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Dean Foods Co. (NYSE:DF)

Q4 2007 Earnings Call

February 13, 2007 9:00 am ET

Executives

Gregg Engles - Chairman and CEO

Jack Callahan - CFO

Barry Sievert - VP of Investor Relations

Analysts

Pi Aquino - Credit Suisse

Pablo Zuanic - J.P. Morgan

Joe Herrick - Gutterman Research

Farha Aslam - Stephens Incorporated

David Palmer - UBS

Christine McCracken - Cleveland Research

Eric Katzman - Deutsche Bank

Terry Bivens - Bear Stearns

Operator

Good morning and welcome to the Dean Foods Company fourth quarter and year-end Earnings Call. Please note that today's call is being recorded and is also being broadcast live over the Internet on the Dean Foods corporate website. This broadcast is the property of Dean Foods. Any redistribution, retransmission or rebroadcast of this call in any form without the 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, Melissa and good morning, everyone. Thanks for joining us for our fourth quarter 2007 conference call. We issued a press release this morning, which is available on our website, at Dean Foods.com. The release is also available on the SEC's website at 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 nonrecurring items, in order to enable you to make a 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 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 these formalities out of the way, I will now turn the call over to Gregg Engles, our Chairman and CEO, who will review our fourth quarter performance and give an update on our strategic initiatives and forward outlook. Following Mr. Engles, Jack Callahan, our Chief Financial Officer, will summarize our consolidated financial results. Following Mr. Callahan’s remarks, we open the call up for your questions. Gregg.

Gregg Engles

Thank you, Barry and thank all of you for joining us on this morning's call. 2007 was obviously a very challenging year, as the US dairy industry stepped into the world market in a meaningful way. A declining dollar, constraints on global dairy supply growth and rising Asian demand for dairy-based proteins, combined to sharply increase foreign demand for US produce non-fat dry milk powder. This export demand drove the US dairy complex steeply higher in 2007.

After ending the previous year at $12.43 per hundred-weight, Class I milk prices began an historic ascent as we entered 2007, rising over 75% to an all-time high of $21.91 just nine months later. As costs moved up month after month, our field teams worked aggressively to raise our prices fast enough to keep pace. As milk costs soared, so did our cost of shrink.

At the same time the pricing dynamics in the dairy complex resulted in sharply reduced contribution from excess cream sales to third parties. The combination of shrink cost and decreased cream realization resulted in well over half the year-over-year decline, in Dairy Group operating income.

While the conventional side of our business was challenged as never before during 2007, our WhiteWave team also faced a significant challenge. In late spring, the organic milk industry entered a period of severe oversupply that drove down realized prices and increased competitive intensity in the industry. You all remember that prior to 2007 the organic milk category had grown at a rate of about 25% per year and processors labored each year to procure enough additional supply and to meet the escalating demand.

However, strong economic incentives for conventional farmers to become organic, plus a change in the organic form transition rules, caused supply to increase dramatically in 2007. This oversupply led to steep discounting and aggressive expansion, by processors trying to sell their supply in the organic milk market.

Faced with the potential of losing market share to aggressive competitors, we made the strategic decision to defend the long-term value of the Horizon Organic brand, by lowering our prices and increasing our marketing investment behind the brand. We are very pleased with the results of this strategy as Horizon volumes grew close to 40% in the fourth quarter and our market share expanded. However, this incremental investment decreased the overall profitability of the WhiteWave division in 2007.

The impact of these market forces hit us especially hard in the third quarter, as Class I prices had hit historic highs and the investment in Horizon Organic kicked in to high gear.

In the fourth quarter we continue to be challenged by these same issues. Dairy commodities remained at historically high levels as the Class I mover averaged $21.03 for the fourth quarter, down only slightly from the third quarter, but almost 70% higher than the fourth quarter of 2006.

Despite an average retail price $0.75 per gallon higher than in the Q4 of 2006, we were pleased to see fluid milk volumes rebound from their uncharacteristic decline, in the third quarter, to be basically flat with year ago levels in Q4.

However, with milk costs that were 70% higher than a year ago, we were still challenged by the negative effects of shrink, as well the significantly reduced profit contribution from excess cream sales, as well as higher fuel and resin cost. As a result, the fourth quarter Dairy Group operating income clearly showed improvement over the third quarter, that was 13% below a year ago levels, at $151 million.

At WhiteWave, our branded portfolio turned in a very strong topline performance, with net sales increasing by 13% over the previous year. This was the strongest topline growth at WhiteWave, since the fourth quarter of 2005.

The growth was broad-based across the portfolio with all of our core brands contributing to the strong sales performance. Silk and International Delight sales both increased in the low double digits, on the strength of increasing market share and continued strong category growth.

Land O'Lakes creamers grew in the mid-teens due to commodity driven price increases and volume growth. Horizon Organic fueled pure by competitive pricing, increased distribution and the success of our DHA enhanced products, saw fluid milks sales grow over 20% on the strength of volumes, that were nearly 40% higher than the same period at year ago.

The incremental investment we made in Horizon pricing has allowed us to successfully defend and expand market share during this period of industry wide oversupply and intensified competition.

However, in the fourth quarter the stepped-up investment and higher marketing spend across the portfolio, led the WhiteWave segment operating income up $37 million or 20% below year ago levels, although the fourth quarter was a challenging and to a difficult year.

While consolidated operating income remained well below year ago levels, the fourth quarter represented a significant step forward from the third quarter and gives us confidence that our profitability will grow when milk prices move materially lower and stabilize.

The unforeseen instability in the dairy commodity markets in 2007 took the entire US industry by surprise and created significant difficulty. Consistent with challenging periods in the past, this environment has created step-up competitive intensity and has also created opportunities to make small tuck-in acquisitions and strengthen our market presence in select regions.

