Dean Foods (DF) Gregg A. Tanner on Q2 2016 Results - Earnings Call Transcript

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Dean Foods Co. (NYSE:DF)

Q2 2016 Earnings Call

August 08, 2016 9:00 am ET

Executives

Sherri Baker - VP-Investor Relations & Corporate Finance

Gregg A. Tanner - Chief Executive Officer & Director

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

Analysts

John Joseph Baumgartner - Wells Fargo Securities LLC

Lubi Kutua - Jefferies LLC

Farha Aslam - Stephens, Inc.

Alexia Jane Howard - Sanford C. Bernstein & Co. LLC

Freda Zhuo - Goldman Sachs & Co.

Jonathan Feeney - Consumer Edge Research LLC

Mario Contreras - Deutsche Bank Securities, Inc.

Amit Sharma - BMO Capital Markets (United States)

Thomas Hinsdale Palmer - JPMorgan Securities LLC

Operator

Good morning and welcome to the Dean Foods Company's Second Quarter 2016 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 expressed written consent of the company is strictly prohibited.

At this time, I would like to turn the call over for opening remarks to the Vice President of Investor Relations and Corporate Finance, Ms. Sherri Baker. Please go ahead, ma'am.

Sherri Baker - VP-Investor Relations & Corporate Finance

Thank you, Karen and good morning, everyone. Thanks for joining us on our second quarter 2016 earnings conference call. This morning, we issued an earnings press release, which is available in the Investor Relations section on our website at deanfoods.com. The press release is also filed as an exhibit to a Form 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.

During our call today, we will reference certain adjusted results and other non-GAAP financial measures which we believe to be useful to investors. A reconciliation of these non-GAAP financial measures to their comparable GAAP measures is included in our earnings release available on our website. Earnings per share, gross profit, selling and logistic, G&A, total operating cost, operating income, net income, interest expense and EBITDA 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 non-recurring items and other items that are not indicative of our core operating performance.

We would also like to advise you that our 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, potential acquisitions, disclosure of earnings targets as well as expectations regarding anticipated volumes, price realization, dairy commodity pricing, cost savings, network optimization plans, regional and national branding and marketing initiatives, the timing of product launches, our capital structure, the payment of any future dividends, potential share repurchases, our leverage ratio, covenant compliance and various other aspects of our business.

These statements involve risks and uncertainties that may cause actual results to differ materially from the statements made on today's conference call. Information concerning those risks is contained in the company's periodic reports on Forms 10-K and 10-Q 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 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 to Gregg for comments on the forward outlook and other closing remarks. We will then open the call to your questions.

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

Gregg A. Tanner - Chief Executive Officer & Director

Thank you, Sherri, and good morning, everyone, thanks for joining us on the call today. This morning, we reported our second quarter adjusted diluted earnings of $0.38 per share, towards the high-end of our previously provided guidance range. For the quarter, we reported adjusted operating income of $70 million, which equates to $0.11 a gallon. This marks the sixth consecutive quarter of year-over-year improvement in adjusted operating income. Year-to-date adjusted EBITDA was roughly $233 million, and we generated nearly $80 million of free cash flow.

Our Q2 performance demonstrates our continued focus on driving strong operational and financial performance across all functions. In the second quarter, total Dean Foods volume across all products of 632 million gallons was in line with our expectations. The declines in our fluid milk products were primarily due to large format, private label volume we have chosen to exit as this volume was not consistent with our more disciplined pricing architecture. Our branded white milk volume in all channels was flat year-over-year, and we experienced an increase in our flavored milk volume.

Across our other non-fluid milk product categories, we experienced a decline in ice cream volume of 2%, driven primarily by decreases in our private label business. I will discuss our overall ice cream performance in more depth later in the call.

We're very encouraged by the continued improvement in the fluid milk category. Fluid milk sales data published by the USDA through May show a quarter-to-date category growth of 0.1% on a year-over-year basis. Conventional flavored milk continues to drive growth in the fluid milk category with a healthy quarter-to-date increase of 4% versus prior year.

Within IRI-based data, through June, Q2 fluid milk sales experienced a 2% decline year-over-year. We saw a minimal decline in our share of the category quarter-to-date through May, sequentially down 10 basis points from 34.6% to 34.5%, driven primarily by private label volume we have exited. In Q2, our branded white milk share at retail increased by 10 basis points versus Q1, and 40 basis points versus prior year. Across the majority of our channels, fluid milk volume performance is exceeding or meeting our expectations. As we previously stated on the first quarter call, we expect our share to remain stable or grow modestly over the balance of this year.

When we launched DairyPure, our goal was to provide benefits to the consumer, retail customers, the category and our company. This quarter, we celebrate the one-year anniversary of the launch. And I'd like to share what we have accomplished to-date. Educating the consumer on the health credentials of conventional milk is a priority for both our company and the dairy industry as a whole.

With a product that delivers 8 grams of protein per serving and is cold-shipped from our local dairies, typically within 100 miles from the store, we deliver a fresh, lightly processed and nutrient-packed product that meets consumer demands for pure, fresh and local.

With the ability to advertise on a national scale, we're able to reach more consumers through print, store circulars and television media than previously, through regional advertising and, clearly in a more cost-effective manner.

As you'll see in a recent ad at a major large format retailer, we were able to advertise our suite of products across our entire portfolio including core products, line extensions and new innovations such as Caribou Iced Coffee.

Since the launch, DairyPure brand loyalty has increased 190 basis points and both ACV and velocity have increased since year-ago levels. Along with Milk Life, both DairyPure and TruMoo are teaming up to support the 2016 Olympic Games through both packaging and media. We're also entering a promotional partnership for the upcoming DreamWorks movie, Trolls, with Halloween-themed limited time offerings under our TruMoo brand. The increased efforts from both Dean Foods and MilkPEP are helping to drive overall category improvement.

