Dean Foods Co. (NYSE:DF)
Q3 2007 Earnings Call
November 8, 2007 9:00 am ET
Barry Sievert - Senior Director, IR
Gregg Engles - Chairman and CEO
Jack Callahan - EVP and CFO
Farha Aslam – Stephens, Inc.
Terry Bivens - Bear Stearns
Eric Katzman - Deutsche Bank
Pablo Zuanic – JP Morgan
Christine McCracken - ClevelandResearch
Eric Serotta - Merrill Lynch
Robert Moskow -Credit Suisse
Edgar Roesch - Bancof AmericaSecurities
Good morning and welcome to the Dean Foods Company thirdquarter earnings conference call. Please note that today's call is beingrecorded and is also being broadcast live over the Internet on the Dean Foodscorporate website.
This broadcast is the property of Dean Foods. Any redistribution,transmission or rebroadcast of this call in any form without the expresswritten consent of the company is strictly prohibited.
At this time, I would like to turn the call over for openingremarks to the Vice President of Investor Relations, Mr. Barry Sievert. Pleasego ahead, sir.
Thank you and good morning, everyone. Thanks for joining usfor our third quarter 2007 conference call. We issued a press release thismorning which is available at our website, at Dean Foods.com. The release isalso available on the SEC's website at www.SEC.gov.
A replay of today's call will be available on our websitebeginning this afternoon.
The consolidated earnings, operating income and operatingmargin information that will be provided today are from continuing operationsand have been adjusted to exclude the impact of discontinued operations,financing costs related to the recapitalization of the balance sheet, theexpense related to facility closings and reorganizations, and non-recurring items,in order to enable you to make meaningful evaluation of our operatingperformance between periods.
The earnings release contains more detailed discussion ofthe reasons why these items are excluded from the consolidated results, alongwith a reconciliation between GAAP and adjusted earnings. We will explain theseitems in more detail later in the call.
We also would like to advise you that all forward-lookingstatements made on today's call are intended to fall within the Safe Harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. These statements will include, amongothers, disclosure of earnings targets, as well as expectations regarding ourbranding initiatives, expected cost savings and various other aspects of ourbusiness. These statements involve risks and uncertainties that may causeactual results to differ materially from the statements made on today's call.Information concerning those risks is contained in the company's periodicreports on Forms 10-K and 10-Q, and in today's press release.
With those formalities out of the way, I will now turn thecall over to Gregg Engles, our Chairman and CEO, who will review our third quarterperformance and give an update on our strategic initiatives. Following Mr.Engles, Jack Callahan, our Chief Financial Officer, will summarize ourconsolidated financial results for the third quarter of 2007 and discuss ourforward outlook.
Following Mr. Callahan's remarks, we will open the call foryour questions.
Thank you, Barry and I thank all of you for joining us onthis morning's call. When we spoke to you in August, we knew the third quarterwould be particularly difficult. Raw milk prices had risen sharply to recordhighs, and we were challenged to increase our pricing fast enough to keep pace.The Class I mover averaged $21.53 during the quarter, nearly double theprevious year's third quarter average of $11.05, and 32% higher than the secondquarter of this year.
Shrink, or milk lost in production, had become a substantialyear-over-year drag on earnings as the value of the lost milk roughly doubled.At the same time, we were spending aggressively to defend the Horizon Organicbrand through reduced pricing, expanded distribution, and increased promotionalactivity in an organic milk market that is faced with significant oversupply,driving down retail prices as competitors work to stimulate demand and drivetheir own distribution in an effort to sell their milk as organic.
These factors were every bit as challenging as we hadexpected. However, as we moved through the quarter, retail prices forconventional milk began reaching levels of increasing elasticity in many areas.The average gallon of milk has risen approximately $0.75 this year throughSeptember. With the steep rise in retail prices, we also began to experienceother difficulties, including a larger than expected weakening in volume.
In what is typically a fairly inelastic product category, weexperienced our first quarterly volume decline since 2004 and the largestquarterly volume decline in our history. For the full quarter, our fluid milkvolumes decreased approximately 3%, roughly in line with the overall industrybased on USDA and federal market order estimates.
In addition, several of our key markets where our brandstypically sell at a significant premium experienced a higher than expected mixshift into private label and out of our more profitable brands, both reducingthe profitability of our sales and exacerbating our overall volume decline.
At the same time, the sharp increase in raw skim milk pricessignificantly reduced the cash received from our excess cream sales sold as abyproduct. Because of the size of our fluid milk operations relative to ourcultured and ice cream operations, the milk we buy from the farm contains morefat than the products we sell. As a result, we generate a significant amount ofexcess cream. Approximately half of the excess cream produced by our fluidoperations is used internally in our creamer, ice cream and cultured productoperations, and about half is sold to third parties.
The industry standard for cream sales is to price the creamrelative to the CME butter market. This price has been relatively stable thisyear, largely due to the strong growth in dry milk powder production, whichcreates butter as a byproduct. Cream pricing tracks the value of butterfat.However, each load of cream also contains approximately 60% skim milk, thevalue of which has essentially doubled over the course of the past year.
The higher cost of goods sold in our excess cream sales, anda very competitive market and historical pricing mechanism for cream, havecombined to reduce what has historically been a meaningful offset to our costof goods sold.
As a result of the confluence of these challenges, DairyGroup operating income for the third quarter came in at $137.3 million, a 21%decrease compared to the prior year. While the third quarter was disappointingfor the Dairy Group, and we expect continued high commodity prices through thefourth quarter, there are signs that raw milk pricing may improve as we moveinto 2008.
