Seeking Alpha
Long/short equity, student, value, deep value
Profile| Send Message|
( followers)

Summary

  • Wall Street does not appreciate the long history of the milk industry and Dean Foods' normalized margins.
  • Milk prices will tumble, with Whole Milk Powder already crashing ~40%+, and with multiple short-term and mid-term catalysts on the horizon.
  • With only a 5x multiple on next year's EBITDA, the stock is worth ~50% greater than where it stands today.

Current Price: $16.05/share

Market Cap: $1.5 billion

Enterprise Value: $2.4 billion

1-year target price range: $24.00-$26.00/share (~50%-60% upside)

I am continuing to build a long position in Dean Foods (NYSE:DF) with the aim of making it my largest position. While Wall Street has largely left the stock for dead, I see the company generating ~$478 million in EBIT, ~$650 million in EBITDA, ~$250 million in FCF, and $2.90 in EPS in 2015. My estimates imply a forward EV/EBIT of ~5x, EV/EBITDA of ~3.7x, EV/FCF of ~9.7x, and a P/E of ~5.5x. The story is rather simple: falling raw milk prices will boost DF's gross margins in 2015 (I model 22%), boosting profitability and normalizing the operating environment.

Why the Stock fell in 2013

DF fell from its high of $22/share to $15/share in 2013 and 2014, respectively. The cause of the 30% drop was due to an anomaly in the raw milk industry: A drought in New Zealand and increasing demand for Whole Milk Powder (WMP) in China caused WMP prices and other milk prices (such as Class I) to shoot up to levels never before seen. The result of this unusually bad operating environment deteriorated DF's gross margin and profitability, which led to management guiding downwards and sell-side analysts downgrading the stock. Even though Class I milk prices were still at all-time highs of $23/100 lbs as of the first half of this year, there are strong technical and macro catalysts that will tear them down in 2015, and possibly as soon as the 2nd half of 2014.

The Business

There are multiple articles written on Dean Foods, so I will keep this segment rather short. In a nutshell, DF buys raw milk and processes it into value-added products (fluid milk, ice-cream, creamers, etc.). DF then transports the products directly by truck to its customers (retailers, 64%; foodservice, 14%; government schools, 7%; distributors, 3%; distributors, 5%; and 3% goes to an "other" category).

Because the largest input into its products is raw milk, it's no surprise gross margins have been extremely volatile over the past 9 years. Below is a table outlining 3 different raw milk prices (Class 1 mover, Class 1 skim, and WMP) and the massive effect that changes in those prices have had on the gross margin of the dairy business over the years. It is also easy to notice how the change in prices of milk parallel each other from year to year.

Year

2005

2006

2007

2008

2009

2010

2011

2012

2013

Dairy Sales

8961.5

8821.0

9411.1

9804.6

8566.4

9094.0

9715.7

9274.7

9016.3

% y-y growth

-1.6%

6.7%

4.2%

-12.6%

6.2%

6.8%

-4.5%

-2.8%

COGS

6843.7

6529.3

7320.5

7559.8

6229.2

6948.2

7618.7

7179.0

7161.7

Gross Profit

2117.8

2291.7

2090.6

2244.8

2337.2

2145.8

2097.0

2095.7

1854.6

%

23.6%

26.0%

22.2%

22.9%

27.3%

23.6%

21.6%

22.6%

20.6%

adj. EBIT

642.0

678.0

538.0

591.3

414.5

174.7

116.9

203.2

175.7

%

7.2%

7.7%

5.7%

6.0%

4.8%

1.9%

1.2%

2.2%

1.9%

EV/adj. EBIT

3.8x

3.6x

4.5x

4.1x

5.9x

13.9x

20.7x

11.9x

13.8x

Class I raw skim milk mover

$ 8.54

$ 7.47

$ 13.47

$ 12.94

$ 7.40

$ 9.26

$ 12.02

$ 11.82

$ 13.50

% y-y growth

-12.5%

80.3%

-3.9%

-42.8%

25.1%

29.8%

-1.7%

14.2%

Class 1 mover

$ 11.88

$ 18.14

$ 18.00

$ 11.48

$ 15.35

$ 19.13

$ 17.46

$ 18.84

% y-y growth

52.7%

-0.8%

-36.2%

33.7%

24.6%

-8.7%

7.9%

WMP y-y average

$ 3,246.10

$ 3,893.60

$ 4,805.00

$ 3,155.00

$ 4,935.60

% y-y growth

19.9%

23.4%

-34.3%

56.4%

The competitive situation for Dean Foods is favorable. The company is the nation's largest processor and distributor of milk, with the next largest competitor being 5x less in size (implying that the 2nd-largest competitor has ~7% fluid milk share). As of Q2 2014, DF's fluid milk share stands at ~36%. While market share and volume has deteriorated due to the loss of Wal-Mart's private label business and a customer who vertically integrated, market share has rebounded 1% with contract wins, and volume deterioration has slowed. Currently, asset utilization in the industry is sitting at ~50%, and assuming the bulk of direct competitors are multiples below DF in size, it's difficult for other players to compete on the same scale as DF without suffering greater financial pain, especially during this unusual milk environment.

