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Dean Foods Co. (NYSE:DF)

Q3 2007 Earnings Call

November 8, 2007 9:00 am ET

Executives

Barry Sievert - Senior Director, IR

Gregg Engles - Chairman and CEO

Jack Callahan - EVP and CFO

Analysts

Farha Aslam – Stephens, Inc.

Terry Bivens - Bear Stearns

Eric Katzman - Deutsche Bank

Pablo Zuanic – JP Morgan

Christine McCracken - Cleveland Research

Eric Serotta - Merrill Lynch

Robert Moskow - Credit Suisse

Edgar Roesch - Banc of America Securities

Operator

Good morning and welcome to the Dean Foods Company third quarter 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, transmission or rebroadcast of this call in any form without the express 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, Mr. Barry Sievert. Please go ahead, sir.

Barry Sievert

Thank you and good morning, everyone. Thanks for joining us for our third quarter 2007 conference call. We issued a press release this morning which is available at our website, at Dean Foods.com. The release is also available on the SEC's website at www.SEC.gov.

A replay of today's call will be available on our website beginning this afternoon.

The consolidated earnings, operating income and operating margin information that will be provided today are from continuing operations and have been adjusted to exclude the impact of discontinued operations, financing costs related to the recapitalization of the balance sheet, the expense related to facility closings and reorganizations, and non-recurring items, in order to enable you to make meaningful evaluation of our operating performance between periods.

The earnings release contains more detailed discussion of the reasons why these items are excluded from the consolidated results, along with a reconciliation between GAAP and adjusted earnings. We will explain these items in more detail later in the call.

We also would like to advise you that all forward-looking statements made on today's call are intended to fall within the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements will include, among others, disclosure of earnings targets, as well as expectations regarding our branding initiatives, expected cost savings 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 call. Information concerning those risks is contained in the company's periodic reports on Forms 10-K and 10-Q, and in today's press release.

With those formalities out of the way, I will now turn the call over to Gregg Engles, our Chairman and CEO, who will review our third quarter performance and give an update on our strategic initiatives. Following Mr. Engles, Jack Callahan, our Chief Financial Officer, will summarize our consolidated financial results for the third quarter of 2007 and discuss our forward outlook.

Following Mr. Callahan's remarks, we will open the call for your questions.

Gregg Engles

Thank you, Barry and I thank all of you for joining us on this morning's call. When we spoke to you in August, we knew the third quarter would be particularly difficult. Raw milk prices had risen sharply to record highs, 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 the previous year's third quarter average of $11.05, and 32% higher than the second quarter of this year.

Shrink, or milk lost in production, had become a substantial year-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 Organic brand through reduced pricing, expanded distribution, and increased promotional activity in an organic milk market that is faced with significant oversupply, driving down retail prices as competitors work to stimulate demand and drive their own distribution in an effort to sell their milk as organic.

These factors were every bit as challenging as we had expected. However, as we moved through the quarter, retail prices for conventional milk began reaching levels of increasing elasticity in many areas. The average gallon of milk has risen approximately $0.75 this year through September. With the steep rise in retail prices, we also began to experience other difficulties, including a larger than expected weakening in volume.

In what is typically a fairly inelastic product category, we experienced our first quarterly volume decline since 2004 and the largest quarterly volume decline in our history. For the full quarter, our fluid milk volumes decreased approximately 3%, roughly in line with the overall industry based on USDA and federal market order estimates.

In addition, several of our key markets where our brands typically sell at a significant premium experienced a higher than expected mix shift into private label and out of our more profitable brands, both reducing the profitability of our sales and exacerbating our overall volume decline.

At the same time, the sharp increase in raw skim milk prices significantly reduced the cash received from our excess cream sales sold as a byproduct. Because of the size of our fluid milk operations relative to our cultured and ice cream operations, the milk we buy from the farm contains more fat than the products we sell. As a result, we generate a significant amount of excess cream. Approximately half of the excess cream produced by our fluid operations is used internally in our creamer, ice cream and cultured product operations, and about half is sold to third parties.

The industry standard for cream sales is to price the cream relative to the CME butter market. This price has been relatively stable this year, largely due to the strong growth in dry milk powder production, which creates butter as a byproduct. Cream pricing tracks the value of butterfat. However, each load of cream also contains approximately 60% skim milk, the value of which has essentially doubled over the course of the past year.

The higher cost of goods sold in our excess cream sales, and a very competitive market and historical pricing mechanism for cream, have combined to reduce what has historically been a meaningful offset to our cost of goods sold.

As a result of the confluence of these challenges, Dairy Group 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 disappointing for the Dairy Group, and we expect continued high commodity prices through the fourth quarter, there are signs that raw milk pricing may improve as we move into 2008.

High prices have led to a significant supply response from farmers, with production volumes up approximately 3% in each of July, August and September. Nonfat dry milk, which has been the primary driver of the record Class I prices we've experienced, has also seen strong growth in production, as continued export demand has kept prices around $2 a pound, a historically high level.