High prices have led to a significant supply response fromfarmers, with production volumes up approximately 3% in each of July, Augustand September. Nonfat dry milk, which has been the primary driver of the recordClass I prices we've experienced, has also seen strong growth in production, ascontinued export demand has kept prices around $2 a pound, a historically highlevel.
However, there is evidence that processor inventories ofnonfat dry milk powder are building, and prices have begun to moderate. Mostdairy economists we track believe the market is headed lower in 2008. Thiswould obviously be favorable for our results. Declining prices would begin todecrease the year-over-year negative impact from items like shrink and excesscream sales in our P&L. We would also expect volumes to respond positivelyto lower prices at retail.
Turning to WhiteWave, as expected, the third quarter was astrong quarter for sales and volumes, but difficult from an operatingprofitability perspective due to the significant incremental investment behindthe Horizon brand. This investment has had the intended effect, however. Salesand volumes for Horizon were quite strong, growing in excess of 20% and 30%respectively, and we have successfully defended our market share. International Delight and Land O'Lakes alsohad very strong quarters, while Silk sales growth was in the mid single-digits.
At the operational level, we continue to see strongimprovement in efficiency that should become more apparent in the divisionalresults once we get through the oversupply situation in the organic milkmarket, which we expect to happen sometime during 2008, probably toward thelatter portion of the year.
However, we aren't just sitting still waiting for commodityprices to come down. By facing the challenges created by this difficultoperating environment, we're driving improvements in the business that willmake us stronger long term. Although shrink accounts for only 1.5% of theroughly 800 million gallons of milk that moves through our plant each quarter,we are focused on eliminating as much of this cost as possible.
We are also in the process of working with our customer baseto educate them about the impact shrink and cream sales are having on ourbusiness, and are working to implement incremental pricing to help cover someof these costs. This program is in its early stages and will take some time toimplement.
In spite of the difficult operating environment, we continueto make solid progress against our long-term strategies. We have now largelycompleted a reduction in force we announced at the beginning of October. Thevast majority of the reduction was completed through a voluntary program, andwe're pleased with the results.
We are also continuing to move forward with our purchasinginitiative and back office centralization program. The purchasing initiative isdriving significant savings in 2007, and more efficiencies are expected in2008. Our efforts to drive efficiency by moving a lot of the back office work thathas traditionally been done at the plant level to centralized finance andaccounting centers is also moving forward. This initiative is a net cost thisyear as we brought on and trained new employees. We expect this program to belargely complete by the end of the year.
We're also making good progress towards realigning the DairyGroup's business into three distinct business platforms: DSD milk, Morningstar andice cream. As you know, our DSD milk business is a high velocity, direct storedelivery model. Winning in this business depends upon having a low cost modeland driving high levels of customer service. Harrald Kroeker, who came to usfrom Pepsi Bottling Group, is leading our efforts to build the capabilities weneed to continue to win in the future in the milk business.
Morningstar, our private-label extended shelf life andculture products business, runs on a warehouse delivery model. Separately, ourice cream business, which is a mix of regional brands, private label andfoodservice businesses, operates through a hybrid frozen warehouse and DSDmodel. By aligning these businesses along their underlying production anddistribution platforms, we expect to better define their individual strategicroles under the Dean Foods umbrella and drive better business performance.
We are also moving forward with the build out of our seniorleadership team. Rick Zuroweste has joined us from Coca-Cola to lead our DairyGroup marketing efforts, as our new Dairy Group Chief Marketing Officer. Rickbrings over two decades of experience to bear in assuming strategic leadershipfor the Dairy Group's portfolio of brands.
Gregg Tanner joined us this week as our Chief Supply ChainOfficer. Gregg has over 20 years of supply chain management experience. He willbe tasked with leading the effort to optimize our manufacturing and othersupply chain systems across the company. We are very pleased to have these keyroles filled with such top caliber executives and look forward to theircontributions.
So in summary, the third quarter was the most difficultquarter of the year so far. We were challenged by record-high commodity prices,softening volumes, mix shift out of our brands, significant cost friction, andcontinued investment to defend the Horizon Organic brand. This is the mostdifficult operating environment we've ever experienced as a company.
Looking forward, we are expecting commodity coststabilization in the fourth quarter, and are optimistic about the potential fordeclining prices in 2008. We continue to drive improved efficiency andcapability across the organization with a view toward building the company forlong-term success.
With that, I would like to turn the call over to JackCallahan, who will walk you through more detail on our third quarter resultsand summarize our forward outlook.
Thank you, Gregg and good morning, everyone. As Greggdiscussed, the third quarter was perhaps the most difficult quarter in thehistory of Dean Foods. Consolidated adjusted earnings came in at $0.14 pershare, compared to $0.56 in the third quarter of 2006. Operating incomedeclined approximately 29%, a $50 million decline, and interest expenseincreased $42 million due to our new capital structure put in place at thebeginning of the second quarter.
On the business segment level, Dairy Group operating incomefor the quarter fell 21%, a $36 million decline on a year-over-year basis to $137million, due to the record high commodity costs. To put the $36 milliondecrease in operating profits into perspective, due to the sharp rise in dairycommodity costs, cost of goods sold for the Dairy Group were approximately $600million higher in the third quarter this year than the same period a year ago.This brings the year-to-date rise in cost of goods sold in the Dairy Group toover $1 billion through just the first three quarters of the year.
The increased commodity costs are being passed throughfairly effectively, but as we've mentioned, the business is being significantlyimpacted in a number of other areas. In order of magnitude: increased shrinkcost, reduced cost of goods sold offsets from excess cream sales, lowsingle-digit fluid milk volume declines, and the mix shift to private label allhad meaningful impacts on the Dairy Group profitability in the quarter, as didthe lapping of a one-time supplier payment adjustment received in the thirdquarter of last year.