We are seeing a definite uptick in the pipeline of potential acquisition opportunities. You may have seen that we recently completed the acquisitions of Welsh Fluid Dairy operations in the Le Mars, Iowa, giving us our first area in that state and a stronger presence in that region of the country.

Additionally we expect to close another tuck-in acquisition in the first quarter. As we move forward we may choose to selectively make additional small acquisitions if attractively valued and strategically desirable opportunities continue to present themselves.

While 2007 was a difficult year operationally, these near term challenges did not slower our progress towards transforming the company into a stronger long-term competitor. In 2007 we laid much of the groundwork that we will build on, as we transform the business to drive productivity and increase efficiency in the years to come.

One of our key accomplishments over the past year is the continued build-out of a leadership team that we believe has the right blend of deep dairy industry experience, and operational and strategic expertise from related industries that have already been through the wrong transformational processes.

We believe we have been able to attract some of the best talent in the industry to Dean Foods. These ambitious and capable executives are drawn to our unique opportunity to create value both by reducing the cost and complexity of our existing businesses, and by driving topline growth in our on trend brand and categories.

As we assemble these talents, we aligned our new leadership teams around clearly defined business platforms. As part of this move to a platform-based business alignment, we will disaggregate the dairy group into a DSD Milk platform, a DSD Ice Cream platform and a Morningstar platform.

Harrald Kroeker, who came to us from Pepsi Bottling Group in 2006, has now assumed leadership over our two DSD operations, food, milk and ice cream. Rachel Cullen, our ice cream lead will report to Harrald. This more clearly defined business structure creates a unit that is completely focused on our high velocity short-shelf life direct store delivery businesses who are delivering low cost and high levels of customer service are critical to success.

As part of these efforts, we are also centralizing our milk and ice cream marketing function under Rick Zuroweste who joined the leadership team in 2007, from Coco Cola. Rick will report to Harrald and will work to maximize the effectiveness of our DSD marketing programs across the country.

Our Morningstar business run by Chris Sliva will now report to Joseph Scalzo, who has been named CEO and President of WhiteWave and Morningstar. WhiteWave and Morningstar are both primarily warehouse delivered long shelf-life businesses. Over time this change in reporting relationships will leverage the manufacturing, innovation and systems infrastructure of both Morningstar and WhiteWave, across an extended warehouse platform.

To help maximize the effectiveness of this realignment we've also significantly bolstered our supply chain management capability, with the addition of Gregg Tanner, who joined us in October from Hershey as Executive Vice President and Chief Supply Chain officer. Gregg is tasked with driving cost out of our supply chain, through additional plant rationalization, network optimization and more efficient business practices.

As part of this effort, Gregg will also be working closely with our new centralized procurement team, to identify and capture additional cost savings from our procurement efforts. Brad Holcomb and his procurement team are leveraging the scale of over $3 billion of spend across Dean that had historically been managed at a local and regional level.

We enjoyed some early success in 2007 through consolidating our spend around items like packaging and fuel. Working together with Gregg on holistic supply chain optimization strategy, the procurement team will be focused on additional areas to mitigate cost inflation as we move through 2008. I expect Gregg's expertise to play a strong role in our future success and we're pleased to have him with us.

Another important step forward in 2007 was the progress we made on our finance realignment project. We are well into this program that centralizes many of the administrative functions that were historically accomplished at the plant level in the specialized accounting and transactions centers; increasing quality and capability by positioning us to drive greater simplicity and consistency across the business going forward. This project taught us valuable lessons in driving change and we are proud of the efforts of our people in finance and in the field, for putting into it to make it a success.

In 2007, we also completed the installation of SAP of WhiteWave, giving management the insight that they need to drive meaningful incremental improvements in the years to come.

Our new leadership teams are defining and validating the strategies that will shape our direction, as we move forward. With much of the top level organization now in place, we expect 2008 to be a year of transition, in our transformational efforts, as we begin to operationalize our strategies and make systems improvements.

Turning to the outlook for 2008, it appears that our results this year will continue to be driven by dramatic swings in the dairy commodity markets including the organic milk market.

In 2007 we learned how difficult it is to forecast these markets given the impact of global dairy demands swings in a highly challenged organic milk supply chain. As a result we've built conservative financial plans and have taken actions to reduce our cost base.

Given these highly volatile and uncertain markets, we believe it is prudent to provide a wider guidance range for each upcoming quarter than previous practice and to be very circumspect, about what guidance we can and should give for the full year.

Looking at the first quarter in our conventional dairy operations, dairy commodity prices will remain well above year ago levels. The Class I mover increased $0.93 from December to January to $20.97 a hundredweight. This compares to the $13.59 for January of 2007.

The Class I price fell to $19.68 per hundredweight in February, a meaningful decline but still well above February 2007s price of $13.39 per hundredweight. The Class I price is widely expected to fall in March but almost certainly we will continue to be well above year ago levels.

With this in mind, we continue to expect shrink and excess cream sales to have a negative impact on results in the first quarter. Additionally, we believe that the organic milk oversupply situation that has challenged the industry for most of 2007, is swinging to undersupply.

Supplies were tightening and we are starting to increase our pricing to better match supply-and-demand. This rapid swing towards an environment of tighter supply is in part caused by surging organic dairy farm costs, primarily feed, that are pressuring organic farm profitability and increasing cost on our own farms.

This rise in cost, combined with record high conventional pay prices, creates a disincentive for new farmers to convert to organic farming and has resulted in a material decline in the pipeline of farmers converting.

These dynamics have combined with renewed increase in competition among processors, for available milk to create upward price pressure on raw organic milk. To protect our supply, we will respond to this upper pressure, which will mitigate some of the recovery you would expect in WhiteWave's results, related to the abatement men of the oversupply situation and the reduction of promotional spending.