For our retail customers, we simplified and enhanced efficiency with a single UPC, rationalizing over 1,000 SKUs within our system to fewer than 300 SKUs nationally. DairyPure also enables national promotions, such as the co-promotion with Oreos and Mondelēz at Walmart stores across the country.

For the company, we've experienced a number of benefits. First, we built a brand that can grow as a platform, helping to drive innovation into the category. Since the launch, we have introduced eight new product extensions, including lactose-free, creamers and half-and-half. We have a long-term goal to increase the brand mix of our portfolio while improving the profitability of our private label business.

Our fluid white milk brand mix is up 80 basis points year-over-year, helping to fuel our strong financial performance. One year is early in the life of a brand, however, we are pleased with all it has accomplished in a very short time period. Over the last year and a half, we have leveraged the DairyPure launch to thoughtfully expand the price gap between private label and branded white milk. Our long-term goal is to create a brand that commands a premium similar to other CPG companies.

Through the end of 2014, our regional brands commanded a premium on average just under 20%. Beginning in 2015, our pricing discipline combined with the DairyPure launch quickly expanded this gap. As of Q2 2016, our brand gap to private label is currently at 26%. We remain focused on striking a balance between pricing, volume and long-term growth.

Within the grocery channel, our brands average $3.41 per gallon at retail, down $0.34 versus Q2 of 2015, and down $0.11 versus Q1 of 2016. As a result, the price gap between our branded and private label products was $0.71 per gallon, a $0.07 decrease versus Q2 of 2015 as compared to Q1 of 2016 the price gap decreased by $0.04.

In MULO+C-store, while our branded white milk volumes are down around 2% year-over-year, our dollar share is up 50 basis points versus year ago and 20 basis points versus Q1. We continue to drive a favorable mix in our branded versus private label white milk mix.

For Q2, we averaged 35% which is 80 basis points better than Q2 of 2015. As a reminder, our branded white milk mix includes DairyPure and all of our other brands, all of which have varying economics across different channels and geographies.

Along with the category, we continue to see strong performance in flavored milk. Retail category volume saw a 6% increase in Q2 versus year ago.

Within MULO+C-store, TruMoo volume grew nearly 2%. We're driving strong growth in our private label flavored milk volumes while, at the same time, executing our brand focus that balances volume and price realization.

As we look at our ice cream performance, I will first highlight the completion of the acquisition of the Friendly's Ice Cream product business in late June. We are thrilled with the team, the brand presence, innovative product offerings and manufacturing capabilities that Friendly's brings to our overall ice cream portfolio.

At a purchase multiple of just under 8 times, immediate earnings accretion, volume growth and opportunity for meaningful synergies, we're very pleased with the value we are bringing to our shareholders. With cost synergies, which we expect to begin in 2017, the purchase multiple falls below 6 times. For the balance of 2016, our focus is to integrate the Friendly's business into our core business and support processes.

We will also begin to assess with consumer testing how and when to extend the Friendly's portfolio into other markets in which our regional Dean ice cream brands compete, driving further revenue synergies with the acquisition.

Within our ice cream performance, we saw a decline in our volumes from approximately 2% as compared to a year ago, primarily driven by decreases in our private label business. However, in the vast majority of the areas where Blue Bell has returned, we continue to see year-over-year share gains. Additionally, as in our fluid milk business, we're seeing an increase in our mix of branded products year-over-year.

In July, we began production at our new ice cream facility in St. George, Utah. We completed the closing of our ice cream production facility in California and will complete the closing of our ice cream production facility in Orem, Utah in Q3.

Now, I will turn the call over to Chris for a more detailed review of the financial results. Chris?

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

Thank you, Gregg, and good morning, everyone. I'll walk through the Q2 results as well as provide a review of our balance sheet and cash flow performance. Starting at the top of the P&L, we reported adjusted gross profit of $490 million in Q2, which represents a $6 million decline versus the year-ago quarter.

However, with total volumes declining 3.2% in Q2, our gross profit per gallon improved over 2% as a result of both the increase in margin from our branded portfolio and declining input costs. As compared to Q2 of 2014, our Q2 adjusted gross profit per gallon has improved 30%.

Below the gross profit line, total company adjusted operating expenses decreased approximately $9 million from the year-ago period. A reduction of almost $8 million in logistics expenses more than offset a roughly $4 million increased in selling expenses, primarily driven by advertising.

As a result of our continuing strong results, we've been able to continue investing in our brands. Q2 advertising grew by roughly $4 million versus prior year and year-to-date advertising increased by approximately $11 million.

The decrease in G&A expenses was primarily due to lower incentive-based compensation as we overlapped higher performance-based accruals in the prior year. In total, we experienced a year-over-year adjusted operating income increase of $3 million to $70 million.

Below the operating income line, adjusted EBITDA for the quarter was $110 million, a nearly $4 million increase from the prior year period. The marginally higher interest expense in combination with our normalized adjusted tax rate of 38% yielded adjusted diluted earnings per share of $0.38.

As I stated, Q2 adjusted gross profit per gallon improved 2% versus Q2 2015. Adjusted operating income was $70 million or $0.11 a gallon, which represents close to $0.01 per gallon increase versus the year ago period.

We have delivered seven consecutive quarters of adjusted gross profit per gallon year-over-year improvement, and six consecutive quarters of year-over-year improvement in adjusted operating income, driven by both net price realization and diligent cost control.

Driving cost and waste out of our system remains a focus for our entire supply chain, and as a result, we are seeing year-over-year cost decline in both plant and logistics operations. For example, our logistics organization has fueled a 7% reduction in both miles driven and fuel gallons consumed both in Q2 and year-to-date. In addition, through actions such as frequency reduction, routing efficiency and mile-per-gallon increases, we have reduced our delivery assets by 144 year-to-date and 248 on a year-over-year basis. The repeatable success of productivity initiatives like these demonstrate our ability to remove fixed and variable cost at a rate equal to or greater than the rate of volume decline, which is an essential element of the disciplined private label pricing architecture that Gregg mentioned earlier.