As Gregg said, we have initiatives under way to reduceshrink in the plants, and to obtain some level of pricing adjustments to offsetthe impact of the shrink in excess cream. These initiatives will take time toimplement and will likely soften the future impact, but not totally removethese issues.
Additionally, while we expect volume growth and mix shift toreturn to more normalized levels when commodities decline, we cannot be surethis will happen if prices remain at these unprecedented retail levels.
Turning to WhiteWave Foods, total net sales for the quarterincreased 9% to $336 million. Operating income at WhiteWave for the quarter was$22 million, a decrease of 37% over the prior year. Operating margins were6.6%, down significantly from last year's double-digit margins due largely to theincreased investment behind the Horizon Organic brand.
As Gregg mentioned, our creamer business had a particularlystrong quarter, with International Delight sales growing in the low double-digits,outpacing the category and taking share on the strength of our updatedpackaging and flavor innovation. Land O'Lakes creamers grew in the mid-teensdue to strong volume growth and increased pricing. Silk sales grew in the midsingle-digits in the quarter, down a bit from the first half of the year, butSilk is off to a stronger start in the fourth quarter, and has stepped upmarketing support in the fourth quarter this year versus last.
On both a volume and sales basis, Horizon Organic had a verysuccessful quarter, with milk dollar sales increasing just over 20%. Volumegrowth in the quarter was in excess of 30% due to the promotional activitywhich reduced realized pricing in the category. The third quarter marked thefirst full quarter of the impact from the investment behind the brand, inreaction to the oversupply situation. These investments have resulted in strongbrand growth, increased distribution, and stable share trends over the courseof the quarter.
We now believe that the organic milk market will be in astate of oversupply through the end of the year, and well into 2008. Weanticipate continued aggressive competitive pricing pressure, and we willcontinue to protect our long-term market leadership position throughinvestments in promotion, distribution, new products and advertising.
Turning to corporate expense, corporate expenses in thethird quarter totaled $36.5 million, a 4.5% increase over the prior-yearresults due to strategic initiative spending. As we've mentioned before, thisline item is likely to move around a bit quarter to quarter as we buildcapability and continue to pursue our strategic initiatives.
On a consolidated Dean Foods basis, the unprecedentedchallenges across both the Dairy Group and WhiteWave resulted in consolidatedadjusted operating income of $123 million, a 29% decrease from the thirdquarter of 2006.
Interest expense totaled $89.7 million in the third quarter,compared to $48 million of interest expense in the third quarter of 2006. Ourhigher interest expense is largely related to the recapitalization of ourbalance sheet in the second quarter, in conjunction with the special cashdividend. We continue to anticipate full year interest expense will be about $325million for 2007.
As a result of the significantly higher interest expense andthe lower operating income, net income for the third quarter was $18.7 million,down from $77.9 million in the third quarter of last year.
Relative to the taxes, our lower income increased theunfavorable effect that non-deductible items have on the company's estimatedannual effective tax rate, resulting in a quarterly tax rate that wassignificantly higher than our yearly expectations. We estimate a full-year taxrate of approximately 39.5%.
Cash flow from continuing operations for the first ninemonths of the year was $221 million, down from last year due in part to loweroperating results, higher year-over-year interest expense, and increasedworking capital requirements. Cash flow is well behind what we had anticipatedwhen we issued a special dividend in April. I would estimate now that we areabout a year behind our original pay down expectations.
As we look ahead, as commodities begin to decrease ourworking capital investment will also decrease, and we would anticipateaccelerating debt reduction. Year-to-date capital expenditures totaled $165million. We continue to target approximately $250 million in CapEx spending forthe year, although all proposed balance of year spending is being very highlyscrutinized.
Debt outstanding net of cash on hand at the end of the thirdquarter was $5.3 billion. Our leverage ratio at the end of the third quarter,as defined by our bank covenants, was 5.97 times funded debt to EBITDA.
In closing, I would like to discuss the forward outlook aswe finish out the year. Looking ahead to the fourth quarter for the DairyGroup, we expect record-high raw milk prices will continue to pressure results.Milk cost stabilization should help in terms of price realization but shrink,lower cost of goods sold offsets from excess cream sales, and the potential fora continued unfavorable mix shift, will likely continue to challenge earnings.
At WhiteWave, we will continue to invest to protect theHorizon Organic brand from aggressive competition through this period ofindustry oversupply, which will dampen WhiteWave profitability.
All in all, we expect fourth quarter adjusted earnings to beapproximately $0.30 per share, a solid step up from our third quarterperformance and our results so far in the fourth quarter suggest we are ontrack.
Looking into 2008, the dairy commodity and organic milkoversupply situations remain sufficiently unsettled that we believe it ispremature today to set out expectations for the full year.
Entering 2008, pricing realization should begin to improveif the Class I price moderates from current levels, as we expect. However, thecommodity cost overlaps will continue to be a meaningful drag on performance,as current forecasts suggest a range for the first quarter of $18 to $20 perhundredweight compared to only $13.74 in the first quarter of 2007.
At WhiteWave, we anticipate that the organic milk oversupplywill persist into 2008, continuing to limit WhiteWave profit growth.Additionally, as you think about first quarter performance, you should alsokeep in mind that the first quarter in 2008 will present a very difficultoverlap, as our operating profit growth in the first quarter of this year 2007was well over 12%.
Also as a reminder, we will also be lapping the old capitalstructure through the first quarter. Net-net, with the tough cost overlaps oncommodity milk and the organic milk surplus, we anticipate overall operatingprofits in the first quarter will continue to be below previous year levels,consistent with the trend since the second quarter of 2007. Additionally, the overlap of the old capitalstructure will further negatively impact first quarter EPS by approximately$0.16.