Keeping these factors in mind, we are expecting these continued challenges related the high overall dairy commodity prices, to be offset somewhat by the benefits of commodity price declines in February and March. This combined with the quickly shifting environment in the organic milk market, leaves us to expect first quarter earnings per share between $0.15 and $0.20.

Looking at beyond the first quarter, we find it difficult to have much confidence in the current dairy commodity forecast even the unprecedented levels of volatility we have experienced. In fact, given the recent volatility in the dairy commodity markets, it now appears likely that the April Class I mover will be above March levels.

Beyond that, there is a wide disparity of expectations in the dairy community, as to how the balance of year will play out. Given the volatile trading in dairy commodities, prices may continue to vacillate between strong up-months and strong down-months. Additionally, it is difficult for us to predict how the rest of the year will play out in the organic milk market, as the situation is evolving quickly and Horizon brand economics could swing materially as the year progresses.

Balancing these factors and the uncertainty we see, as we look ahead, we currently expect earnings for 2008 to be at least $1.20 per share, with expectations for significant growth in EPS in the back half of the year. We will update you more specifically on this outlook as the year unfolds.

In summary, 2007 was the most challenging year in Dean`s history. We faced record high dairy commodity prices and an industry oversupply of organic milk.

Although our results are below expectations, I am proud of the efforts of our team to deal with these issues. The challenges we faced in 2007 have strengthened our resolve to transform the business. I am excited about the team we have assembled and the progress we have made so far. I am confident we are pursuing the right strategies to build the new Dean Foods and maximize long-term value for our share holders.

I expect the fruits of our efforts will become increasingly evident as time goes on. With that, I’d like to thank you for joining us on the call today and I will turn it over to Jack, who will give you more detail on the fourth quarter and our outlook for the coming year. Jack?

Jack Callahan

Thank you, Greg and good morning, everyone. As Greg discussed, we continue to be challenged by historically high commodity prices and an imbalance in the organic milk market in the fourth quarter.

Earnings per share was $0.27, almost doubling third quarter results. This compares to $0.61 for the fourth quarter of 2006, which was under our old capital structure.

On a year-to-year basis, approximately half of the decrease in earnings in the quarter is due to the higher interest expense related to the $15 per share special cash dividend paid out in April of this past year and about half is related to the decline in operating income.

Full year earnings were $1.20 per share compared to $2.12 per share in 2006. Approximately 60% of the decline in earnings per share for the year is due to the incremental interest expense, as a result of the new capital structure and 40% is related to the decline in operating income. And please keep in mind that the negative interest overlaps due to the recapitalization which will continue through the first quarter of 2008.

Turning to the Dairy Group. Dairy commodity prices finally plateaued in the fourth quarter, after rising dramatically, virtually all year. However, the Class I price remains 70% above year ago levels. Consistent with the rest of the year, the Dairy Group field teams effectively passed through the overwhelming majority of the increased milk cost in the quarter.

Additionally, as Gregg mentioned, in spite of retail prices that were more than 20% higher than last year volume performance normalized in the fourth quarter and was roughly on par with year ago. Regardless, the difficult dairy commodity cost overlaps led to shrink cost in the quarter that were materially higher on a year-over-year basis.

Our fluid milk processing operations normally lose up to 1.5% of the milk that is processed in our facilities resulting in a material incremental cost, as dairy commodities escalate. Going forward, we are working to minimize the volume loss with several capital spending projects.

Also as Gregg mentioned, a significant reduction in benefit, derived from excess cream sales continue to hinder profitability in the fourth quarter. As a reminder because we generate more cream than we need, we typically sell the excess cream to third parties. Historically these sales have been a significant offset to cost of goods sold.

The industry standard is to price excess loads of cream, based on the CME butter price. The CME butter price has been relatively stable this year, largely due to the strong growth in nonfat milk powder production, which creates butterfat as a byproduct.

However, in addition to butterfat, cream loads contained approximately 60% skim milk, which has increased significantly over the past year. The cost of Class II skim was approximately a 130% higher in the fourth quarter than it was in the same period a year ago. This increase in the component cost of our excess cream sales significantly reduced the net benefit we receive from these sales. This put additional pressure on gross margins in an already difficult period.

Additionally, we had negative overlaps in both fuel and resin cost in the fourth quarter. In total dairy group operating income declined by 13% in the quarter to a $151 million, with more than half of the decline attributable to the combination of increased shrink and reduce proceeds from excess cream sale.

For the full year of 2007, total net sales for the dairy group were $10.4 billion, an increase of 18% of 2006. The steep increase in dairy commodity prices resulted in a $1.6 billion increase in both net sales and cost of good sold, as the vast majority of the increasing cost was passed through in the form of price increases as the year progressed.

However, the challenging operating environment and incremental cost associated with the steep rise in commodity cost led to an operating income decline for the dairy group of $60 million or negative 9% to $625 million, with the impact from cream sales and shrink accounting for well over half of the annual decline.

Turning to WhiteWave foods. Total net sales for the quarter increased 13% to $388 million with strong sales growth across all of our core brands. As Gregg mentioned, this is our strongest quarter of sales in the WhiteWave in two years.

However, the increased investment behind the Horizon Organic brand and increased marketing spending across the portfolio resulted at a 20% decline in operating income in the quarter at WhiteWave to $37 million and an operating margin of 9.4%, a significant decline from the prior year.

On an annual basis, WhiteWave sales increased 9.2% to $1.4 billion, behind the continued growth of our core brands. For the year Horizon Organic milk sales were up 18%, due to the volume acceleration in the back half for the year, fueled by the strong growth in supply and the increase in promotional spending.

Land O'Lakes sales were up 13%, International Delight grew 11% for the year and Silk sales increased 8% on an annual basis. The increased investment in the support of the Horizon Organic brand and higher infrastructure and distribution costs led to an operating income decline of 11% for WhiteWave from 2006 levels to a $118 million.