Turning now to our free cash flow performance. For the sixth months ended June 30, 2016, we have generated $80 million in free cash flow from continuing operations. With the Q2 results, we have delivered seven consecutive quarters of positive free cash flow since Q4 2014.

Our sequential change in invested capital across accounts receivable, inventory and accounts payable was an increase of $3 million, primarily driven by seasonal ice cream inventory build, partially offset by lower commodity cost. When adjusting for the federal income tax refund received in Q1 2015 and the higher incentive compensation cash payments made in Q1 2016, our free cash flow performance remains comparable year-over-year.

We have utilized our year-to-date 2016 free cash flow and cash proceeds from asset sales to pay our higher dividend, to opportunistically repurchase our shares and to fund a portion of our Friendly's acquisition. We expect our quarterly free cash flow to sequentially fall in Q3, primarily due to seasonal higher working capital investment and sequentially higher quarterly capital expenditures.

From a balance sheet perspective, we increased our total net debt outstanding to $896 million in Q2 as compared to $762 million in Q1. The $134 million increase in net debt reflects the Friendly's Ice Cream acquisition closed on June 20, 2016 that was funded with cash on hand and revolving capacity.

On an all-cash netted basis, our total leverage sits at 2 times net debt-to-bank EBITDA and remains over two full turns lower than Q4 2014. For covenant purposes, our cash on hand continues to exceed our senior secured indebtedness, thereby resulting in a senior secured net leverage ratio of zero times.

During Q2, we executed $25 million in share repurchases. Over 11 trading days during Q2, we successfully repurchased approximately 1.4 million shares or 1.5% of total shares outstanding. We purchased our shares at an average price of $18.21, which is approximately 14% below our 52-week high.

Based on this year's quarterly earnings, our Q2 share repurchases are immediately accretive at approximately $0.02 per share on an average diluted full year basis. This is our third share buyback since Q1 2014, in aggregate, totaling $103 million and 6.3 million shares, at an average cumulative price of $16.35 per share. The share repurchase follows the 29% increase in our dividend to $0.09 per share in Q1 2016. These actions together evidence our ongoing confidence in the business and our balanced approach to capital deployment that returns cash to shareholders while prudently investing in our business strategy. Our strong financial performance and balance sheet provide Dean Foods with ongoing opportunities to drive total shareholder return.

With that, I'll now turn the call back to Gregg for a look at the commodity landscape, as well as commentary on our forward outlook. We will then open the call for your questions. Gregg?

Gregg A. Tanner - Chief Executive Officer & Director

Thanks, Chris. On our last call, we discussed the expectations for a modest increase in raw milk cost in the back half of 2016. With recent increases in futures markets on both butter and cheese, we're starting to see that inflationary pressures impact the Class I milk forecasts.

With U.S. butter and cheese prices remaining significantly higher than international prices, we continue to see a steep decline in U.S. exports. Butter prices in the U.S. are 90% higher than its international counterpart. As a result, we're seeing inventory levels on both cheese and butter at record highs since 1993.

On the supply front, total U.S. milk production increased 1.5% year-over-year in June, supported by increases in dairy herd and milk per cow, both sequentially and year-over-year. The current USDA forecast calls for 2016 milk production to increase 1.8% year-over-year in 2016 and an additional 1.5% year-over-year in 2017.

Looking internationally, EU milk production continues to grow despite overlapping unprecedented production growth in 2015. New Zealand production continues its slight year-over-year decline but has shown a slight improvement in the recent quarter.

In Q2, raw milk costs were down approximately 7% versus Q1 of 2016. The quarterly average cost for the second quarter was $13.53 per hundred-weight, which represents a decline of $2.30 or nearly 15% on a year-over-year basis. With regards to the dairy commodity outlook, we forecast raw milk cost for the third quarter to average $15 per hundred-weight which represents an approximately 11% increase sequentially but an approximately 8% decrease year-over-year. On a per gallon basis, this equates to a sequential increase of $0.13 and year-over-year decline of $0.12.

Historically, we've primarily focused to ensure the changes in the Class I mover. However, it's important to note that our cultured and ice cream businesses are impacted by changes in Class II driven by skim and butter fat cost.

With the seasonality of our ice cream business, changes in the Class II cost during Q2 and Q3 may drive additional cost fluctuation. In Q2, at an average butter fat of 18%, we saw year-over-year increase of 8%. In Q3, we are estimating a year-over-year increase of 9%.

Moving to pricing through the quarter, the margin over milk and the spread between Class I mover and the retail price of private label gallons of fresh milk in the grocery channel increased slightly from $1.52 per gallon in Q1 to $1.53 per gallon in Q2. As the Class I mover average decreased by $0.08 during the same time period, June's margin over milk exit rate was $1.55, up $0.03 per gallon from March's margin over milk. Generally speaking, the margin over milk continues to remain within historically normative levels, and we view this as indicative of rational pricing by the retailers.

Looking forward to Q3, we estimate a sequential increase of 11% in the cost of Class I raw milk, but versus 2015 raw milk costs, are still a modest tailwind. Additionally, we believe our cost productivity agenda and pricing management will minimize the impact of the forecasted sequential increase.

For the third quarter, on a year-over-year basis, we expect total volume declines to improve significantly versus our recent trends. With the additional private label volume we talked about on our last call, in addition to the Friendly's volume, we believe, Q3 total volume will decline by about a point. Looking forward, we're cautiously optimistic that volume growth will move into a positive territory in Q4.