Looking beyond the first quarter, it's clear that commoditycosts will be the key driver of our performance. While the Class 1 mover isshowing signs of moderation, when you look across the commodity forecastsavailable, there is a wide range of estimates as to the timing and extent ofany price declines. As dairy commodity costs remain high, 2008 could be quitedifficult as we would continue to face negative cost overlaps until at leastmid-year.
Similarly, we expect the oversupply situation in the organicmilk market to persist well into 2008 and it is unclear when supply and demandwill come into better balance. As we are committed to defending the Horizonbrand through this period of oversupply, you should expect WhiteWave results tobe impacted for as long as the supply imbalance persists.
Balancing all of the possible outcomes for 2008 right now,we are expecting a difficult first quarter followed by sequentially improvingresults as we move through the year. We will provide more perspective on 2008on our fourth quarter call as we complete our planning activities and theoutlook for the 2008 commodity environment becomes a bit clearer.
With that, I would like to thank you all for joining ustoday and ask the operator to open up the call for your questions.
Your first question comes from Farha Aslam - Stephens, Inc.
Farha Aslam -Stephens, Inc
Good morning. Some questions on Horizon Organic, Gregg. Thevolume growth that you've experienced as a result of the supply of organicmilk, do you still expect 90 million gallons for this year, or are we going tobe above that level?
Farha, we're going to be right around that, maybe slightlyabove.
Farha Aslam -Stephens, Inc
What was the price of Horizon Organic during the quarter,and was it in line with what you were thinking, or did you have to discount more?
It varied by region in the country but we had moved down tothe $3 per half gallon retail price level in most places in the Eastern part ofthe United States, slightly higher than that in the Western part of the UnitedStates. It was entirely consistent withwhat we expected.
Farha Aslam -Stephens, Inc
As you look into the fourth quarter, are you seeing thatmaybe go up to $3.20, or is it still at the $3 level?
Our expectation today, Farha, is that as long as we remainin oversupply, the price is going to stay right where it is. That moves around a little bit withcompetitive pressures. But broad brushacross the span of the $400 million brand, we expect it to stay about where itis.
Farha Aslam -Stephens, Inc
When you look out going into future next year, do you thinkthat at this $3 level, the retailers are at a level that they're going to keepit here because they're going to use it as a traffic driver? Or do you thinkthat private label milk will have to move up because they're losing money onevery gallon they're selling?
Your question assumes that the pricing is being driven byprivate label. That's not reallyentirely the case. The whole category,the other brands and private label, have moved to this $3 per half gallonlevel, at least in the eastern part of the country. I don't necessarily believe that they'reusing it as a traffic driver, but I do believe that people are investing in thecategory because of the very strong growth rate.
So we're in a position today where given the oversupplysituation in the category, people are playing for share of this category forthe long term. Just to again go back tothe growth rates, on the volume side of the business, we saw Horizon grow up intothe 30s in terms of volume during the quarter. So, extraordinarily strong growth rates for the category, and I thinkthat's what's causing people to play for the long run.
Your next question comes from Terry Bivens - Bear Stearns.
Terry Bivens - Bear Stearns
Gregg, as you look at the powdered milk market, it's begunto come down a little bit after all this time, but now cheese is beginning tolook a little bit more worrisome. As welook into next year, we see things kind of flattening out in late spring, butI'd like to get your idea on that, just in terms of the Class 1 mover. Is there some point you're tentativelylooking at now?
Well, it's tentative. You can buy my crystal ball on eBay for a relatively small price. There is a weak consensus out there, I wouldsay globally, around the fact that milk is going to move down from this pricingin the low 20s to I'd say a range between $16 or $17 and $19. So we're going to get a move down; everybodybelieves that that's the case.
Theunderlying dynamic -- and you see it reflected in the fact that as powder issoftening, cheese is strengthening -- the underlying dynamic however is that,again, this loose consensus is that the world is effectively out of safetystocks of storable dairy products. So aswe depleted stocks of powder, you saw the powder price spike, and that's driventhe Class I price. It also drovelots of milk into dryers and butter churns and out of cheese plants. That's causing the cheese stocks to tighten. So now as powder comes down, you're going tosee milk move back to cheese.
We're going to move back and forth in a global marketplacethat is in precarious balance between supply and demand. In fact, demand growth for the next severalyears, it looks like will be driven by supply growth. The question is, what is supply growth goingto look like over that period of time? Whatyou're seeing out of the USis you're seeing meaningful supply growth. I believe you're going to see supply growth out of the rest of theworld. I don't think it will be as largeas the USsupply response.
Therein lays the debate as to where the milk price is goingto settle out. Is it going to settle outin the high-teens, or is it going to settle out into the mid to highmid-teens? Is it going to be $13 to $16,or is it going to be $16 to $18? That'sthe debate, really, in the global dairy markets. But there is going to be some volatilityalong the way; everybody agrees on that.
Again, just to wrap up a relatively long answer to yourquestion, I think, people believe that this marketplace is moving down off ofits peak, and it is moving down off of its peak. I don't think that anybody is prepared tocommit to the notion that it's going to be a straight line down to asignificantly lower price level, and that it's going to stay there for a longtime. You see that uncertainty reflectedin our comments this morning. If we feltlike this milk market was going to move down and settle in at $15 for anextended period of time, we would be more bullish.
Terry Bivens - BearStearns
Thanks for that explanation or ventured opinion. Just a quick one on Silk. I was a little bit disappointed to see thesales figures in the third quarter. Canyou give us a little more color on what you think needs to be done to thatproduct to get the sales growth reaccelerating a bit?