The Milk Price Lift-off of 2013 and 2014

Exactly why did raw milk prices skyrocket to levels never before seen in 2013 and 2014? Let's take a look at New Zealand, the 8th-largest producer of milk and the 2nd-largest exporter of milk.

During the first half of 2013, New Zealand experienced a drought, which decreased milk production by ~7% in June and ~5% in July over 2012. Net/net, for the full year, total milk production decreased ~1%. 40% of New Zealand's exports, however, are made up WMP! In 2013, China imported roughly 800 thousand metric tons of milk powder, and guess what? 75% of its milk powder imports were WMP! It's no surprise that WMP prices shot up ~100% from $2500/MT to ~$5000/MT in a year's time. Once WMP rose, the other classes of milk followed.

The reasons behind China's immense demand are well-known: high population growth, not enough internal output, fear of internal contamination, etc. China is expected to import 1.4 million metric tons of milk powder this year, ~75% of the imports being comprised of WMP.

What will tear prices down?

So, with China's demand ever increasing, what will in fact bring down raw milk prices and restore DF's margins? Well, I am happy to report that the price of WMP has already fallen ~40% from its China and New Zealand-induced highs to $2800/MT this year, and that historically, milk prices tend to rise and fall together (just look at the table above). Below is a table showcasing the historical and current Class I mover price.

Analysis

2009

2010

2011

2012

2013

Q1

Q2

Q3

Q4

2014E

2015E

Class 1 Mover

$ 11.48

$ 15.35

$ 19.13

$ 17.46

$ 18.84

$ 22.38

$ 23.66

$ 23.90

$ 23.90

$ 23.46

$ 18.50

Volume

746.2

592.4

507.9

531.2

478.6

104.6

101.2

95

100

400.8

520

Sales

8566.4

9094.0

9715.7

9274.7

9016.3

2341.0

2393.9

2270.5

2390.0

9395.4

9620.0

% y-y growth

6.2%

6.8%

-4.5%

-2.8%

4.2%

2.4%

% q-q growth

2.3%

-5.2%

5.3%

Milk production in New Zealand has significantly rebounded 11.5% from its 2013 levels as weather patterns have normalized. As farmers scramble this year to take advantage of the all-time highs, milk income alone is expected to boost New Zealand's GDP by 2.6% ($4.6 billion). With WMP prices already collapsed to 2012 levels, it should only be a matter of time when the Class I mover price will fall. Industry experts and DF's management have indicated that milk industry fundamentals should push milk prices downward in the near future.

Another catalyst, which is occurring in April 2015, is the abolishment of Europe's milk quota. Implemented in 1984, EU's milk quota placed a cap on milk production to protect against overproduction. To gain an appreciation of the magnitude of the abolishment, below is an excerpt from the MTT Agrifood Finland Research Finland report, Competitiveness of Northern European dairy chains:

"World demand for dairy products is predicted to grow faster than supply as consumption expands steadily in emerging economies. The EU seeks to get its share of that growth, which will affect markets in, for example, China, Russia, the Arab world, and Africa. The removal of milk quotas in a year will profoundly modify allocation of production volumes across EU countries, as the large effects of the reform of the EU sugar policy, which took place a few years ago, may suggest… The quota abolition will speed up a broad process of structural change that has been ongoing for years, and increase the geographical concentration of agricultural production in Europe."

After reading over the sensitivity analysis presented in Economic Impact of the Abolition of the Milk Quota Regime, the scenario which assumed an end to the quota in 2015 modeled raw milk prices falling by 10%, and assuming normal weather patterns in 2015, this could potentially mean that raw milk prices could drop below $17/100 lbs, a price level not seen for the past 4 years.

How much is the business worth?

I've come to the conclusion that the raw milk price anomaly is not the development of a new, negative secular trend for raw milk processors. The only secular trend will be coming in 2015, when the raw milk industry experiences a leap in competition due to the abolishment of the EU's milk quota, and that event will only lower prices.

I base my intrinsic value range on normalized estimates of EBITDA and earnings taxed at 35%. At 22% gross margin, which I believe is a conservative estimate, considering the aforementioned catalysts which I believe should bring Class I down by more than ~30% in 2015, EBITDA will come in at ~$650 million, and EPS at ~$2.90. At just 5x EBITDA and 9x EPS, DF is worth $24-$26/share, or 50%-60% upside.

Risks

1) Customer concentration.

2) Weather could be adverse in 2015.

Conclusion

Dean Foods presents a compelling value investment for those patient enough to wait until 2015. With milk industry fundamentals strongly suggesting a forthcoming downward correction in raw milk prices, and with WMP already tumbling ~40%+ this year from its China-induced highs of 2013 and early 2014, I cannot see EBIT coming in at less than $400 million with operating expenses being largely fixed in this industry, and cost reducing initiatives further reducing expenses next year and years on out. With the Wall Street community too focused on quarterlies, it pays to look at the big picture and the history of the company and the milk industry. I have been long this stock, and continue to build a position.

Source: With Milk Prices Crashing And The Operating Environment Normalizing, Dean Foods Is Set To Travel Up