With that improving volume performance, continued pricing and cost disciplines, and favorable year-over-year commodity costs, we expect Q3 to be our seventh consecutive quarter of year-over-year adjusted operating income and adjusted EPS growth, as well as the third consecutive quarter overlapping the very strong results from 2015. All told, we expect Q3 adjusted diluted EPS of between $0.32 and $0.40 per share.

We remain focused on our strategic plan for sustainable long-term growth. Our actions align with the key pillars of our strategy and our entire organization is focused on executing our agenda each and every day. To all of our employees, thank you for your hard work, focus and energy you commit to making Dean Foods successful.

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

Question-and-Answer Session

Operator

Thank you. Our first question for today comes from the line of John Baumgartner from Wells Fargo. John, your line is open. Could you check your mute button? We'll try his other line. John, your line is open.

John Joseph Baumgartner - Wells Fargo Securities LLC

Yeah. Hi. Can you hear me?

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

We can, yes.

Gregg A. Tanner - Chief Executive Officer & Director

We can. Good morning, John.

John Joseph Baumgartner - Wells Fargo Securities LLC

Great. Thanks, guys. Hey, Gregg, I wonder if you could speak a little bit more in terms of the detail to your pricing mechanism. Are there any changes or improvements having been made there, I guess, maybe just kind of giving you the confidence in terms of resiliency going forward in the inflationary market for Class I?

Gregg A. Tanner - Chief Executive Officer & Director

Yeah. I mean, I think there's a couple of things. One, as we put in a pricing team that has gotten some new tools and Chris could speak more specifically to what the tools are, that I think has made us much more effective and efficient in our pricing. And, secondly, I think the investments that we've made behind the brands, so I think DairyPure and TruMoo both, have allowed us to kind of expand our margins and really focus on that gap between private label and branded.

I mean, I spoke to it in my comments that prior to DairyPure and, to some degree, TruMoo, we were down in that 20% range or less. And we're running at 26% and have expectations that we'll go beyond that as we continue to move forward with our DairyPure investments, so.

John Joseph Baumgartner - Wells Fargo Securities LLC

Great. And...

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

John, the only thing I'd add to what Gregg's kind of – actually picking up where he left off. The thing that gives me additional confidence now that we head back into an inflationary cycle. First, remember, it's now been about three years since the last real inflection point back into an inflationary cycle. And a lot, I think to your point, has changed in those three years in terms of capabilities at Dean Foods.

The other thing that's important, I think, is real clarity on where we want to go. So, Gregg talked about the clarity on the brand, private label price premium, also clarity on private label price architecture. So, between that revenue management team that Gregg talked about and our field force out in the sales and our national accounts field, our national accounts sales teams, a real sense of where we want to put the guardrails for those pricing decisions.

John Joseph Baumgartner - Wells Fargo Securities LLC

Great. And then, just in terms of the M&A side, the buy-and-build strategy, I guess a lot of these assets are not public in nature. So, can you just maybe provide a little bit of color there in terms of how we should think about additional bolt-on deals or anything larger, more transformational, the timing for that and what the pipeline looks like?

Gregg A. Tanner - Chief Executive Officer & Director

Well, I mean, I think it's a constant pipeline. We get calls every day with different ideas and different things that are coming at us. I think the things that we're looking at, John, are things first and foremost, that are brands.

Secondly, trying to look at capabilities, are there capabilities out there that we can buy versus build that help us get through our strategies in a more effective way.

And then lastly, it's really – it's got to be accretive to the P&L as to what we're going to do going forward. So, I think when you look at those and that's going to help us with the utilization of our plants or trucks in many cases. So, I think those are the things that we're looking at and as you know as well as I do, it's all about timing and when those deals come forward. But we seem to be getting plenty of ideas. I think people after the Friendly's acquisition, have recognized the fact that we're in the market. So, we'll continue to get those, I believe.

John Joseph Baumgartner - Wells Fargo Securities LLC

Okay. Thanks a lot.

Operator

Thank you. And our next question comes from the line of Akshay Jagdale from Jefferies.

Lubi Kutua - Jefferies LLC

Hi. Good morning. This is actually Lubi filling in for Akshay.

Gregg A. Tanner - Chief Executive Officer & Director

Hello, Lubi.

Lubi Kutua - Jefferies LLC

Hi. So, it looks like gross profit per gallon moved down sequentially in the second quarter despite lower sequential milk cost. Could you provide some color on what drove that? And then I think your 3Q guidance implies sort of stable gross profit per gallon, despite the fact that sequentially, it looks like milk costs have ticked up slightly. So, if that's correct, could you provide some color on what gives you confidence on that outlook as well given the trend that we saw in 2Q?

Gregg A. Tanner - Chief Executive Officer & Director

Chris, do you want to take that?

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

So, Lubi, the sequential movement down from Q1 to Q2 is normal seasonality. Yeah. So essentially, you wouldn't have seen that last year. So if you back and sort of test that normal seasonality theory against Q1 to Q2 of 2015, you have to remember that last year milk prices were decelerating through Q1. And so, the exit rate in Q1 last year was higher – first of all, higher than the average for Q1, and then that exit rate became the average for Q2. So, last year was a little bit of an anomaly where you saw an increase quarter-over-quarter from Q1 to Q2 in gross profit per gallon. This year, we returned to that more normal seasonality. And the seasonality is largely driven by the school business and the decrease in school volume as we head into the summer time.

And then, on sequential change from Q2 to Q3, we obviously – we don't guide to that level. So, as you decompose that in your model, you may come up with a different answer than what's embedded in our numbers. But we haven't – we obviously, we didn't give guidance on what GP per gallon will look like in Q3.

Lubi Kutua - Jefferies LLC

Okay. And then, if I could ask a follow-up, well, it's a unrelated question. So, with the Walmart decision to vertically integrate in milk, there's some concern out there that Walmart could eventually drive a price war in milk. Could you provide any thoughts on how you think industry dynamics might be affected by Walmart's decision? And what impact could that have on just sort of general milk prices and, maybe, margins as well? Thank you.