First of all, I would note that sales growth for Silk duringthe period was behind volumes. So we hadpromotional activity on the brand during the period that we didn't seeflow-through into the P&L. So, thenet price realization on Silk was below what we had expected for thequarter.
It's causing us to move our thinking about how to drive thisbrand going forward, and shifting somewhat away from promotion and more towardsa consumer-driven approach to the brand. But the brand continues to put up high single-digits volume growth, andwe see that firming over time. So wefeel quite good about Silk going forward. But as this brand gets more mature, it's now going to be well in excessof a $400 million brand going into '07, we are recalibrating how best to drivethis brand forward -- and the category forward, frankly, given our shares --around our mix of marketing and promotional spending. So that's where we're doing most of our worktoday.
Terry Bivens - BearStearns
Thanks very much.
Your next question comes from Eric Katzman - Deutsche Bank.
Eric Katzman -Deutsche Bank
My first question, Gregg, has to do with there's obviouslysome things you can't control, but on the cost saving side, that is somethingyou can control. Given your work to-datewith the centralization efforts, any update you can share on what you thinkthat is going to look like in '08?
Yes. We've talkedabout this over the last year or so, and we're talking about it more and moreas it comes more and more to be reality in terms of a program. We're talking about this as a year's longprogram of re-architecting our business. We started with the near-in, more foundational aspects of thistransformation; the procurement initiative, which will yield a net positivebenefit in 2007, and a more significantly net positive benefit in 2008; aboutthe back office and the G&A realignment that we began in 2007. That was a meaningful net cost in 2007, andwill be neutral or a modest net benefit going into 2008.
But on the back of that P&L improvement in the G&Aarena and the purchasing arena, we will be making investments in the nextphases of the transformation of the business as we move more heavily towardslooking at our underlying physical plant asset infrastructure and otherfunctional aspects of our business in terms of how we actually conduct ourbusiness, whether it's in the sales area or the marketing area. Yousee us adding people to build skills and capabilities in those areas that weare announcing or talking about this morning.
We believe there's a very meaningful payoff for this companyas we attack its cost structure. Attacking its cost structure is going to require upfront investments tobuild capabilities and to make investments in the infrastructure of thebusiness. We're phasing those so that wereach a level of investment here somewhere in '08 or '09 that in the future thenstarts to pay material dividends.
So I would say we're sort of towards the third quarter ormaybe early fourth quarter of legging into the cost of attacking our costbase. You'll start to see the payoff ofthat as we get out into future years, but there's not going to be a huge payoffin '08 because we're going to be beginning to make further investments in areasaround supply chain, manufacturing infrastructure, marketing infrastructure, inthe business and there's an upfront cost associated with that.
Eric Katzman -Deutsche Bank
A follow-up on the dairy profitability. I goback far enough to remember the last time you talked about cream and butter in1998, what a mess that was. The $137million of profits that you put up in the third quarter, given how volatile andhow high the cost is, actually isn't that bad relative to what you have beendoing in that segment on a quarterly basis.
Can you frame how you felt, even with the demand elasticity,the pass-through mechanism worked, and how that will affect the negotiationsthat you seem to be moving forward with the retailers about how thepass-through mechanism and the calculations work?
Let me take a stab at it from a high level, and then I'lllet Jack talk about it. We're an organizationthat's used to hitting our numbers and hopefully exceeding our numbers. So I won't sugarcoat it and say we're notdisappointed with our performance across the business in the third quarter. On the other hand, given the fact that we'vegot a $600 million cost step-up on milk alone in our dairy business in thethird quarter, I think it does speak to the strength of our underlying businessand our franchise.
We've got a great group of people that operate ourbusinesses in the field, and they have done an extraordinary job through anextraordinarily difficult environment and they are working incrediblyhard. In this environment, which is areal phase shift from where this industry has been, they are learning andadapting at an incredibly fast rate. SoI'm very, very, proud of our team. I'm frankly impressed by the resilience of ourbusiness.
Notwithstanding the fact that we've seen some volumedeclines in mix shift, I'm also, frankly, impressed by the inelasticity of thiscategory. While we still have negativevolume comps, we actually see volume sort of firming as consumers get used tothis higher level of retail price. SoI'm impressed with the underlying resiliency of our business.
I believe as we move into '08, all of the dimensions thatwe've been talking about as negative factors are going to get better during'08. I can't tell you the exact timingof it, but they're going to get better, and it's not going to be just becausethe price is coming down. It's going tobe because we are honing and refining our business model as we understand allof the factors that affect us in this more difficult commodity environment. So, I am encouraged by the underlying strengthof our business.
The other point that I would make is that, and this isanecdotal information, but I believe that we are very meaningfullyoutperforming the rest of the business because of the strength of our franchiseand the strength of our team. I think the industry as a whole has got tohave more pricing to sustain its investment in the infrastructure that it takesto keep this industry going. I believe we're going to have success in thenegotiations with our customers and frankly , getting our formulas right.
That's what the exercise is about with our customers; it'sabout getting our formulas right so that they in fact reflect the costs of achanging milk environment in our wholesale prices. So there's a large education effort going onout there. It is difficult, as you wouldimagine, given the competitiveness that our customers face. But there's logic behind what we're showingto our customers, and we're having success in our effort. We believe we'll have continued success as wemove into '08.
It feels like a bottom in the business here. The question ishow quickly do we come off the bottom? How does the commodity work its way through and play out, and how do ourefforts to minimize these costs and adjust our pricing formulas, how does thatplay out over time? And there's a lot ofuncertainty around that.
