than it been at. And then within all that we also have to gauge our ability to gain share. So, all those things will intersect to sort of guidance towards the right level of cost productivity. And I think as we sit here today it might be a little premature to pull the [fire alarm] on that.

Akshay Jagdale - KeyBanc

Thank you.

Gregg A. Tanner

We’re currently at -- if you just look at our network ops, as volumes continues to fall you’re not going to see us back away from taking costs out of the system. So our network optimization will continue. So it will more dependent upon whether or not the category continues in the two-month trend or not, and I think Chris said it well. If the category goes back to normal trends and you should expect us to continue to drive our cost advantage.

Operator

We have time for one more question coming from the line of Brett Hundley with BB&T Capital Markets. Please proceed.

Brett Hundley - BB&T Capital Markets

Hi. Good morning, gentlemen.

Chris Bellairs

Hi, Brett.

Brett Hundley - BB&T Capital Markets

I just have a one quick question. Chris, just want to confirm your level of confidence on guidance for Q3. We watch kind of this average industry margin and it seems to continue to fly during July and August, and hopefully you guys have some savings roll through as well to offset some of that. Can you just talk about your level of confidence in that range?

Chris Bellairs

Well, I looked back the day, the other day and through 2013, the four quarters last year we met or exceeded guidance for four quarters in a row and then this year now we missed guidance at the low end for two quarters in a row. So I’m confident. We’ve expanded the range a little bit. We had previously been at $0.06 or $0.08. So you see us today announcing a $0.10 range. That I guess mathematically allows me to be a little bit more confident but obviously the market place is still pretty volatile.

We have good line of sight obviously as you know today to what milk costs are going to look like in the quarter and that’s a big contributor to my level of confidence, the piece that we probably have a little less and sense of confidence level that’s visibility to is the category. So as I said to Akshay, I think the category is a big driver of how our income statement plays our every quarter and if the category stays that kind of that minus four it rebounds to two that’s a little bit guess work right now.

The only other thing I would remind everybody, I know everybody on the call knows, but we deal with a fairly thin margin of error in our business where we are $0.01 is worth a million and a half dollars of operating income even a$0.10 range even the odd $0.06 range that we’ve quoted in the past those are fairly tight tolerances on a business that’s going to do $2 billion to $2.5 billion of net sales in the quarter, it sort of equates that to a level of forecast accuracy that’s above 1% volume accuracy and around $0.01 per gallon of profit accuracy. So we ask our team to forecast with a pretty sharp pencil when they do it.

Brett Hundley - BB&T Capital Markets

Understood, alright thanks Chris.

Chris Bellairs

Thank you.

Operator

Your next question comes from the line of Robert Moscow with Credit Suisse. Please proceed.

Robert Moskow - Crédit Suisse AG, Research Division

Yeah thanks for getting me in there. I wanted to know – I’ve heard the management talk about the likelihood or possibility anyway of capacity coming out of the industry and clearly this is the time for it to happen since conditions are so bad. But I’ve never seen any kind of numbers or any kind of even maybe some anecdotal information about what your competitors, how your actions or how the industry has affected your competitors. Have you ever done any math around here’s how much capacity we think really could come out and here’s how much capacity probably won’t come out simply because maybe its in a co-op and it just has different kind of capital requirements or different constituents involved. Thanks.

Gregg A. Tanner

Robert, I obviously am not going to speculate of what our competitors are doing or what we think they are going to do. If we look at the overall category or we look at where we’re at, our asset utilization I think is probably not inconsistent with the industry and it’s in the low 50s. So you can draw your own conclusions of how much needs to come out for that to get up in that 70%, 75%, 80% range from an asset utilization perspective. I try to keep our organization focused on the things we can do and the things we can control and our competitive set is not one of them. So we try to stay pretty much focused on our own.

Robert Moskow - Crédit Suisse AG, Research Division

And maybe if I could ask the follow-up then, Gregg, can you help us on our side maybe think regionally? Like, are there any regions of the country where the capacity utilization is particularly low?

Gregg A. Tanner

No, I think you’ve got a balance across most of between verticals and independent processors and co-ops you’ve got to balance across most of the country. So it’s really not a given part of the country where you would say it is totally different, I can’t think of one…

Robert Moskow - Crédit Suisse AG, Research Division

Okay. Well, thank you.

Operator

We have time for one more question coming from the line of Eric Katzman with Deutsche Bank. Please proceed.

Eric R. Katzman - Deutsche Bank AG, Research Division

Thanks for allowing the last question. I guess you talked about in a little bit more detail the leveraging of the DSD network. It sounded like -- I wasn't sure I understood all the phrases, but maybe bringing on third-party product to leverage the DSD and the fixed cost. Could you just go into that in a little more detail and what could that mean in terms of a help to -- versus the core milk business?

Gregg A. Tanner

Yeah, we didn’t talk about it in the context of product coming in Eric, what we did talk about is we talked about in third party freight. So in many cases where we would take in freight on a two way trip we now have looked at going to third parties to do it one way. And, so we talked about it in the context of lean logistics what we are doing, so we’ve taken out third party providers down by about 75% and taken our leverage in scale and leverage in that for all of our third party freight which will provide us a significant savings.

The other piece of the logistics that I spoke about today was more around the intermodal and that using intermodal, which just piggybacks on rail to go from the Midwest to the East Coast or West Coast and by using that we get significantly lower transportation cost. And then beyond that the big things that we’re doing are continuing to drive just all of our key productivity measurements getting all the right key performance indicators in place and then driving that through continuous improvements.

Now, that’s all on the drive efficiencies, drive effectiveness or logistics. We continue to look at opportunities to bring things into our network that would allow us to take advantage of our refrigerated system and leverage that up to improve drop size or drop size economics and we’ll continue to look for opportunities along those lines, but we didn’t speak to anything in specific about that.

Eric R. Katzman - Deutsche Bank AG, Research Division

Okay. All right, I pass on. Thank you. Good luck.

Gregg A. Tanner

Thanks.

Operator

That concludes the question-and-answer session. I will turn the call back over to Gregg Tanner for closing remarks. Please proceed.

Gregg A. Tanner

Thank you, again, for joining us for the call this morning. We appreciate your continued interest in Dean Foods. Have a good day.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. And have a great day.

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Source: Dean Foods Company (DF) CEO Gregg Tanner on Q2 2014 Results - Earnings Call Transcript

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