Now, let me turn to corporate expense. Corporate expense in the fourth quarter totaled $38 million or 12% increase over prior year results. For the year, corporate expenses were $153 million, an increase of 8%. This increase in corporate expense from the prior year is due to the investments we are making to strengthen our centralized capabilities.

Most notably, the finance realignment project, new innovation capability and human resource investments. In 2008, our basic financial plan assumes modest growth in corporate expense.

For the company as a whole, consolidated adjusted operating income in the quarter was $149 million down 19% from the fourth quarter of 2006. For the full year, consolidated operating income increased almost 13% from the prior year to $590 million.

As I mentioned earlier, interest expense was materially higher on a year-over-year basis, due to the recapitalization of our balance sheet in the second quarter, in conjunction with the special cash dividend. Total interest expense for the fourth quarter was $88.8 million, compared to $50.2 million in the fourth quarter of 2006. We will continue to have these negative interest expense comparisons through the first quarter as it will have the recapitalization of the balance sheet.

For the full year, interest expense which includes three quarters under our new capital structure was $320 million, an increase of $125 million from the prior year. We will have four full quarters under our new capital structure in 2008 and currently expect interest expense to be approximately $340 million. Although we are currently about 80% hedged, interest expense could move around a bit as interest rates remained highly volatile.

Adjusted net income for the fourth quarter was $37 million, down from $84 million in the fourth quarter of last year. Full year adjusted net income for 2007 was $164.5 million, a decrease of 44% from the $296 million we reported in 2006.

Cash flow from continuing operations accelerated in the fourth quarter as working capital needs plateaued. For the year, cash flow from operations was $350 million, down from last year due to higher year-over-year interest expense, lower operating results and increased working capital requirements.

Cash flow is well behind what we anticipated, when we issued the special cash dividend in April. I would estimate that we are about a year behind our original debt pay-down expectations.

As we look forward, once commodities begins to meaningfully decrease, our working capital investment will also decrease and we anticipate accelerating debt reduction, like we saw in the fourth quarter.

Total capital expenditures for the year were $241 million, essentially flat to a year ago. For 2008, we suggest you assume up to $250 million in capital spending, but we will pace that spending according to the progress we make on debt pay-down especially in the first half of the year.

Debt outstanding net of cash on hand, at the end of the fourth quarter was $5.24 billion. Total debt declined by approximately $94 million in the fourth quarter due to improvements in working capital and the sequential improvement in profitability. Our leverage ratio at the end of the fourth quarter as defined by our bank covenants was 5.95 funded debt to EBITDA.

In closing, a few additional thoughts on our forward outlook, broadening the comments Gregg made earlier. We find it very difficult to forecast the coming year, due to the highly volatile conventional dairy commodity markets and a quickly evolving organic milk market.

In our conventional dairy operations, declining Class I prices in February and most likely in March, will be helpful, but we expect excess cream and shrink to continue to negatively affect results.

At WhiteWave, our portfolio of brands entered the year with good top line momentum and we are optimistic that the growth will continue in the first quarter. We expect Horizon Organic pricing to be below prior year, at least through the first part of the year, which will keep margin comparisons to the prior year difficult in the first quarter and into the second.

Remember, Horizon investments ramped up significantly in the third quarter of 2007 and given the tremendous growth in the organic milk market, the cost of organic milk to fuel the category growth continues to increase.

Additionally, as you think about the first quarter, I would also like to remind you that we were lapping in an extremely strong first quarter from 2007, that included a $7 million one time payment as part of the customer settlement that was disclosed last year in the dairy group results.

Furthermore, as you think about the first quarter and the full year, keep in mind that full year interest expenses are likely to be approximately $20 million higher as a result of the first quarter overlap of the old capital structure.

As Greg mentioned, we will continue to update you regarding our expectations as the year unfolds and we gain increased clarity about both the conventional and organic dairy market.

With that, I would like to thank you for joining us today, and now we will open up the calls to your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) And we will take our first question from Eric Katzman with Deutsche Bank.

Eric Katzman - Deutsche Bank

Hi, good morning everybody.

Gregg Engles

Good morning, Eric.

Eric Katzman - Deutsche Bank

I guess my first question, the way you worked historically, maybe that's not relevant but the way you work historically, it wasn't so much the year-over-year comparison in dairy, it was more the sequential ability on the pass-through, and that doesn't seem to be at a $150 million of EBIT. I mean it doesn't seem to be that bad and I am just kind of wondering is there additional investment spending that for centralization that's running through that part of the P&L that makes you a little bit more cautious?

Jack Callahan

Well, when you say $150 million, you mean the results for the December quarter or the fourth quarter.

Eric Katzman - Deutsche Bank

Yeah.

Gregg Engles

Yeah. The fact that our operating income is declining, and in this case period-over-period of around 9% in the quarter is magnified by our leverage. So, you see the effects on our bottom line, earnings per share magnified by the leverage. We are passing through the vast majority of these price increases and you see as the fourth quarter stabilized, an uptick in volume from the third quarter and somewhat of our rebound from the third quarter in the Dairy group.

As we move into 2008 the picture is just very murky. We saw another strong move up in January in the price, that's obviously, as you refer to the sequential periods or quarter as opposed to the annual overlaps, are a significant issue. And we look to 2008, at least the first four months look to be very choppy, right you are going to have apparently two up-months and two down-months. So, not the extended period of downs that the industry have been forecasting as we came to the third and the fourth quarters of 2007.

It was very difficult to get confidence that we are going to have the reversal of the strong period of sequential ups that we had in 2007.That would be most beneficial for recapturing our margins.

Jack Callahan

And Eric but in terms of our go forward guidance, our approach is, be more driven by our cautious outlook as to the commodity markets, both the organic milk, and in the Class I mover more than any more than -- we are not trying to signal a step down in significant level of investment at this point.