Eric, just a little quantification on what drove thereduction in operating income in the Dairy Group. We did a pretty good job of passing along theprice in terms of the commodity cost increase. I would say that our effectivepricing probably only explains maybe 15% thereabouts of the profit declineversus year ago. Most of what reallydrove the decline had to do with this shrink in the cream sales, which werevery meaningful in our areas where it's an industry issue, and it's a real costof doing business. It's never been anissue before, but we're trying to go back to get some better realized pricingfor those issues. The balance had to dowith the decline that we've seen in fluid volumes and a little bit of a mixshift away from our regional brands to private label. So, a pretty good job overall in passingthrough the prices. The field has done avery good job.
Your next question comes from Pablo Zuanic – JP Morgan.
Pablo Zuanic – JPMorgan
Good morning, everyone. Just going back to the dairyindustry questions, we have tight capacity drying capacity out there, which hasexacerbated the problems with prices in this phase. Now that production starts to go up, youwould think the opposite would happen, right? Because there's going to be moreproduction, you said 3%, if you cannot dry more because you have tightcapacity, then the effect on the domestic market is exacerbated. You have even a greater supply. So that should speed up the decline inprices. What am I missing there in thatanalysis?
I think there are two things that you have to factor in.First of all, this is a global market for powder. This powder is not being soldor consumed in the United States,it is all going offshore. So the Class 1 price is a build up of componentprices of powdered cheese and butter. It is a build up of the higher of thoseprices.
So we could have the odd situation of in fact, not beingable to process all of the milk that we produce in the United States and not have the Class 1 price comedown, because the global price of powder stays high. So we have got aregulatory regime that is not a modern one, and it is not dealing perfectlywith these very, very rapid changes in commodities.
So if we've got excess milk in the U.S.and it can't get dried, it's going to flow into cheese manufacturing; there'splenty of capacity there. But the powderprice is going to stay high and the Class 1 price is going to stay high.
The second thing that I would point out is that the worldstocks of powder have been depleted. I think it's the global industry's point ofview that supply growth is going to lag behind demand growth for a while. Europe is constrainedby its quota in terms of how much increased production is going to happen in Europe. New Zealandand Australiaare constrained by just the ability to convert land at a rapid pace, and bywater in Australia. Chinais growing their supply very rapidly, but demand is growing more quickly.
So the USisn't going to change its price unconnected anymore from the global price. Prior to 2006 and 2007, the USreally moved in a way that was in many ways uncorrelated with the globalprice. That's not going to be the casegoing forward, at least for the foreseeable future. So we're going to have to look externally tounderstand what's going to happen to our domestic price.
The final point that I'd make, which I should have madeearlier, but it's a huge issue as it relates to what's going to happen toprice, is the value of the US dollar. These commodities are priced in dollars around the world. As the US dollar plummets in value, theglobal price could begin to stabilize and we could see an inflationary price inthe US. That is a force that we are not used to thinkingabout in the domestic industry, and it's going to take us a while to get ourheads wrapped around it.
Pablo Zuanic – JPMorgan
That's very useful. If I think more in terms of the month-to-month changes that the USDAputs out for Class 1 for the October price, the November price, they were downsequentially, I'm thinking when you go visit Wal-Mart or similar retailers, youmay want to start talking about how to pass on shrink and excess cream. Thecost of milk is coming down. I don't seehow retailers are going to want to increase prices further if the cost iscoming down.
I think everybody's got an interest, retailers andprocessors, in getting the formulas right. Because these markets over time aregoing to move up and they're going to move down and the cost of shrink andexcess cream sales play into that cost. So we have a course of dealing that's built up in the industry overdecades, where the industry recognizes the impact of the cost of the rawmaterial in the wholesale pricing. That'sworked to everybody's benefit on the way up and on the way down on the otherside of this long-term relationship between suppliers and retailers. So I think that's really the point.
The pass-through, you could make the same point about the pass-throughmechanism. The retailers want the pass-throughmechanism on the way down, but they don't want it on the way up. But the fact is we all live with it throughboth phases of the cycle. This effort isall about getting the formulas right.
Pablo Zuanic – JPMorgan
One last one if I may. What would you say are gross profits per pound on a normalized basis inthe dairy business?
I'm going to turn it to Jack, but I don't know that we havethought about it that way.
First, we think about if first, always by gallon. Dependingon the year, sort of high-teens, maybe $0.20 per gallon. That's more operatingincome. So I would have to factor out --
Pablo Zuanic – JPMorgan
We can follow up offline.
But that directionally gives you some sense of what thetotal number is.
Pablo Zuanic – JPMorgan
In terms of the financial covenants on the debt, you gave usa ratio; any concerns there that the covenants would be breached during thisperiod?
Obviously, we're looking at it real closely. But based on the work we're doing right now,we expect to be in compliance with our covenants right now. As you noticed, despite the fact that we hada big run-up in the Class 1 price in the third quarter, our net debt stayedeffectively flat in the third quarter. Weanticipate starting to pay down some debt in the fourth quarter. With some recovery, hopefully, with the Class1 price coming down, we'll get some working capital relief. We think that will accelerate as we go intonext year.
Your next question comes from Christine McCracken -Cleveland Research.
Christine McCracken -Cleveland Research
If you look back over time when oil prices spiked it didimpact, obviously, your cost of packaging. You've looked at higher fuel prices as being a cost pressure in thepast. In this environment and goingforward, how do you look at that potential cost hit as you head into fiscal'08?