However, there is evidence that processor inventories of nonfat dry milk powder are building, and prices have begun to moderate. Most dairy economists we track believe the market is headed lower in 2008. This would obviously be favorable for our results. Declining prices would begin to decrease the year-over-year negative impact from items like shrink and excess cream sales in our P&L. We would also expect volumes to respond positively to lower prices at retail.

Turning to WhiteWave, as expected, the third quarter was a strong quarter for sales and volumes, but difficult from an operating profitability perspective due to the significant incremental investment behind the Horizon brand. This investment has had the intended effect, however. Sales and 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 also had very strong quarters, while Silk sales growth was in the mid single-digits.

At the operational level, we continue to see strong improvement in efficiency that should become more apparent in the divisional results once we get through the oversupply situation in the organic milk market, which we expect to happen sometime during 2008, probably toward the latter portion of the year.

However, we aren't just sitting still waiting for commodity prices to come down. By facing the challenges created by this difficult operating environment, we're driving improvements in the business that will make us stronger long term. Although shrink accounts for only 1.5% of the roughly 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 base to educate them about the impact shrink and cream sales are having on our business, and are working to implement incremental pricing to help cover some of these costs. This program is in its early stages and will take some time to implement.

In spite of the difficult operating environment, we continue to make solid progress against our long-term strategies. We have now largely completed a reduction in force we announced at the beginning of October. The vast majority of the reduction was completed through a voluntary program, and we're pleased with the results.

We are also continuing to move forward with our purchasing initiative and back office centralization program. The purchasing initiative is driving significant savings in 2007, and more efficiencies are expected in 2008. Our efforts to drive efficiency by moving a lot of the back office work that has traditionally been done at the plant level to centralized finance and accounting centers is also moving forward. This initiative is a net cost this year as we brought on and trained new employees. We expect this program to be largely complete by the end of the year.

We're also making good progress towards realigning the Dairy Group's business into three distinct business platforms: DSD milk, Morningstar and ice cream. As you know, our DSD milk business is a high velocity, direct store delivery model. Winning in this business depends upon having a low cost model and driving high levels of customer service. Harrald Kroeker, who came to us from Pepsi Bottling Group, is leading our efforts to build the capabilities we need to continue to win in the future in the milk business.

Morningstar, our private-label extended shelf life and culture products business, runs on a warehouse delivery model. Separately, our ice cream business, which is a mix of regional brands, private label and foodservice businesses, operates through a hybrid frozen warehouse and DSD model. By aligning these businesses along their underlying production and distribution platforms, we expect to better define their individual strategic roles under the Dean Foods umbrella and drive better business performance.

We are also moving forward with the build out of our senior leadership team. Rick Zuroweste has joined us from Coca-Cola to lead our Dairy Group marketing efforts, as our new Dairy Group Chief Marketing Officer. Rick brings over two decades of experience to bear in assuming strategic leadership for the Dairy Group's portfolio of brands.

Gregg Tanner joined us this week as our Chief Supply Chain Officer. Gregg has over 20 years of supply chain management experience. He will be tasked with leading the effort to optimize our manufacturing and other supply chain systems across the company. We are very pleased to have these key roles filled with such top caliber executives and look forward to their contributions.

So in summary, the third quarter was the most difficult quarter of the year so far. We were challenged by record-high commodity prices, softening volumes, mix shift out of our brands, significant cost friction, and continued investment to defend the Horizon Organic brand. This is the most difficult operating environment we've ever experienced as a company.

Looking forward, we are expecting commodity cost stabilization in the fourth quarter, and are optimistic about the potential for declining prices in 2008. We continue to drive improved efficiency and capability across the organization with a view toward building the company for long-term success.

With that, I would like to turn the call over to Jack Callahan, who will walk you through more detail on our third quarter results and summarize our forward outlook.

Jack Callahan

Thank you, Gregg and good morning, everyone. As Gregg discussed, the third quarter was perhaps the most difficult quarter in the history of Dean Foods. Consolidated adjusted earnings came in at $0.14 per share, compared to $0.56 in the third quarter of 2006. Operating income declined approximately 29%, a $50 million decline, and interest expense increased $42 million due to our new capital structure put in place at the beginning of the second quarter.

On the business segment level, Dairy Group operating income for the quarter fell 21%, a $36 million decline on a year-over-year basis to $137 million, due to the record high commodity costs. To put the $36 million decrease in operating profits into perspective, due to the sharp rise in dairy commodity costs, cost of goods sold for the Dairy Group were approximately $600 million 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 to over $1 billion through just the first three quarters of the year.

The increased commodity costs are being passed through fairly effectively, but as we've mentioned, the business is being significantly impacted in a number of other areas. In order of magnitude: increased shrink cost, reduced cost of goods sold offsets from excess cream sales, low single-digit fluid milk volume declines, and the mix shift to private label all had meaningful impacts on the Dairy Group profitability in the quarter, as did the lapping of a one-time supplier payment adjustment received in the third quarter of last year.