Eric Katzman - Deutsche Bank

I understand and then the I mean it seems that the farmers are reacting. I mean half a retention is up, production in terms of the USDA data that comes out both on dry powder and fluid milk seems to be up significantly. So, is it the disconnect on the other parts of the complex and the international impact that is keeping the prices high?

Gregg Engles

Yeah. I think that we talked about this on our third quarter call. This market has just changed completely in terms of the way that it operates over the last 24 months, and that’s attributable to the rise in global demand, unlike what we have seen before. So the demand side of the equation has gotten significantly more robust internationally, but also the decline in the value of the dollar and challenges that are facing Australia, in particular on the production side are making the USD the port of first choice when people are seeking additional dairy commodities.

So this change in the supply-demand balance globally is falling first and foremost and most heavily on the US dairy industry. So Europe is still relatively highly protected, and they have still a highly complex quota system that is going to prevent the European supply response from being as strong as it is in the US. So this increased demand fueled by Asia primarily, and the falling value of the dollar, is going to get reflected in the supply response in the US.

So we see very strong supply response in the US, though we have not yet seen a meaningful down in terms of our domestic prices because either the reality or the belief is that those products will be off-shored. So we are seeing cheese and butter move offshore out of the US for the first time in memory, which follows behind what we saw in powder in 2007. And I think that's a factor we're just going to live with going forward at least as long as the dollar remains as weak as it is and Asia continues to grow as strongly as it does.

The other thing that is starting to creep into people's belief about this marketplace is that the farmers are operating a bit on historical data as well, and as things play out in their marketplace, that historical data isn't holding up as it isn't for the processor side. So that you would think that the pricing in the $20 range or the $19 range, would translate into supply-growth as far as the eye can see and has translated into strong supply-growth so far.

But as people work back through the math, of much higher grain input cost because of ethanol primarily, so you see soaring cost for corn and soybean, critical inputs to the dairy complex and higher fuel and fertilizer cost. The break even level for US dairy farmers, the economic level has moved up very meaningfully.

And there is some belief in those who are analyzing the dairy complex that if we start to get prices that fall below the $16 range you'll start to see farmers begin to cull herds and reduce supply. Now that's a very much higher price level that never existed in the past. So this thing is still very fluid in the supply-demand equation.

Eric Katzman - Deutsche Bank

And then, the last question, I'll pass it on. Just a foot to the organic side. I mean, it seems that again things are changing rapidly and I appreciate that, but historically, a tighter supply situation and high prices has benefited Horizon Organic even with the cost of ownership on the farms which I think I think like are like 25% internal. Is that a fair characterization or is it just again just so fluid that it's kind of it tough to generalize?

Gregg Engles

I think it is a fair characterization, Eric. We should do better in a tighter environment than we did in the long environment, in terms of organic milk supply. The issue we're going to face in '08 is that we were not in a long environment in the first half of '07, and so we had the same sort of favorable dynamics that is now beginning to reemerge more favorable dynamics in the organic milk supply today.

So we're going to have a tough overlap in the first half, no matter what. The overlap in the back half of the year should be better for Horizon Organic but how is going to wash out on the year is difficult to tell, because we really started heavily promoting the category, as this wall of milk emerged in the third quarter of last year.

So it's evaporated relatively quick and what I really can't call today is what price it is going to take in the organic farm community to stabilize supply. So, I don't know if you say the piece that came out about four to six weeks ago, around the escalation in the price of organic feed and organic grain. But in about a three months period in the fourth quarter last year organic grain prices went from $200 a ton to $500 a ton.

Now, that's a meaningful cost increased for our own farms, but it is also putting pressure on the organic farmer that makes up the bulk of the industry supply and our supply. And how that is going to sustain and play out in this marketplace given these high conventional prices, is something that we couldn't call an input price that stabilizes or a milk price that stabilize the supply right now. So that is pretty dynamic. And we will just have to see how it plays out in 2008. And as it does play out and organic milk prices rise, we will learn even more about elasticity of organic milk as compared to conventional milk. So there are lot of moving parts there too.

Eric Katzman - Deutsche Bank

Okay. I will pass on. Thank you.

Gregg Engles

Thanks.

Operator

And we will take our next question from Eric Serotta with Merrill Lynch.

Eric Serotta - Merrill Lynch

Good morning.

Gregg Engles

Good morning Eric.

Eric Serotta - Merrill Lynch

I have a question here, first of all last quarter, you talked about, I am working with your customers a little bit to try and work in some the interact factors like shrink and the excess cream, reduced profitability in excess cream sales into your monthly price negotiations. Has there been any progress on that thus far, particularly with the large international customers?

Jack Callahan

There is been some progress. We've been able to work that in, in a couple of situations. But, obviously just kind of given the significant year-on-year comparisons that we have on a year-ago basis on shrink, it's still been a significant drag on the P&L, but we are picking up some and we hope to get more as we get into the full benefit of this program as get to '08.

Eric Serotta - Merrill Lynch

Okay. And then Gregg you are provided some qualitative details as to the actions that you have taken to better position the company for '08 a lot that touching upon some the productivity efforts and the like. A lot of investors I talked to are still a bit frustrated that you haven't quantified what the opportunity is over the next couple of years. I know that you put out some numbers about what the ultimate potential opportunity is, in terms of potential -- in terms of compressible cost base. But any chance that you could provide a little bit more detail as to what you expect in terms of cost savings from all these various projects over `08 and `09?

Gregg Engles

Yeah. Eric I am not prepared to do that at this point in time for a number of reasons. First of all I will just point out that the complexity of the challenges is very significant. We have over a 100 plants in the United States and we have a business that is still managed in many aspects, on a very decentralized basis. So, I have a team, including probably most importantly in this regard Gregg Tanner, who is new on the ground. Right, he has been here 100 days.