Milk isn't the only cost pressure we have, you're absoluteright about that. The market isobviously attuned to those changing costs as well. They've traditionally been part of ourformulas. So the reason we're nottalking about them if milk was flat, we would be talking a lot about them. It's just that they're dwarfed by the milkprice changes, but they do work into our formulas in our conversations with ourcustomers. Frankly, given the otherchanges in milk, they're relatively minor factors during this period of time.
The oil really drives fuel for us, or has historically. Natural gas has driven resin and packagingcosts. Those correlations are changing alittle bit as natural gas prices stay very low compared to oil prices, we'restarting to see domestic resin move into the world market, because most of therest of the world makes resin out of oil. So we are seeing resin prices now start to be more correlated with oilprices than they are with natural gas prices. We don't know how long that will last.
We all thought in the United States that globalization was going to workin our favor, and I think it probably does over time. But, boy, the transition is sure complicated.
Christine McCracken -Cleveland Research
It makes it tough for us, too.
Neither resin nor fuel has not had really had a meaningfulimpact one way or the other on the P&L, that's in puts and takes throughoutthe year. But we're looking at itclosely as we go into next year, particularly with the Class I price of milkhopefully moderating a bit.
Christine McCracken -Cleveland Research
Is that something that is protected by contract that wouldbe renegotiated as you head into next year, or is it something that kind offluctuates with the market?
Well we do have, with our new purchasing capability,particularly in the area of resin, we do have some longer-term workingarrangements in place that do give us some protection there. But at the end ofthe day, there could be some market swings there.
Christine McCracken -Cleveland Research
Gregg, you, obviously are somewhat critical of the current FarmBill policy. Have you taken an activerole in trying to get involved in that? It doesn't look like there's any significant change expected in thiscurrent round. I'm just wondering is itsomething that you anticipate changing, or are you just kind of reacting towhat is in fact a very difficult dairy policy?
Right now we've got our hands full reacting, and it's prettymuch a full-time job for me right now. Tryingto influence this Farm Bill in Washingtonis something that from a personal perspective, I just unfortunately don't havethe time to blunt my sword on right now. We have an active Washingtonpresence. We have an ongoing lobbyingoffice in Washington. We're constantly trying to influence policyboth through our own efforts and through our industry associations.
But the reality of it is these policy programs have beenworked out by virtue of political compromise over the span of decades. Only when everybody in the industry, from theproducer side to the processor side, comes to some sort of alignment thatthings are broken will you start to see meaningful changes in dairy farmpolicy. So it's a policy stability orequilibrium right now, with opposing forces having settled out here on theMaginot line.
If we get to a world where farmers have a high price formilk, but no one wants to take it off the farm because there isn't processingcapacity or profitability to take it off, then you'll see a shift inpolicy. But until something as dramaticas that happens, I think, you'll see only incrementalism in policy.
Christine McCracken -Cleveland Research
One final question. There are some reports that one of your organic competitors isessentially maybe not as strict on their organic guidelines. You've been criticized in the past but Idon't think have any current issues. Isit possible that you actually get a positive benefit from some of thisdisruption?
We've worked very hard to make sure that the milk that weproduce ourselves and the milk that we buy meets the very highest of theorganic standards. We're investingheavily in our own farms to make them the best farms in the industry, and wehave a rigorous effort to make sure that our other suppliers comply.
So you're correct; we're currently in very good shape withrespect to our organic milk supply. While you might be tempted to take some competitive satisfaction oversomebody else's difficulties in the marketplace, at the end of the day, organicis about trust and it's about consumers believing in the proposition across thescope of the industry. So it's not goodfor anybody when there's issues and controversy around the nature of theorganic standards.
The industry is moving to adjust to the USDA's revised viewof what the organic standards mean, in light of the Harveylitigation and just the maturing of the category. That is having a beneficial effect on thequality of organic products. And we'rein the vanguard in terms of complying with those standards, and we intend toremain in the vanguard in terms of complying with those standards.
Your next question comes from Eric Serotta - Merrill Lynch.
Eric Serotta -Merrill Lynch
Gregg, I hoping you could give us some color as to youroutlook for industry supply growth in organic milk for next year as a whole? Ifyou could maybe break it up between the first half and the second half of theyear, and then what you guys are expecting in terms of your access to supplyfrom your network of family farms, as well as the company-owned farms?
Yes, I can give you some comment on that. I think the big driver of this oversupplysituation was the new standards that went into effect July 1st last year aroundconversion. That pulled a lot of milkforward. As we've said in the past, weexpected total industry supply to grow in excess of 40% per annum as a resultof that, in the face of a category that was growing about 25%. We put a lot of excess gallons into themarketplace, and that bubble of excess supply is being winnowed down today byvirtue of lower pricing in the category, which has led to accelerated volumegrowth in the category. In fact, the fact the rate of supply growth following thisbubble has slowed down.
The rate of supply growth has slowed down for a number ofreasons. First of all, the cost toconvert post-July 1 went up. Secondly,the incentive to convert that's driven by the differential between conventionaland organic milk compressed with the Horizon Organic milk. Finally, given the growth in organicgenerally, the cost of feed inputs to organic farmers has continued torise. So, farmers who already areconverted seem to be producing slightly less than they have in the past byvirtue of cutting back on feed and other cost inputs to their existing stock oforganic cows.
This bubble will pass. It's just hard to predict when it's going to pass. Frankly, our emerging view is that the priceof organic milk at wholesale is not going to move until it's passed.
We have always believed that it would be 2008 when it wasgoing to pass. We don't have the kind ofvisibility that I wish we had into external third party supply of organic milk,so where our competitors really are in terms of supply. We've seen, however, a narrowing ofoversupply in our own supply. So we knowthat it's happening; we just don't know what the rest of the balance of theindustry looks like exactly, so it's hard to call when it's over.