Gregg A. Tanner - Chief Executive Officer & Director

Yeah. Lubi, I'm not going to speculate on what Walmart may or may not do. I think the thing that we've got to stay focused on is what drives Dean Foods. And they have announced that they're going to build a plant in Fort Wayne, Indiana. And the last time we checked, they have not broke ground on that yet, but assuming that they'd go through with that, we're very confident that we're going to be able to take the cost out, that it will have minimal to no impact to our financials for Dean Foods. And if they decide that they want to go further, we're putting contingency plans together that we believe will continue to minimize the impact of that to our portfolio.

So – and what they do from a retail perspective and if they start a pricing war, I just – I think everybody learned a lot from 2010, and our margin over milk would tell us that that's probably not something that many retailers would be interested in doing again.

Lubi Kutua - Jefferies LLC

Got it. Thank you.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

The history I think has suggested that when milk prices are low, there's a higher likelihood that the retail trade is going to heat up the retail price. And over the last several quarters, we've obviously been in a very, very low milk price environment for raw milk costs. So, it would have been a great opportunity had retailers wanted to go back and revisit that 2010-2011 period of time when there was a retail price war going on.

And as you saw from margin over milk over the last several quarters, there's really been no evidence of that. So, we certainly don't see retailers head in that direction and that's during a period of time when it would have been conducive for them perhaps to consider that.

Lubi Kutua - Jefferies LLC

That's very helpful. Thank you.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

You bet.

Operator

Thank you. And our next question comes from the line of Farha Aslam from Stephens.

Farha Aslam - Stephens, Inc.

Hi. Good morning.

Gregg A. Tanner - Chief Executive Officer & Director

Good morning, Farha.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

Good morning, Farha.

Farha Aslam - Stephens, Inc.

Question around contracting and shrinkage as we go into the inflationary environment. Over this past year, have you had an opportunity to kind of look at how you've priced your contract, looked at how your price shrink, and do you think that this time around, with this inflationary environment, shrink will impact you the same as in the past or differently?

Gregg A. Tanner - Chief Executive Officer & Director

Well, I'll start with – first and foremost, I worry less about the contract of what we do with shrink as I do about the actual shrink itself. And our focus has been on how do we reduce the amount of shrink that we have in our system. And I can tell you that the supply chain is doing a really nice job of getting that shrink and reducing the amount of shrink that we have in our system. So, I feel much better in this environment than I would have two or three years ago.

Secondly, much of our private label business is all based on the contracts, and shrink is built into those contracts. But, I think, from a brand perspective, we would expect to maintain our premium pricing and that shrink should not have an impact on that. So, is there anything you'd add to that, Chris?

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

I guess, Gregg, the only thing I'd add is just the perspective around our expectations for the cost of the raw milk. I mean, for our last time, we really spent a lot of time talking about the headwind that shrink caused in some of those private label contracts. Raw milk costs were also around $24 a hundred-weight. So, while we do see some inflationary pressures in the back half of this year, we certainly are – our milk forecast wouldn't dare go to those kinds of levels, again, in the relatively short term.

So, while there could be some shrink headwind, just the absolute magnitude of the raw milk cost would suggest it will be dramatically less than what we experienced in 2014.

Farha Aslam - Stephens, Inc.

That's helpful. And could you just provide us some increased perspective on the opportunity in your distribution chain and is there any read you could tell us on kind of when we could see some benefits closer to the bottom line, in your efforts to improve distribution?

Gregg A. Tanner - Chief Executive Officer & Director

Sure. Well, I think you're seeing it now. I think you're starting to see what the 144 assets that have come off the road in the first half of this year and 240-some-odd assets since last year this time. So, I think our – the work that the logistics team is doing around frequency, the work that they're doing around route optimization, and I'm extremely proud of the work that the logistics team is putting forward right now, and I would expect that to continue through the rest of this year. So, I'm very happy with the cost reductions right now. And I think, we're still in the early innings of our logistics cost reduction. So, there's still a lot of room to go, but that team's doing a great job of getting at it.

Farha Aslam - Stephens, Inc.

And would you say you're in the second inning, fourth inning, any read on which inning we're in?

Gregg A. Tanner - Chief Executive Officer & Director

Well, third inning.

Farha Aslam - Stephens, Inc.

Third inning.

Gregg A. Tanner - Chief Executive Officer & Director

I'll go between the two. I think it's still early.

Farha Aslam - Stephens, Inc.

That's helpful. Thank you.

Operator

Thank you. And our next question comes from the line of Alexia Howard from Bernstein.

Alexia Jane Howard - Sanford C. Bernstein & Co. LLC

Good morning, everyone.

Gregg A. Tanner - Chief Executive Officer & Director

Good morning, Alexia.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

Hi, Alexia.

Alexia Jane Howard - Sanford C. Bernstein & Co. LLC

So, two fairly short questions. The category volumes finally seem to be stabilizing, maybe even improving. Do you expect them to stay flat from here or actually start to rebound? And what are the drivers of that? Is it the birth rate? Is it cereals? Is it lower milk prices?

And then secondly, how long do the benefits of the health claims on DairyPure last? I mean, obviously, those claims are on there. But how long will it be before other competitors or maybe even private label can actually start putting that type of claims about antibiotic-free and growth hormone-free on those packs? Thank you and I'll pass it on.

Gregg A. Tanner - Chief Executive Officer & Director

Great. Thank you. Thanks, Alexia. When I think about the category as a whole, I think you're just seeing the same turnaround that we saw in butter to some degree. As the saturated fats became less of an issue. I mean, we're seeing it in our whole milk volume versus skim milk volume. So, we're seeing whole milk, and I'm going to quote some numbers that may not be totally accurate, but last quarter was up 5%, whole milk, and skim milk was down about 11%.