So, by far the biggest opportunities in our compressible cost algorithm are, is the footprint of our manufacturing facilities, and what runs through those facilities. So that’s going to be a very significant opportunity for us but it is going to be a relatively long-term opportunity for us.

So Gregg is in the process of finalizing his `08 objectives and deliverables in that regard. There definitely will be some in terms of rationalizing our footprint, but we are going take the opportunity upfront to make sure that we get our network design right, and I think that this is a program, particularly on the manufacturing side of things that you will see gain momentum as we move beyond `08 rather than being primarily a huge ’08 event.

Now Jack and his team, he will speak to that they are busy laying the foundation for making sure that this work can proceed, and proceed smoothly on systems and finance and analytics, and those sort of things. But we are in the capability building phase to some degree today, and I think that the big benefits that you’ll start to see from this will be beyond the '08 time horizon.

Eric Serotta - Merrill Lynch

Okay, and then finally sort of a bigger picture question with all of the complex moving pieces that you've spoken about, on both the conventional dairy side, and the organic side, how do you think about the normalized level of profitability that you expect to get toward the level of profitability that you would expect to get to, and a whatever the new normal is for dairy cost, given what you've pointed out are some pretty significant structural shifts in terms of global trade and as well as the structural shifts that we have seen in the organic market?

Jack Callahan

Eric you mean in terms of the sort of assumed profit growth on a go\forward basis?

Eric Serotta - Merrill Lynch

Yeah, in terms of either a profit growth and then from what base we should look at that, or if we were to assume an $18 or hundredweight milk price or pick your number? How are you guys conceptually thinking about the level of operating income that you could generate? Lots of people are making the argument that it's been permanently impaired versus what it was previously, given lot of those structural changes that you've mentioned and I am wondering how you respond to that, even if you can't give us a specific growth rate or normalized profitability number?

Gregg Engles

I think at the end of the day, the industry that we operate in is an industry that given the totality of the competitive set, doesn't have a lot of room in it, in terms of earnings based over cost of capital.

So I don't think that the price of milk whatever the stabilized level is -- fundamentally changes are belief about our earnings capability unless it fundamentally changes volume in the industry. Right, so if volumes are as an elastic as they appear to be coming out of the fourth quarter, then I don't think that this move up in the relative price level of the dairy complex fundamentally changes our profit algorithm.

Now, there is of a lot of noise and education is, shrink and cream sales and those sorts of things that haven't been meaningful inputs into our pricing conversations with customers who work there way through the system and become items that are openly acknowledged and dealt with. And there is a clearly a period of adjustment, but the capital investment in this industry has got to require a certain level of return in order to sustain it. And so I don't see the profit algorithm changing significantly overtime.

I do see a higher dairy complex putting pressure on the smaller less well capitalized participants in the industry.

Eric Serotta - Merrill Lynch

Okay. Thanks for that. And I like to ask more a very quick question before I pass it on. You talked several times about looking at the April Class I being above March. That's different from some other forecast that I have seen. I am just wondering what gives you the visibility into April. Are you assuming cheese prices will stay at the current high levels there, what's behind the April forecast?

Jack Callahan

Well. I mean this is a great example of why we're trying to be very cautious about our commodity assumptions going forward. We for the last four months have been assuming April would be a continuation of the down that we expect to see in March. But over the last really two weeks kind of given some was that a higher in trade in cheese, we now think it is over 50% like with the April could go up a little bit.

So, that's why it's makes this whole complex remains highly volatile and that's why we get so - we just want to be very pragmatic as we look forward.

Unidentified Analyst

Thanks. That’s all I got, I will pass it on.

Gregg Engles

Thanks.

Operator

And we will take our next question from Terry Bivens with Bear Stearns.

Terry Bivens - Bear Stearns

Good morning everyone. Can you guys hear me?

Gregg Engles

Yes we can Terry.

Terry Bivens - Bear Stearns

Okay. I apologize for the cell phone, but I got snowed in today. Just two things I have. Taking into account all you guys have said about first quarter, I understand the main issue will still be there. The shrink, the spillage etcetera and the interest expense. It still looks to us, we are having very hard time figuring out how it can be that low and it occurs to me, is the answer that, it's in WhiteWave with the combination of the lower price vis-à-vis last year. But perhaps a more significant than we thought cost base there, is that kind of the piece that's really dragging it down?

Gregg Engles

No, Terry one way we will face the overlap challenge of Horizon Organic in the first quarter, but it is not fundamentally a WhiteWave issue, it's really going to be primarily a milk issue, a conventional milk issue. So WhiteWave we expect to have a negative comp, quarter-over-quarter, given the Horizon situation and Morningstar, we expect to be relatively flat or slightly up to last year short of on their trajectory, but milk coming in the January with a big up, put’s it on a challenging path coming out of the blocks in the quarter.

Terry Bivens - Bear Stearns

So challenging Gregg that you can’t really recover as we go. I think we are going go into the 16s, is my understanding in the March. So you are not going to be a able to, sounds like January is going to be especially bad but you won’t necessarily make it up through February and March. Is that the way to look at it?

Jack Callahan

I think, Terry. This is Jack, I think getting to your point - your plan. March is sort of the wild card. We get a significant down, I mean, that’s the one that is very hard for us to really call right now because we haven’t had a down of that magnitude in quite some time. So it we are absolutely happy that we may have some relief in the market place. But that becomes a tough one to really say, just where the upside could be in that particular month.

Terry Bivens - Bear Stearns

Okay. My understanding was that it’s pretty much locked in at this point, kind of very high 16s or low 17s, but I mean, it sounds like you guys are a little bit more cautious on that kind of outlook?

Jack Callahan

Well no. I think we are going have strong down-month in March but we have been through pretty difficult period here. So our willingness to step out there and call a huge month in March is not exactly robust right now.