As Gregg said, we have initiatives under way to reduce shrink in the plants, and to obtain some level of pricing adjustments to offset the impact of the shrink in excess cream. These initiatives will take time to implement and will likely soften the future impact, but not totally remove these issues.

Additionally, while we expect volume growth and mix shift to return to more normalized levels when commodities decline, we cannot be sure this will happen if prices remain at these unprecedented retail levels.

Turning to WhiteWave Foods, total net sales for the quarter increased 9% to $336 million. Operating income at WhiteWave for the quarter was $22 million, a decrease of 37% over the prior year. Operating margins were 6.6%, down significantly from last year's double-digit margins due largely to the increased investment behind the Horizon Organic brand.

As Gregg mentioned, our creamer business had a particularly strong quarter, with International Delight sales growing in the low double-digits, outpacing the category and taking share on the strength of our updated packaging and flavor innovation. Land O'Lakes creamers grew in the mid-teens due to strong volume growth and increased pricing. Silk sales grew in the mid single-digits in the quarter, down a bit from the first half of the year, but Silk is off to a stronger start in the fourth quarter, and has stepped up marketing support in the fourth quarter this year versus last.

On both a volume and sales basis, Horizon Organic had a very successful quarter, with milk dollar sales increasing just over 20%. Volume growth in the quarter was in excess of 30% due to the promotional activity which reduced realized pricing in the category. The third quarter marked the first full quarter of the impact from the investment behind the brand, in reaction to the oversupply situation. These investments have resulted in strong brand growth, increased distribution, and stable share trends over the course of the quarter.

We now believe that the organic milk market will be in a state of oversupply through the end of the year, and well into 2008. We anticipate continued aggressive competitive pricing pressure, and we will continue to protect our long-term market leadership position through investments in promotion, distribution, new products and advertising.

Turning to corporate expense, corporate expenses in the third quarter totaled $36.5 million, a 4.5% increase over the prior-year results due to strategic initiative spending. As we've mentioned before, this line item is likely to move around a bit quarter to quarter as we build capability and continue to pursue our strategic initiatives.

On a consolidated Dean Foods basis, the unprecedented challenges across both the Dairy Group and WhiteWave resulted in consolidated adjusted operating income of $123 million, a 29% decrease from the third quarter 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. Our higher interest expense is largely related to the recapitalization of our balance sheet in the second quarter, in conjunction with the special cash dividend. We continue to anticipate full year interest expense will be about $325 million for 2007.

As a result of the significantly higher interest expense and the 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 the unfavorable effect that non-deductible items have on the company's estimated annual effective tax rate, resulting in a quarterly tax rate that was significantly higher than our yearly expectations. We estimate a full-year tax rate of approximately 39.5%.

Cash flow from continuing operations for the first nine months of the year was $221 million, down from last year due in part to lower operating results, higher year-over-year interest expense, and increased working capital requirements. Cash flow is well behind what we had anticipated when we issued a special dividend in April. I would estimate now that we are about a year behind our original pay down expectations.

As we look ahead, as commodities begin to decrease our working capital investment will also decrease, and we would anticipate accelerating debt reduction. Year-to-date capital expenditures totaled $165 million. We continue to target approximately $250 million in CapEx spending for the year, although all proposed balance of year spending is being very highly scrutinized.

Debt outstanding net of cash on hand at the end of the third quarter 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 as we finish out the year. Looking ahead to the fourth quarter for the Dairy Group, 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 for a continued unfavorable mix shift, will likely continue to challenge earnings.

At WhiteWave, we will continue to invest to protect the Horizon Organic brand from aggressive competition through this period of industry oversupply, which will dampen WhiteWave profitability.

All in all, we expect fourth quarter adjusted earnings to be approximately $0.30 per share, a solid step up from our third quarter performance and our results so far in the fourth quarter suggest we are on track.

Looking into 2008, the dairy commodity and organic milk oversupply situations remain sufficiently unsettled that we believe it is premature today to set out expectations for the full year.

Entering 2008, pricing realization should begin to improve if the Class I price moderates from current levels, as we expect. However, the commodity 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 per hundredweight compared to only $13.74 in the first quarter of 2007.

At WhiteWave, we anticipate that the organic milk oversupply will persist into 2008, continuing to limit WhiteWave profit growth. Additionally, as you think about first quarter performance, you should also keep in mind that the first quarter in 2008 will present a very difficult overlap, as our operating profit growth in the first quarter of this year 2007 was well over 12%.

Also as a reminder, we will also be lapping the old capital structure through the first quarter. Net-net, with the tough cost overlaps on commodity milk and the organic milk surplus, we anticipate overall operating profits 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 capital structure will further negatively impact first quarter EPS by approximately $0.16.

Looking beyond the first quarter, it's clear that commodity costs will be the key driver of our performance. While the Class 1 mover is showing signs of moderation, when you look across the commodity forecasts available, there is a wide range of estimates as to the timing and extent of any price declines. As dairy commodity costs remain high, 2008 could be quite difficult as we would continue to face negative cost overlaps until at least mid-year.

