Dean Foods: Aggressive Moves Needed For Growth

| About: Dean Foods (DF)

Summary

Company will continue to face sales volume pressures.

Expected increase in dairy costs would weigh on its earnings growth.

DF needs to increase its focus on cost savings to expand margins, which will offer EPS growth visibility.

Dean Foods (NYSE:DF) in the recent years has struggled to grow its sales volume consistently because of decline in per capita milk consumption and intense competition. However, low dairy prices have helped the company to fuel its EPS growth despite sales volume pressures. In the upcoming quarters, the company's performance will come under pressure as DF is expected to experience increase in dairy costs and sales volume pressures due to sales losses to private label customers. Therefore, the company needs to act with a higher sense of urgency to create shareholders value. It should look to diversify its product portfolio by undertaking strategic acquisitions, which will not only support its sales volume but also strengthen its product portfolio. Moreover, it needs to focus more on productivity improvement, to expand margins and fuel EPS growth, which will augur well for its stock valuation.

Financial Performance and Catalysts

The company registered mixed financial performance for 2Q16. Earnings for the quarter came out to be $0.38, at the higher end of its guidance range of $0.32-$0.40 but missed the consensus estimate of $0.39. EPS for the recent second quarter grew by 15% YoY, due to low dairy prices; raw milk prices were down 15% YoY. DF's 2Q16 revenues of $1.849 billion surpassed the consensus estimate of $1.836 billion. Sales volumes for the quarter were down 3.2% YoY to 632 million gallons; the company has been facing challenges to grow its sales volumes due to intense competition and declining milk demand due to shift in consumer preferences towards flavored milk and other alternatives.

In the upcoming quarters, the company will continue to face sales volume pressures, and also expected increase in dairy costs will put pressure on its earnings growth. Intense competition in the industry has weighed on DF's sales, and recently Wal-Mart (NYSE:WMT)'s decision to start its milk processing facility resulted in a 100 million gallons milk contract loss at WMT. DF declining footprint in the industry and competitive retail environment will deteriorate its earnings power in the upcoming years. Also, there is a risk that DF might experience additional private label customer losses. Therefore, the company needs to focus more on building stronger relations with retailers to secure its volumes.

Also, the company needs to look to diversify its product portfolio, by adding product lines which are consistent with consumer demands; currently, almost three quarters of DF regular business is private label, where competition is very high. DF should also look for strategic acquisitions to diversify its portfolio and expand its market presence. To partially offset the 100 million gallons milk contract loss at Wal-Mart, DF signed a new contract, which along with Friendly's Ice Cream acquisition will add 300bps to sales volumes in the second half of 2016.

During the second quarter's earnings call, the company's management signaled that dairy prices are expected to increase in the 2H16, which I think will adversely affect its earnings. DF has historically been able to pass on dairy cost inflation quickly to customers, but I think now it would be difficult to pass on commodity cost inflation as the retail environment is becoming competitive. Also, the company's cheese and butter exports outside the U.S. will remain weak, as inventories are at a record level, and the U.S. prices are 90% more than international markets. The company's CEO, during the 2Q16 earnings call, said, '' 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.''

The company should increase its focus on cost savings and margin expansion to support earnings growth. If the company increases its focus on cost savings, it will provide visibility for future earnings growth, which will enhance investors' confidence and positively affect the stock price. Also, as the competition in the private label market is becoming intense, DF should look to exit from loss-making private label milk contracts, which will result in margin expansion. Also, it should increase exposure to frozen brands, which generates operating margin of almost 15%, in contrast to its consolidated operating margin of approximately 5%.

Summation

As the industry environment stays challenging, the company should make correct strategic decisions to create shareholders value. In the near-term, the company will continue to face sales pressure, and expected increase in the dairy costs would weigh on its earnings growth. DF should seek to diversify its product portfolio and look for more strategic acquisitions. And it should work to increase its exposure to high-margin brands, which will bode well for its margins. Also, the company needs to increase its focus on cost savings to expand margins, which will offer EPS growth visibility, and will augur well for the stock valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.