Terry Bivens - Bear Stearns

Okay and I think you probably looking at 20 buck cheese, and that’s the reason you are little thinking about back up in April. Is that correct?

Gregg Engles

Yeah. The Class I movers ultimately set by the higher of the cheese price for the powder price. Powder price has been moving down but the cheese price has been very strong in the last two weeks, up over 20%. So these cheese prices will drag the Class I price up if the hold and they have been very, very strong though.

Again, these markets are very murky right now in terms of what's driving this. There's lots of conversation about cheese moving offshore, that almost never happens in the US but given the underlying macro dynamics that we discussed earlier and these markets are behaving in ways that they have never behaved.

Terry Bivens - Bear Stearns

I do understand that, and I appreciate your conservative ways of kind of looking forward. In fact, to shift just briefly, Gregg, as you look at these addressable, compressible costs that we've talked about I guess, pretty close to $5 million. It sounds like there's a lot on the plate this year and I guess, this gets back a little bit to one of the Eric Serotta's questions.

But it just sounds like that's going to take him backseat this year, as you navigate through volatility, try to get somewhat stability in organic milk and it sounds like a fairly serious corporate reorganization there. Is that a fair way to look at it, that we really shouldn’t expect to see what could, I think clearly be some big numbers, but we shouldn't expect to see a lot of that this year in terms of those costs?

Jack Callahan

Terry, it's Jack. This is kind of based on the experience we all collectively had in the work we've done in the finance realignment project for over the last year and a half. I wouldn't characterize it as we are taking a backseat, but what I would say is, we are as convinced as ever of the opportunity and the necessity to change is there, it's just that it's harder than I think we ever imagined just kind of given -- the number of discreet businesses that came into Dean Foods, and the need to kind of drive simplicity and consistency.

It is just a lot of moving parts and I think what we're continuing to move forward, using our finance to move forward in supply chain. But I think sort of our timeframe is a bit more pragmatic based on some of the learning we've had so far. So it's not like off the table, we're pushing forward, I just think we are a bit more thoughtful about how much time it's going to take.

Gregg Engles

Yeah. I would add to that Terry there. The reality is you've got a build capability a lot of which really didn't exist here in a robust way to undertake the level of change that will ultimately roll through this company. And that has two implications, first of all it means time all, right. Because you have to get people with the right experiences on the ground and as part of the team and then exerting there influence on the process. But we also have to make the investment of building that team. So that's why you see the progression of corporate cost that you see.

We're on a capability building mode here. Some of those capabilities that have been on the ground longer, procurement, this back office realignment, will start to generate positive economic contributions to the business, but as Jack has described in quarters past, much of that benefit will then be rolled into the funding of additional capabilities we've got to build.

So we will be spending more money in the supply chain organization than we have in the past. And that for example will be funded by some of the things that we've done in purchasing and procurement and some other things that we'll begin to materialize from tax efforts and finance in the back office function.

So this is rolling progression in remake of the business from a highly decentralized roll-up into a more unified $12 billion operating company in the food and beverage space. And it's a big transformation.

Terry Bivens - Bear Stearns

Okay. Thank you very much.

Operator

We'll take our next question from Christine McCracken with Cleveland Research.

Christine McCracken - Cleveland Research

Good morning.

Gregg Engles

Good morning.

Jack Callahan

Good morning, Christine.

Christine McCracken - Cleveland Research

I just wanted to touch on your thoughts on shrink. Does that include the, I guess the retail returns that you get assuming that doesn't include part of the sales?

Jack Callahan

It does -- but it does Christine but the more significant issue is just a milk loss in the plants. That's the primary driver of the number. Just kind of given the why our product does have relatively short shelf-life, there are returns but the meaningful issue is the loss in the plant.

Christine McCracken - Cleveland Research

Have you seen any shift by consumers given the gap between private label and branded, in terms they are trading down especially in the high-cost environment? Has that impacted at least the number of sales or specifically looking at how well your branded business is doing relative to what where you get back in private label?

Jack Callahan

Well, as we mentioned in the third quarter we have seen a little mixed shift particularly in some regions of the country where we have some very strong brands over to the private label side. So yes, we have seen a little of that mixed shift and that has been another drag on the P&L, and but we are hopeful as retail pricing gets back to more normalized levels that mixed shift maybe, may go back the other way.

Christine McCracken - Cleveland Research

And then just on Silk that seems like you did a little better there this quarter. You thought last quarter and think about change in the way you look at that business. Did you make any significant changes to that? As you operating that this quarter was anything significant driving that?

Jack Callahan

There was stronger marketing support for Silk in the fourth quarter compared to year ago. However also to it, as we mentioned throughout '07 we lost of fairly significant customer in the fourth quarter of '06 which is kind of a drag on the Silk growth rate through out the year. We have now lapped that and we are looking to kind of continue the fourth quarter to success into the next year.

Christine McCracken - Cleveland Research

Okay. And then just in terms of your fuel and packaging cost. Is that your expectation that you have there are kind of in the higher cost environment. Is that kind of trying to cycle in or will be that be variable as you missed through the year and some those old contract fuel loss? Can you give us any visibility around those costs?

Jack Callahan

In the fourth quarter we did have a step-up in resin and fuel cost, that did hit the P&L. Some of which we are able to recover in our pricing but it did become a bigger factor in the fourth quarter though not as quite as the same magnitude as something like shrink.

Christine McCracken - Cleveland Research

All right. I will leave it there. Thanks

Operator

We will take our next question from David Palmer with UBS.

David Palmer - UBS

Good morning everyone.

Gregg Engles

Good morning David.

David Palmer - UBS

I guess one question that wades through many of these question is how much of your margin paying or gain will be the impact of short-term sequential moves in the commodity versus an impact on a year-over-year basis. And I guess maybe a good way to ask you about that and the impact of earning is, if dairy prices remain on average, I can understand that might be week-to-week or month-to-month does that stay at average or relatively flat quarter-to-quarter even at higher levels?