Similarly, we expect the oversupply situation in the organic milk market to persist well into 2008 and it is unclear when supply and demand will come into better balance. As we are committed to defending the Horizon brand through this period of oversupply, you should expect WhiteWave results to be 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 improving results as we move through the year. We will provide more perspective on 2008 on our fourth quarter call as we complete our planning activities and the outlook for the 2008 commodity environment becomes a bit clearer.

With that, I would like to thank you all for joining us today and ask the operator to open up the call for your questions.

Question-and-Answer Session

Operator

Your first question comes from Farha Aslam - Stephens, Inc.

Farha Aslam - Stephens, Inc

Good morning. Some questions on Horizon Organic, Gregg. The volume growth that you've experienced as a result of the supply of organic milk, do you still expect 90 million gallons for this year, or are we going to be above that level?

Gregg Engles

Farha, we're going to be right around that, maybe slightly above.

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?

Gregg Engles

It varied by region in the country but we had moved down to the $3 per half gallon retail price level in most places in the Eastern part of the United States, slightly higher than that in the Western part of the United States. It was entirely consistent with what we expected.

Farha Aslam - Stephens, Inc

As you look into the fourth quarter, are you seeing that maybe go up to $3.20, or is it still at the $3 level?

Gregg Engles

Our expectation today, Farha, is that as long as we remain in oversupply, the price is going to stay right where it is. That moves around a little bit with competitive pressures. But broad brush across the span of the $400 million brand, we expect it to stay about where it is.

Farha Aslam - Stephens, Inc

When you look out going into future next year, do you think that at this $3 level, the retailers are at a level that they're going to keep it here because they're going to use it as a traffic driver? Or do you think that private label milk will have to move up because they're losing money on every gallon they're selling?

Gregg Engles

Your question assumes that the pricing is being driven by private label. That's not really entirely the case. The whole category, the other brands and private label, have moved to this $3 per half gallon level, at least in the eastern part of the country. I don't necessarily believe that they're using it as a traffic driver, but I do believe that people are investing in the category because of the very strong growth rate.

So we're in a position today where given the oversupply situation in the category, people are playing for share of this category for the long term. Just to again go back to the growth rates, on the volume side of the business, we saw Horizon grow up into the 30s in terms of volume during the quarter. So, extraordinarily strong growth rates for the category, and I think that's what's causing people to play for the long run.

Operator

Your next question comes from Terry Bivens - Bear Stearns.

Terry Bivens - Bear Stearns

Gregg, as you look at the powdered milk market, it's begun to come down a little bit after all this time, but now cheese is beginning to look a little bit more worrisome. As we look into next year, we see things kind of flattening out in late spring, but I'd like to get your idea on that, just in terms of the Class 1 mover. Is there some point you're tentatively looking at now?

Gregg Engles

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 would say globally, around the fact that milk is going to move down from this pricing in the low 20s to I'd say a range between $16 or $17 and $19. So we're going to get a move down; everybody believes that that's the case.

The underlying dynamic -- and you see it reflected in the fact that as powder is softening, cheese is strengthening -- the underlying dynamic however is that, again, this loose consensus is that the world is effectively out of safety stocks of storable dairy products. So as we depleted stocks of powder, you saw the powder price spike, and that's driven the Class I price. It also drove lots 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 to see milk move back to cheese.

We're going to move back and forth in a global marketplace that is in precarious balance between supply and demand. In fact, demand growth for the next several years, it looks like will be driven by supply growth. The question is, what is supply growth going to look like over that period of time? What you're seeing out of the US is you're seeing meaningful supply growth. I believe you're going to see supply growth out of the rest of the world. I don't think it will be as large as the US supply response.

Therein lays the debate as to where the milk price is going to settle out. Is it going to settle out in the high-teens, or is it going to settle out into the mid to high mid-teens? Is it going to be $13 to $16, or is it going to be $16 to $18? That's the debate, really, in the global dairy markets. But there is going to be some volatility along the way; everybody agrees on that.

Again, just to wrap up a relatively long answer to your question, I think, people believe that this marketplace is moving down off of its peak, and it is moving down off of its peak. I don't think that anybody is prepared to commit to the notion that it's going to be a straight line down to a significantly lower price level, and that it's going to stay there for a long time. You see that uncertainty reflected in our comments this morning. If we felt like this milk market was going to move down and settle in at $15 for an extended period of time, we would be more bullish.

Terry Bivens - Bear Stearns

Thanks for that explanation or ventured opinion. Just a quick one on Silk. I was a little bit disappointed to see the sales figures in the third quarter. Can you give us a little more color on what you think needs to be done to that product to get the sales growth reaccelerating a bit?

Gregg Engles

First of all, I would note that sales growth for Silk during the period was behind volumes. So we had promotional activity on the brand during the period that we didn't see flow-through into the P&L. So, the net price realization on Silk was below what we had expected for the quarter.