We believe that the pricing situation that we're living withat wholesale will continue to exist until it is over. But it will end. The factors that are driving the currentoversupply situation are all working towards resolving it. They're absolutely all working towardsresolving it.
We have a point of view about how this category is going togrow over time. And our expectation, our plan, is to maintain our shareleadership in this category. And our effort is to grow our supply consistentlywith the long-term growth of the category, and that's what we're working to do.We'll let the rest of the industry resolve itself over time.
Eric Serotta -Merrill Lynch
If you could perhapsput some numbers around it without giving away too much competitive informationhere, what's your expectation for category growth as we look into 2008? Is itstill in that 25% range? Or do you think it will be somewhat higher, given thenarrower gaps between organic and conventional prices, or somewhat lowerperhaps given that we won't have this wall of milk that you referred to, wewon't have as much supply coming online?
Eric, as we prepare for 2008, we continue to call thecategory pretty much in the same range, 20% to 25%. We're managing our supplyfor '08 to be able to support that level growth too, as we go into next year.So, no change in terms of category outlook right now.
Given the way youbring supply on here, you have to manage towards a longer-term view of categorygrowth. We think the category grows in that sort of 20s range for an extendedperiod of time, given the level of penetration that it has, and consumerattitudes about organic. We think it's a long-term grower in that range, sowe've got to plan our supply growth with that long-term in mind.
Eric Serotta -Merrill Lynch
Thanks a lot.
Your next question comes from Robert Moskow - Credit Suisse.
Robert Moskow - Credit Suisse
Just a question aboutthe difference between organic milk and then hormone-free milk. Do you foreseeany kind of slowdown in organic milk or competition to organic milk in theshort term from just hormone-free offerings, which I would imagine you can getout there at a lower cost? Seems to me that's the major concern of mostconsumers that I talk to. Do you see any risk of consumer confusion of havingthese two out there, or is it an opportunity just in further segmenting themarket for you?
I do think you'll seethe market further segmented, although the way that the hormone-free thing hasplayed out, it has played out where it's really no one's unique advantage;therefore, no one is driving it as a unique benefit to these products.
What's really happening, given the nature of theconventional supply and the complexity of managing hormone-free versusnon-hormone free, what's happening is that whole markets are moving to onestandard. In the Texas market, whenhormone-free came into the Texasmarket, all drinking milk sold in the Texasmarket moved to being hormone-free. So it's nothing that anybody can advertiseand drive, and the price premiums there have not emerged to permit muchbranding around that particular attribute.
So in fact, we're not seeing a lot of bleed-off of organic;in fact we're not seeing any bleed-off of organic around hormone-free. I think that's sort of structural in terms ofhow it's played out in the marketplace as opposed to benefit-driven.
I also think organic was definitely fueled by Posilac andBST in the marketplace when it began to take off. But I think it's taken on amuch broader set of meanings and attributes over time. So we, in fact, believethe organic proposition is real and meaningful and very enduring in consumer'seyes. Our goal is to make Horizon Organic the preferred consumer brand in thatcategory, because I think that category is playing out much differently thanBST-free is playing out.
Robert Moskow - Credit Suisse
Do you have an estimate on how much of the milk supply todayis hormone-free versus maybe a year or two ago?
It's changeddramatically. This isn't necessarily a commentary on how much of the supply isactually BST-free as opposed to how much of it is marketed and identified asBST-free, because it was co-mingled before. There wasn't any differentiation asto whether a farmer that was on a particular milk truck was using Posilac ornot. The amount that's identified as hormone-free, I don't have an exactfigure, but it's becoming a meaningful percentage of the market.
It's going to be interesting to see if BST-free migratesinto other product categories beyond milk. Is it going to migrate into cheese?Is it going to migrate into ice cream? Is it going to migrate into otherheavily dairy commodities? There are going to be cost structural implicationsof maintaining a segregated supply in the broader conventional market betweenBST-free and non-BST-free milk that are going to have to get sorted out and aregoing to be pretty complicated.
Your next question comes from Edgar Roesch - Banc of AmericaSecurities.
Edgar Roesch - Banc of America Securities
Gregg, you mentioned a precarious supply and demandsituation globally for dairy products. I'm just wondering, do you have anyexpectation that that will increase some of the seasonal factors that we have historicallyonly seen a muted price increase when demand in the summertime is up andproduction slows a little bit?
I haven't reallythought through it, so I'm going to give you just an off-the-cuff answer. Iwould think it would in fact decrease the seasonality, because the productthat's driving price globally is a product that is less seasonal. This nonfatdry milk goes to animal feed; this is a huge use of it. So as you see theanimal agriculture industry in Chinagrow, a lot of nonfat dry milk is moving to that sector. That's a year-roundconstant use.
A lot of it is ingredients in other further manufacturedfoods. That's a year-round constant use. You're able to develop stocks ofnonfat dry milk, cheese and butter that carry over from periods of productioncycles from peaks to valleys. So that's got to smooth out pricing. So I wouldthink it would make for less pricing volatility rather than more. But again, Ihave not thought through it a whole lot.
At this time, forclosing remarks, I would like to turn the call over to CEO Gregg Engles.
Thank you all foryour participation on the call and for the very good questions that you'veasked. We've tried to answer them thoroughly and give you as good a perspectiveon our future outlook as we're able to develop at this point in time given theuncertainties around the commodity markets.
We're working very hard to make this business as productiveand as profitable as we can. We believe that we'll come through this period asa stronger industry player than we entered this period. So we are encouraged byour long-term prospects, we like the proposition of our business and weappreciate all of your support as investors.
Thank you very much, and we'll talk to you on our Q4 call inearly February.
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