So, I think, we're seeing a lot of the good work that we've been doing on the DairyPure brand. And the messaging behind that, the 8 grams of protein and all the nutrition that comes with milk has been the work that MilkPEP is doing. I think it's truly helping the category.

So, is it going to flatten out? I hope not. I hope it continues to go. The flavored milk category has continued to improve every quarter for the last four or five quarters. So, I'm hoping we see that on conventional milk as well. And so, I'm hoping that we'll actually see a category that may see some growth here over the next few quarters.

And as far as how long will the DairyPure message last? Boy, that's a wide-open question. We're going to continue to go to the consumer, talking about the health benefits, the localness of our product, the freshness of our product.

And I don't think there's anybody else that can replicate that on a national basis only because we're the only national footprint out there. But I'm sure there's others who will follow that as time goes. But as far as when that happens, I would hate to speculate on when that will be.

Alexia Jane Howard - Sanford C. Bernstein & Co. LLC

Great. Thanks, Gregg.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

And Alexia...

Alexia Jane Howard - Sanford C. Bernstein & Co. LLC

Yes?

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

I think the really positive part about volume as well is that even if the category does flatten out, and look, I mean, the trajectory would suggest something better than flat. We've gone from down 360 basis points in the dark days of 2014. I think that was 2014. I think that was Q3 of 2014 was down 3.6%, so plus 10 bps now. So, pretty dramatic improvement over a short period of time.

But, to your point, even if does flatten out, remember that we've done a lot of heavy lifting to create an algorithm here that works, even if the category is down 1% or 1.5%. So, I'm sort of treating where we are today without any further progress as very good news and potential upside. And then, if it does continue to extrapolate forward from there, then the benefits only continue to accrue.

Alexia Jane Howard - Sanford C. Bernstein & Co. LLC

Great. Thank you very much. I'll pass it on.

Gregg A. Tanner - Chief Executive Officer & Director

Thank you.

Operator

Thank you. And our next question comes from the line of Judy Hong from Goldman Sachs.

Freda Zhuo - Goldman Sachs & Co.

Hi, everyone. This is Freda Zhuo on for Judy.

Gregg A. Tanner - Chief Executive Officer & Director

Hi, Freda Zhuo, how are you?

Freda Zhuo - Goldman Sachs & Co.

Good. My question was on the volume that you guys called out this quarter about the private label exit. So, could you provide a little bit more detail on the types of businesses that you exited? And is this more one-time in nature or do you see a broader opportunity to further trend, what you see in terms of your private label business over the next few quarters?

Gregg A. Tanner - Chief Executive Officer & Director

Well, I think, as you look at the main reasoning behind this, it's all margin-related. So, when we get into RFPs and the margins get below our – what we'd consider to be below our expectations, we'll exit the RFP or we'll let the business go.

So, I think, as we look forward, as we said in our prepared remarks, we expect that to get a lot better in the third quarter. We expect to be down somewhere around 1% which is a dramatic improvement from where we've been in the past.

And then, as we enter the fourth quarter, we actually expect to possibly see some growth. So, that, I think, is the best thing I can tell you. I mean, we don't plan on losing additional RFPs. But, I think, at the same time, if they don't meet our expectations, we will step away from it. So, we don't get a degradation of our margin.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

The bulk of what we've lost that we've talked about on this call and for the past couple of calls was actually lost in Q4 last year. So, there haven't been – they may be some churn but the material losses, we will overlap here in Q4 of this year. That's one of the contributing factors too when Gregg talked in the prepared remarks on the forward outlook about volume growth becoming positive in Q4. One of the drivers of that is the fact that it will be lapping some of the more material losses in private label from 2014.

Freda Zhuo - Goldman Sachs & Co.

Okay. Great, understood. And then, turning to the SG&A, clearly, you guys have done a pretty good job of rationalizing cost and we're starting to see that flow through. As we think about the next couple of quarters, I mean, you also called out a step up in advertising expense. So, just in terms of the bucket between maybe an increase in advertising versus continued logistic savings, how are you thinking about the pace of SG&A declines as we head to 3Q and 4Q?

Gregg A. Tanner - Chief Executive Officer & Director

Well, I think it goes back to – I would expect the trends that we've seen on our G&A to continue. And that's still in an environment where we're investing in additional research and development activities. We're investing more in our consumer research group. We've invested in much of our sales organization and starting to build some capabilities around our warehouse and ESL capabilities. So, I'm very pleased with where we're at from a G&A perspective in an environment where we're continuing to invest in the business and build capabilities.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

Of course, we don't break our guidance down into the specific pieces of cost elements, but rest assured that productivity across all elements of cost remain a key focus in the third quarter and beyond.

Freda Zhuo - Goldman Sachs & Co.

Okay, great. Thanks.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

Thank you.

Gregg A. Tanner - Chief Executive Officer & Director

Thank you.

Operator

Thank you. And our next question comes from the line of Jonathan Feeney from Consumer Edge Research.

Jonathan Feeney - Consumer Edge Research LLC

Good morning. Thanks very much for the question, guys.

Gregg A. Tanner - Chief Executive Officer & Director

Hey, Jonathan.

Jonathan Feeney - Consumer Edge Research LLC

Chris, you talked about your volume trend. I really don't know. I've been surprised a few times in the past 10 years. I thought I understood that for a while, that there was a certain like wallet-size effect when you got significant retail price increases in 2014, you saw the categories contract. We've seen some significant retail price decreases with margin over milk relatively held flat and the Class I mover off what, like 50% off its peak.

I guess isn't this a question sort of like this volume, isn't this more a question of price and affordability maybe? Like, I guess, I would have expected us to recover some of that by now. And the fact that we haven't makes me think when costs go back up, that we'll go right back to some level of decline. What are you seeing? I know you have a pricing team and you're controlling it and you've managed the Dean Foods share very carefully through that.