It's causing us to move our thinking about how to drive this brand going forward, and shifting somewhat away from promotion and more towards a consumer-driven approach to the brand. But the brand continues to put up high single-digits volume growth, and we see that firming over time. So we feel quite good about Silk going forward. But as this brand gets more mature, it's now going to be well in excess of a $400 million brand going into '07, we are recalibrating how best to drive this 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 work today.

Terry Bivens - Bear Stearns

Thanks very much.

Operator

Your next question comes from Eric Katzman - Deutsche Bank.

Eric Katzman - Deutsche Bank

My first question, Gregg, has to do with there's obviously some things you can't control, but on the cost saving side, that is something you can control. Given your work to-date with the centralization efforts, any update you can share on what you think that is going to look like in '08?

Gregg Engles

Yes. We've talked about this over the last year or so, and we're talking about it more and more as it comes more and more to be reality in terms of a program. We're talking about this as a year's long program of re-architecting our business. We started with the near-in, more foundational aspects of this transformation; the procurement initiative, which will yield a net positive benefit in 2007, and a more significantly net positive benefit in 2008; about the back office and the G&A realignment that we began in 2007. That was a meaningful net cost in 2007, and will be neutral or a modest net benefit going into 2008.

But on the back of that P&L improvement in the G&A arena and the purchasing arena, we will be making investments in the next phases of the transformation of the business as we move more heavily towards looking at our underlying physical plant asset infrastructure and other functional aspects of our business in terms of how we actually conduct our business, whether it's in the sales area or the marketing area. You see us adding people to build skills and capabilities in those areas that we are announcing or talking about this morning.

We believe there's a very meaningful payoff for this company as we attack its cost structure. Attacking its cost structure is going to require upfront investments to build capabilities and to make investments in the infrastructure of the business. We're phasing those so that we reach a level of investment here somewhere in '08 or '09 that in the future then starts to pay material dividends.

So I would say we're sort of towards the third quarter or maybe early fourth quarter of legging into the cost of attacking our cost base. You'll start to see the payoff of that as we get out into future years, but there's not going to be a huge payoff in '08 because we're going to be beginning to make further investments in areas around supply chain, manufacturing infrastructure, marketing infrastructure, in the business and there's an upfront cost associated with that.

Eric Katzman - Deutsche Bank

A follow-up on the dairy profitability. I go back far enough to remember the last time you talked about cream and butter in 1998, what a mess that was. The $137 million of profits that you put up in the third quarter, given how volatile and how high the cost is, actually isn't that bad relative to what you have been doing 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 negotiations that you seem to be moving forward with the retailers about how the pass-through mechanism and the calculations work?

Gregg Engles

Let me take a stab at it from a high level, and then I'll let Jack talk about it. We're an organization that's used to hitting our numbers and hopefully exceeding our numbers. So I won't sugarcoat it and say we're not disappointed with our performance across the business in the third quarter. On the other hand, given the fact that we've got a $600 million cost step-up on milk alone in our dairy business in the third quarter, I think it does speak to the strength of our underlying business and our franchise.

We've got a great group of people that operate our businesses in the field, and they have done an extraordinary job through an extraordinarily difficult environment and they are working incredibly hard. In this environment, which is a real phase shift from where this industry has been, they are learning and adapting at an incredibly fast rate. So I'm very, very, proud of our team. I'm frankly impressed by the resilience of our business.

Notwithstanding the fact that we've seen some volume declines in mix shift, I'm also, frankly, impressed by the inelasticity of this category. While we still have negative volume comps, we actually see volume sort of firming as consumers get used to this higher level of retail price. So I'm impressed with the underlying resiliency of our business.

I believe as we move into '08, all of the dimensions that we've been talking about as negative factors are going to get better during '08. I can't tell you the exact timing of it, but they're going to get better, and it's not going to be just because the price is coming down. It's going to be because we are honing and refining our business model as we understand all of the factors that affect us in this more difficult commodity environment. So, I am encouraged by the underlying strength of our business.

The other point that I would make is that, and this is anecdotal information, but I believe that we are very meaningfully outperforming the rest of the business because of the strength of our franchise and the strength of our team. I think the industry as a whole has got to have more pricing to sustain its investment in the infrastructure that it takes to keep this industry going. I believe we're going to have success in the negotiations with our customers and frankly , getting our formulas right.

That's what the exercise is about with our customers; it's about getting our formulas right so that they in fact reflect the costs of a changing milk environment in our wholesale prices. So there's a large education effort going on out there. It is difficult, as you would imagine, given the competitiveness that our customers face. But there's logic behind what we're showing to our customers, and we're having success in our effort. We believe we'll have continued success as we move into '08.

It feels like a bottom in the business here. The question is how quickly do we come off the bottom? How does the commodity work its way through and play out, and how do our efforts to minimize these costs and adjust our pricing formulas, how does that play out over time? And there's a lot of uncertainty around that.

Jack Callahan

Eric, just a little quantification on what drove the reduction in operating income in the Dairy Group. We did a pretty good job of passing along the price in terms of the commodity cost increase. I would say that our effective pricing probably only explains maybe 15% thereabouts of the profit decline versus year ago. Most of what really drove the decline had to do with this shrink in the cream sales, which were very meaningful in our areas where it's an industry issue, and it's a real cost of doing business. It's never been an issue before, but we're trying to go back to get some better realized pricing for those issues. The balance had to do with the decline that we've seen in fluid volumes and a little bit of a mix shift away from our regional brands to private label. So, a pretty good job overall in passing through the prices. The field has done a very good job.

Operator

Your next question comes from Pablo Zuanic – JP Morgan.

Pablo Zuanic – JP Morgan

Good morning, everyone. Just going back to the dairy industry questions, we have tight capacity drying capacity out there, which has exacerbated the problems with prices in this phase. Now that production starts to go up, you would think the opposite would happen, right? Because there's going to be more production, you said 3%, if you cannot dry more because you have tight capacity, then the effect on the domestic market is exacerbated. You have even a greater supply. So that should speed up the decline in prices. What am I missing there in that analysis?

Gregg Engles

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 sold or consumed in the United States, it is all going offshore. So the Class 1 price is a build up of component prices of powdered cheese and butter. It is a build up of the higher of those prices.

So we could have the odd situation of in fact, not being able to process all of the milk that we produce in the United States and not have the Class 1 price come down, because the global price of powder stays high. So we have got a regulatory regime that is not a modern one, and it is not dealing perfectly with 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's plenty of capacity there. But the powder price 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 world stocks of powder have been depleted. I think it's the global industry's point of view that supply growth is going to lag behind demand growth for a while. Europe is constrained by its quota in terms of how much increased production is going to happen in Europe. New Zealand and Australia are constrained by just the ability to convert land at a rapid pace, and by water in Australia. China is growing their supply very rapidly, but demand is growing more quickly.

So the US isn't going to change its price unconnected anymore from the global price. Prior to 2006 and 2007, the US really moved in a way that was in many ways uncorrelated with the global price. That's not going to be the case going forward, at least for the foreseeable future. So we're going to have to look externally to understand what's going to happen to our domestic price.

The final point that I'd make, which I should have made earlier, but it's a huge issue as it relates to what's going to happen to price, is the value of the US dollar. These commodities are priced in dollars around the world. As the US dollar plummets in value, the global price could begin to stabilize and we could see an inflationary price in the US. That is a force that we are not used to thinking about in the domestic industry, and it's going to take us a while to get our heads wrapped around it.

Pablo Zuanic – JP Morgan

That's very useful. If I think more in terms of the month-to-month changes that the USDA puts out for Class 1 for the October price, the November price, they were down sequentially, I'm thinking when you go visit Wal-Mart or similar retailers, you may want to start talking about how to pass on shrink and excess cream. The cost of milk is coming down. I don't see how retailers are going to want to increase prices further if the cost is coming down.

Gregg Engles

I think everybody's got an interest, retailers and processors, in getting the formulas right. Because these markets over time are going to move up and they're going to move down and the cost of shrink and excess cream sales play into that cost. So we have a course of dealing that's built up in the industry over decades, where the industry recognizes the impact of the cost of the raw material in the wholesale pricing. That's worked to everybody's benefit on the way up and on the way down on the other side 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-through mechanism. The retailers want the pass-through mechanism on the way down, but they don't want it on the way up. But the fact is we all live with it through both phases of the cycle. This effort is all about getting the formulas right.

Pablo Zuanic – JP Morgan

One last one if I may. What would you say are gross profits per pound on a normalized basis in the dairy business?

Gregg Engles

I'm going to turn it to Jack, but I don't know that we have thought about it that way.

Jack Callahan

First, we think about if first, always by gallon. Depending on the year, sort of high-teens, maybe $0.20 per gallon. That's more operating income. So I would have to factor out --

Pablo Zuanic – JP Morgan

We can follow up offline.

Jack Callahan

But that directionally gives you some sense of what the total number is.

Pablo Zuanic – JP Morgan

In terms of the financial covenants on the debt, you gave us a ratio; any concerns there that the covenants would be breached during this period?

Jack Callahan

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 had a big run-up in the Class 1 price in the third quarter, our net debt stayed effectively flat in the third quarter. We anticipate starting to pay down some debt in the fourth quarter. With some recovery, hopefully, with the Class 1 price coming down, we'll get some working capital relief. We think that will accelerate as we go into next year.

Operator

Your next question comes from Christine McCracken - Cleveland Research.

Christine McCracken - Cleveland Research

If you look back over time when oil prices spiked it did impact, obviously, your cost of packaging. You've looked at higher fuel prices as being a cost pressure in the past. In this environment and going forward, how do you look at that potential cost hit as you head into fiscal '08?