But I'm talking industry as a whole. I mean, what is it that you're seeing that makes you think that an increase in price, is it going to lead to another like 2014-type contraction if we ever saw an increase in price like that?

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

Yes. So, I think it's a great question, Jonathan. Our work says that other than a couple of quarters in 2014, I'll say Q2 and Q3 2014, finding a correlation between the health of the category and the price of raw milk or the retail price of milk, and fairly close relationship between those two, it's really not there, which intuitively, kind of makes sense, right. I mean, it's such a stable product that mom or dad is going to get a gallon of milk even if milk prices are a little higher than they're used to. They're still going to buy milk. And if milk prices are pretty cheap, they're probably not going to get two and put one in the pantry.

The exception to that was Q2 and Q3 2014 when we sort of finally broke through a price barrier, where the category became elastic and you saw dramatic demand destruction and downward pressure on the category.

So, to your point, if when, maybe sometime out in the very distant future, we get back to $24 per hundred-weight raw milk costs, we've got to adapt our model for that probably relatively short episodic period to adapt to what would be pressure on the category. But that's certainly our forecast for raw milk prices over the balance of 2016. And, I think, the more modest increases that we're expecting to see will keep us within a band where you'll see limited increases on shelf and probably, no discernible impact on the category.

I think the positive tailwinds blowing behind the category right now, Alexia mentioned a few of them, birth rates and cereal growth and a few other things, plus the work that Gregg talked about that we're doing through DairyPure and the work that MilkPEP is doing. I think, those positive tailwinds far outweigh what will be a very, very modest increase in prices.

Jonathan Feeney - Consumer Edge Research LLC

I got you. Thanks. And just one detailed question if you wouldn't mind. Can you give us a ballpark sense in terms of sales and profit, what ice cream will be pro forma post Friendly?

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

We have not broken out that at the profit line though.

Jonathan Feeney - Consumer Edge Research LLC

Okay. Thank you very much.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

Thanks, Jonathan.

Operator

Thank you. And our next question comes from the line of Mario Contreras from Deutsche Bank.

Mario Contreras - Deutsche Bank Securities, Inc.

Hi. Good morning.

Gregg A. Tanner - Chief Executive Officer & Director

Good morning, Mario.

Mario Contreras - Deutsche Bank Securities, Inc.

So, in your remarks earlier, you mentioned that you were focused on increasing the price gap on your branded products versus private label. But then, at the same time, it was down a bit sequentially. Can you just talk about some of the factors that drove that and then, would you expect that to sort of reverse trend in the back half year and see that gap continuing to improve?

Gregg A. Tanner - Chief Executive Officer & Director

I think we're going to continue to see it improve. I think the one thing that I often caution people around is is being careful on any given quarter as to what that price gap is because, ultimately, the retailer will decide what that price gap is. So, many retailers, depending on whatever they're running promotionally or marketing-wise, may take that number up or down. But our expectation, however, is that we're going to continue to expand that. We'll continue to work towards somewhere in the 30% range over time.

Mario Contreras - Deutsche Bank Securities, Inc.

Okay. Thanks. And then, just as following up on an earlier question, can you give any more specific detail around how you plan to offset some of the lost volume related to the Walmart vertical integration decision? Thanks.

Gregg A. Tanner - Chief Executive Officer & Director

I think it's the same thing that we've done in the past. So, I think it's a continuation of the work that's being done currently in logistics where any routes that were dedicated and we're set up to go to those – to Walmart will be taken off the road and the asset will be eliminated.

I think the production assets that currently produce the 95 million gallons, at some point, we will have to look at our asset base and figure out what we have to do to shut down some of the capacity that supported that.

We will also look at the G&A around that and what supported that volume and we'll reduce accordingly. So, that's why in my mind, I'm very confident that our plans we'll be able to offset that without an issue other than the issue of the people within our organization who will be impacted by that, which I don't take lightly by any stretch.

Mario Contreras - Deutsche Bank Securities, Inc.

Okay. Thank you very much for the color.

Gregg A. Tanner - Chief Executive Officer & Director

Thank you.

Operator

Thank you. And our next question comes from the line of Amit Sharma from BMO Capital Markets.

Amit Sharma - BMO Capital Markets (United States)

Hi. Good morning, everyone.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

Hey, Amit.

Gregg A. Tanner - Chief Executive Officer & Director

Good morning, Amit.

Amit Sharma - BMO Capital Markets (United States)

Chris, a clarification, first, the Class II dynamic, can you give us a little bit more color, like, you said it was an $0.08 increase, and is supposed to be 9% in the next quarter. Is there seasonality that is a bigger component in these two periods versus first and fourth?

Gregg A. Tanner - Chief Executive Officer & Director

I'll touch on it and then let Chris take it from there. But if you look at the normal seasonality of premiums on cream, they're always higher during the summer. So, we will see higher cream costs during the summer when there's, obviously, more demand for cream and around the holidays. So, I think, it's one where it doesn't always go directly in line.

But if you look at the fundamentals of the market and you see butter at 90% more than the international market, I struggle with the fundamentals of why we're seeing the increases that we are. But we are seeing it and it's real and we have to react to it accordingly. But the Class II cream and butter fat is one that we'll continue to deal with as cheese and butter prices stay high.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

But we included in today's remarks, just to remind everyone, I think Class I, of course, has been a tailwind, has been down year-over-year now for 18 months, give or take. And we just wanted to remind folks that Class I is the main cost input driver for us. But class 2 is important and even more important in the summer time when ice cream volume picks up. And so the fact that it's up year-over-year in the second and third quarter, we thought was worth highlighting for folks to make sure that headwind is captured in people's modeling purposes as well.