Gregg Engles

Milk isn't the only cost pressure we have, you're absolute right about that. The market is obviously attuned to those changing costs as well. They've traditionally been part of our formulas. So the reason we're not talking about them if milk was flat, we would be talking a lot about them. It's just that they're dwarfed by the milk price changes, but they do work into our formulas in our conversations with our customers. Frankly, given the other changes 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 packaging costs. Those correlations are changing a little bit as natural gas prices stay very low compared to oil prices, we're starting to see domestic resin move into the world market, because most of the rest of the world makes resin out of oil. So we are seeing resin prices now start to be more correlated with oil prices 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 work in 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.

Gregg Engles

I'm sure.

Jack Callahan

Neither resin nor fuel has not had really had a meaningful impact one way or the other on the P&L, that's in puts and takes throughout the year. But we're looking at it closely as we go into next year, particularly with the Class I price of milk hopefully moderating a bit.

Christine McCracken - Cleveland Research

Is that something that is protected by contract that would be renegotiated as you head into next year, or is it something that kind of fluctuates with the market?

Jack Callahan

Well we do have, with our new purchasing capability, particularly in the area of resin, we do have some longer-term working arrangements in place that do give us some protection there. But at the end of the day, there could be some market swings there.

Christine McCracken - Cleveland Research

Gregg, you, obviously are somewhat critical of the current Farm Bill policy. Have you taken an active role in trying to get involved in that? It doesn't look like there's any significant change expected in this current round. I'm just wondering is it something that you anticipate changing, or are you just kind of reacting to what is in fact a very difficult dairy policy?

Gregg Engles

Right now we've got our hands full reacting, and it's pretty much a full-time job for me right now. Trying to influence this Farm Bill in Washington is something that from a personal perspective, I just unfortunately don't have the time to blunt my sword on right now. We have an active Washington presence. We have an ongoing lobbying office in Washington. We're constantly trying to influence policy both through our own efforts and through our industry associations.

But the reality of it is these policy programs have been worked out by virtue of political compromise over the span of decades. Only when everybody in the industry, from the producer side to the processor side, comes to some sort of alignment that things are broken will you start to see meaningful changes in dairy farm policy. So it's a policy stability or equilibrium right now, with opposing forces having settled out here on the Maginot line.

If we get to a world where farmers have a high price for milk, but no one wants to take it off the farm because there isn't processing capacity or profitability to take it off, then you'll see a shift in policy. But until something as dramatic as 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 is essentially maybe not as strict on their organic guidelines. You've been criticized in the past but I don't think have any current issues. Is it possible that you actually get a positive benefit from some of this disruption?

Gregg Engles

We've worked very hard to make sure that the milk that we produce ourselves and the milk that we buy meets the very highest of the organic standards. We're investing heavily in our own farms to make them the best farms in the industry, and we have a rigorous effort to make sure that our other suppliers comply.

So you're correct; we're currently in very good shape with respect to our organic milk supply. While you might be tempted to take some competitive satisfaction over somebody else's difficulties in the marketplace, at the end of the day, organic is about trust and it's about consumers believing in the proposition across the scope of the industry. So it's not good for anybody when there's issues and controversy around the nature of the organic standards.

The industry is moving to adjust to the USDA's revised view of what the organic standards mean, in light of the Harvey litigation and just the maturing of the category. That is having a beneficial effect on the quality of organic products. And we're in the vanguard in terms of complying with those standards, and we intend to remain in the vanguard in terms of complying with those standards.

Operator

Your next question comes from Eric Serotta - Merrill Lynch.

Eric Serotta - Merrill Lynch

Gregg, I hoping you could give us some color as to your outlook for industry supply growth in organic milk for next year as a whole? If you could maybe break it up between the first half and the second half of the year, and then what you guys are expecting in terms of your access to supply from your network of family farms, as well as the company-owned farms?

Gregg Engles

Yes, I can give you some comment on that. I think the big driver of this oversupply situation was the new standards that went into effect July 1st last year around conversion. That pulled a lot of milk forward. As we've said in the past, we expected total industry supply to grow in excess of 40% per annum as a result of that, in the face of a category that was growing about 25%. We put a lot of excess gallons into the marketplace, and that bubble of excess supply is being winnowed down today by virtue of lower pricing in the category, which has led to accelerated volume growth in the category. In fact, the fact the rate of supply growth following this bubble has slowed down.

The rate of supply growth has slowed down for a number of reasons. First of all, the cost to convert post-July 1 went up. Secondly, the incentive to convert that's driven by the differential between conventional and organic milk compressed with the Horizon Organic milk. Finally, given the growth in organic generally, the cost of feed inputs to organic farmers has continued to rise. So, farmers who already are converted seem to be producing slightly less than they have in the past by virtue of cutting back on feed and other cost inputs to their existing stock of organic cows.

This bubble will pass. It's just hard to predict when it's going to pass. Frankly, our emerging view is that the price of organic milk at wholesale is not going to move until it's passed.

We have always believed that it would be 2008 when it was going to pass. We don't have the kind of visibility 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 of oversupply in our own supply. So we know that it's happening; we just don't know what the rest of the balance of the industry looks like exactly, so it's hard to call when it's over.

We believe that the pricing situation that we're living with at wholesale will continue to exist until it is over. But it will end. The factors that are driving the current oversupply situation are all working towards resolving it. They're absolutely all working towards resolving it.

We have a point of view about how this category is going to grow over time. And our expectation, our plan, is to maintain our share leadership in this category. And our effort is to grow our supply consistently with 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 perhaps put some numbers around it without giving away too much competitive information here, what's your expectation for category growth as we look into 2008? Is it still in that 25% range? Or do you think it will be somewhat higher, given the narrower gaps between organic and conventional prices, or somewhat lower perhaps given that we won't have this wall of milk that you referred to, we won't have as much supply coming online?

Jack Callahan

Eric, as we prepare for 2008, we continue to call the category pretty much in the same range, 20% to 25%. We're managing our supply for '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.

Gregg Engles

Given the way you bring supply on here, you have to manage towards a longer-term view of category growth. We think the category grows in that sort of 20s range for an extended period of time, given the level of penetration that it has, and consumer attitudes about organic. We think it's a long-term grower in that range, so we've got to plan our supply growth with that long-term in mind.

Eric Serotta - Merrill Lynch

Thanks a lot.

Operator

Your next question comes from Robert Moskow - Credit Suisse.

Robert Moskow - Credit Suisse

Just a question about the difference between organic milk and then hormone-free milk. Do you foresee any kind of slowdown in organic milk or competition to organic milk in the short term from just hormone-free offerings, which I would imagine you can get out there at a lower cost? Seems to me that's the major concern of most consumers that I talk to. Do you see any risk of consumer confusion of having these two out there, or is it an opportunity just in further segmenting the market for you?

Gregg Engles

I do think you'll see the market further segmented, although the way that the hormone-free thing has played 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 the conventional supply and the complexity of managing hormone-free versus non-hormone free, what's happening is that whole markets are moving to one standard. In the Texas market, when hormone-free came into the Texas market, all drinking milk sold in the Texas market moved to being hormone-free. So it's nothing that anybody can advertise and drive, and the price premiums there have not emerged to permit much branding 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 of how it's played out in the marketplace as opposed to benefit-driven.

I also think organic was definitely fueled by Posilac and BST in the marketplace when it began to take off. But I think it's taken on a much broader set of meanings and attributes over time. So we, in fact, believe the organic proposition is real and meaningful and very enduring in consumer's eyes. Our goal is to make Horizon Organic the preferred consumer brand in that category, because I think that category is playing out much differently than BST-free is playing out.

Robert Moskow - Credit Suisse

Do you have an estimate on how much of the milk supply today is hormone-free versus maybe a year or two ago?

Gregg Engles

It's changed dramatically. This isn't necessarily a commentary on how much of the supply is actually BST-free as opposed to how much of it is marketed and identified as BST-free, because it was co-mingled before. There wasn't any differentiation as to whether a farmer that was on a particular milk truck was using Posilac or not. The amount that's identified as hormone-free, I don't have an exact figure, but it's becoming a meaningful percentage of the market.

It's going to be interesting to see if BST-free migrates into 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 other heavily dairy commodities? There are going to be cost structural implications of maintaining a segregated supply in the broader conventional market between BST-free and non-BST-free milk that are going to have to get sorted out and are going to be pretty complicated.

Operator

Your next question comes from Edgar Roesch - Banc of America Securities.

Edgar Roesch - Banc of America Securities

Gregg, you mentioned a precarious supply and demand situation globally for dairy products. I'm just wondering, do you have any expectation that that will increase some of the seasonal factors that we have historically only seen a muted price increase when demand in the summertime is up and production slows a little bit?

Gregg Engles

I haven't really thought through it, so I'm going to give you just an off-the-cuff answer. I would think it would in fact decrease the seasonality, because the product that's driving price globally is a product that is less seasonal. This nonfat dry milk goes to animal feed; this is a huge use of it. So as you see the animal agriculture industry in China grow, a lot of nonfat dry milk is moving to that sector. That's a year-round constant use.

A lot of it is ingredients in other further manufactured foods. That's a year-round constant use. You're able to develop stocks of nonfat dry milk, cheese and butter that carry over from periods of production cycles from peaks to valleys. So that's got to smooth out pricing. So I would think it would make for less pricing volatility rather than more. But again, I have not thought through it a whole lot.

Operator

At this time, for closing remarks, I would like to turn the call over to CEO Gregg Engles.

Gregg Engles

Thank you all for your participation on the call and for the very good questions that you've asked. We've tried to answer them thoroughly and give you as good a perspective on our future outlook as we're able to develop at this point in time given the uncertainties around the commodity markets.

We're working very hard to make this business as productive and as profitable as we can. We believe that we'll come through this period as a stronger industry player than we entered this period. So we are encouraged by our long-term prospects, we like the proposition of our business and we appreciate all of your support as investors.

Thank you very much, and we'll talk to you on our Q4 call in early February.

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Source: Dean Foods Q3 2007 Earnings Call Transcript
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