Amit Sharma - BMO Capital Markets (United States)

All right. And, Chris, one more clarification. How much is Friendly contributing in terms of volume in the Q3, Q4? Are you able to break that down?

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

We haven't broken that down. I think it's about 1%, 1.5%, maybe about 1%, I think.

Amit Sharma - BMO Capital Markets (United States)

Okay. Got it. In both those quarters, right?

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

A little lower in the fourth quarter as ice cream volume drops off towards the end of the year.

Amit Sharma - BMO Capital Markets (United States)

Got it. And the last one from me, if we look at (57:34) data, DairyPure versus private label gap through the beginning of this year, so beginning of 2016 through July, are relatively flattish, right and this has – and I clearly (57:49) hear your points from the last two years, certainly gaps are higher from when it was launched. But this year seems to be flat. And this is coming in with almost $0.07, $0.08 of EPS investment, the entire advertisement. Is this in line with where you like it to be or is it something that gets better as you get through the rest of the year and 2017?

Gregg A. Tanner - Chief Executive Officer & Director

Well, I mean, it's in line with where we want it currently. We have – as we talked during the prepared remarks, there's certain promotions and different things that we're doing currently in the marketplace. But it is not where we wanted to be. We want to continue to expand. I would like to see that closer to 30% as we go forward. But again, part of that will be determined by the retailer and what they decide they want a gap within their cost structure to be. So, I would hope that we'll see it continue to expand. And I think we'll continue to support it in a way that will hopefully help retailers understand and decide that they can do that as well.

Christopher J. Bellairs - Chief Financial Officer & Executive Vice President

It's a kind of a complicated algorithm and more inputs than just the cost of Class I milk. So, we're also measuring the gap against ACV gains and against velocity. So, we're trying to engineer that performance over time and not take it in too big a chunks.

Amit Sharma - BMO Capital Markets (United States)

But should we expect you to spend more behind this brand to get that to a 30% level or is this simply a matter of retailers realizing the potential and just increasing?

Gregg A. Tanner - Chief Executive Officer & Director

I wouldn't expect to see a lot more spend. I think we'll continue to support it at the levels that we have. And then, when we introduce new extensions to DairyPure, we may up it a little bit during those periods of time just to introduce it to the marketplace. But I think the current spending is probably the spending that we would expect going forward.

Amit Sharma - BMO Capital Markets (United States)

Great. I really appreciate all that color. Thank you very much.

Operator

Thank you. And our final question for today comes from the line of Ken Goldman from JPMorgan.

Thomas Hinsdale Palmer - JPMorgan Securities LLC

Hey. It's Tom Palmer on for Ken. Thanks for squeezing me in.

Gregg A. Tanner - Chief Executive Officer & Director

Hi, Tom.

Thomas Hinsdale Palmer - JPMorgan Securities LLC

I appreciate it's still early, but how are things progressing with Friendly's? Is there any change to your $0.06 EPS accretion in the second half and where the majority of planned cost synergy is coming from? Is this mainly distribution? Are we looking at some corporate overhead? Just a color there would be helpful.

Gregg A. Tanner - Chief Executive Officer & Director

We continue to be pleased with the Friendly's acquisition. And I think anytime you can pick up such a valuable asset as we have and be able to do it at the multiples that we've talked about on the call, I'm very, very pleased. I think we don't see any change to what we had originally projected. So, I think the number that we gave before is still a solid number. It did – may work around that $0.06 a little bit higher or lower but we haven't seen anything within the business that would tell us that that change was wrong or needed to be changed.

As far as the synergies, it's all the things that you would expect, right? There's distribution opportunities. There are sourcing opportunities. There are revenue opportunities. There are back-office opportunities. All of those will be included in the overall synergies as we start to execute against that.

The thing I would remind you, Ken, is that, really, our focus for the rest of this year is integrating that business and trying not to do anything until we get through the season that may disrupt it at all. So, really focused on integrating, getting the IT systems in, get them into our IT systems, getting out of some of the contracts and service contracts that they're providing to us through the transition and then the synergies will really begin in 2017.

Thomas Hinsdale Palmer - JPMorgan Securities LLC

Okay. Thank you. And just a quick follow-up. I think that by the start of next year, most of the WhiteWave related non-competes will have expired, is that correct? And then, could you talk about any categories that seem more attractive than others? I mean, categories that you could produce in-house, it sounded, for instance, like creamers is a newer category that would set that bucket for you?

Gregg A. Tanner - Chief Executive Officer & Director

Yeah. I mean, I – let me first correct that there were no non-competes with WhiteWave.

Thomas Hinsdale Palmer - JPMorgan Securities LLC

Okay.

Gregg A. Tanner - Chief Executive Officer & Director

So, we didn't have any non-competes. The non-competes that we have were really on the Morningstar business or the Saputo business, and that was really around manufacturing, ESL and some of the other things that we did with Morningstar. So, are those categories attractive? Yeah, there are some of those categories that are very attractive. I think it's – for us, it's a matter of prioritization of our innovation pipeline and which of those choices and sequencing that we want to take on, and how much do we want to throw at the organization at any point in time.

So, as we look to our pipeline of innovation, there's a lot of things that we can do within the portfolio we have today that doesn't get us as far out as plant-based. But we are definitely looking at plant-based as an alternative for pipeline.

Thomas Hinsdale Palmer - JPMorgan Securities LLC

Great. Thank you.

Operator

Thank you. And that concludes our question-and-answer session for today. I would like to turn the conference back over to Dean Foods' management for any closing comments.

Gregg A. Tanner - Chief Executive Officer & Director

Great. Thank you, Karen. And thank you all again for joining us on the call this morning. We appreciate your continued interest in Dean Foods. And everybody, have a great day. Thank you.

Operator

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may now disconnect. Everyone, have a good day.

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