How much of margins improve from here? And I guess that might be a good way for you to discuss kind of the proportionate impact, things like trade down and shrink, which might have a year-over-year component and the gap and timing of your pricing versus input cost and even certain things like working in shrink and your discussion with retail. So would you mind perhaps giving some numbers around the proportions of things and the impact of year-over-year versus sequential? Thanks.

Jack Callahan

I think we can’t give you specific numbers on this Dave. Let me just try this. I think as you think through '08, of what we started to see the increase in commodity cost started to really hit us towards the middle of the second quarter and really hit us full board in the third. So once we've kind of worked these higher costs into our margin structure, or as we start lapping it, you should start to see some improvement as we start to move forward beyond that. But until we get to that point it's really that, it continues to be a pretty significant drag, as you can see in our fourth quarter results and we're signaling for the first quarter. So that's probably the primary driver on how '08s going to play out, at least in our terms, until we get some better clarity into the commodity situation in the back half of the year.

Gregg Engles

Yeah. Let me take a little bit of a crack at it too David. Because you do allude to something I think is in cycle, which is there are at least two kinds of factors impinging on our P&L. The first are factors that are tied to the absolute cost of milk and the those are things like shrink, rebates, cream sales, or cream realization from sales, those are tied to absolute prices either of milk or of components of milk. And to ultimately recover the margin compression from those items if prices stay high will require us to work those factors into our price realization with the marketplace and that’s a process that is going to take time.

The other thing that influences our business is the sequential change in the price whether it is going down or up and the efficiency of our pass-through mechanism either retaining margin when prices move down or recovering at all when prices move up. And that is also depending on price moves, a meaningful impact potentially on our P&L.

So while I agree with Jack I can't give you a numbers on that right now. I would say there, that our price pass-through mechanism is pretty efficient. Now, there is some noise around period-to-period but it's pretty darn effective and efficient.

The changes in our profit algorithm based on things that are driven by the absolute price of milk, however, those just take a lot more time and evoke a different sort of competitive response in the marketplace because they are different from how people have historically thought about maintaining or managing their profitability in this category, and they are just tougher right now.

David Palmer - UBS

So it does sound like for you I mean I don't want to put an imaginary amount but year-over-year impact would be most of what you would call the impact on your margins?

Gregg Engles

That's going to be the biggest driver in '08 versus '07, yes.

David Palmer - UBS

Okay. Thanks very much.

Gregg Engles

Thank you, David.

Operator

And we'll take our next question from Farha Aslam with Stephens Incorporated.

Farha Aslam - Stephens Incorporated

Hi, good morning.

Gregg Engles

Good morning, Farha.

Farha Aslam - Stephens Incorporated

Hey, couple of questions first on shrink, you noted that we're now starting to see butter moving offshore, and nonfat milk prices that drive milk components, coming down. Would that actually help your shrink because it pushes up butter prices and reduce the differential between skim and butterfat?

Jack Callahan

Yes.

Farha Aslam - Stephens Incorporated

So the trends right now are actually moving to help your shrink levels.

Gregg Engles

They are moving to help the cream realization.

Farha Aslam - Stephens Incorporated

Right.

Gregg Engles

Right. Not shrink.

Farha Aslam - Stephens Incorporated

Sorry, So, your cream realization is increasing there.

Jack Callahan

Yes.

Farha Aslam - Stephens Incorporated

And…

Jack Callahan

Although, today butter still very cheap, right so….

Farha Aslam - Stephens Incorporated

But is that differential that's causing you problems and that differential sounds like it's going to shrink?

Jack Callahan

Well, what's helping us most is that the skim component of cream is falling in value.

Farha Aslam - Stephens Incorporated

Right.

Jack Callahan

Falling in cost. So that's helping us but the actual price of butter so that affects the absolute price you get paid for the cream component that you sell is still quite low.

Farha Aslam - Stephens Incorporated

And going forward, do you think that as a gap between kind of that skim and butter closes that's going to help your cream realization?

Jack Callahan

As the skim component moves down and stays low we are definitely moving into a better environment in terms of sequential quarters, and we were in the third and the fourth quarter.

Farha Aslam - Stephens Incorporated

Alright. And when you look at April Class I mover possibly being higher is that actually a positive for you because I remember in '04 when prices just kind went down at that fourth quarter '04, the Class I prices just kind a kept going down and retailers kind a demanded all of that raw material decline back in terms of pricing. In fact that it's going to be a little bit more volatile this time around. Well, could that be a positive for Dean Foods?

Jack Callahan

I love your optimism Farha. I wouldn't want to call that one, yes.

Farha Aslam - Stephens Incorporated

Okay. And I am just moving over to Horizon Organic, last quarter you shared with us kind of the average price that you were selling that half gallon of pricing that around 310 what would it be for the fourth quarter?

Jack Callahan

It would be that a little lower, right the fourth quarter was the full metal jacket of price discounting.

Farha Aslam - Stephens Incorporated

Okay. And then your estimated gallons have been about $25 million gallons in '03, would you say it's about that level or more in '04?

Gregg Engles

On Horizon?

Farha Aslam - Stephens Incorporated

Yeah. Just on Horizon.

Gregg Engles

No. Horizon gallons in '07 were around 80 million gallons total for the year I believe. I think '08 gallons are up 20%, 25% from that on the order of a 100 million gallons.

Farha Aslam - Stephens Incorporated

Okay. And then, could you…

Gregg Engles

For the year.

Farha Aslam - Stephens Incorporated

For the year for '08. You are going to be about 100 million gallons. And when you look at your purchase cost last quarter it was about $3 per 100 weight for organic milk. How much of that increase and kind of where do you see that going?

Gregg Engles

Well it's, we are just in the throws of organic milk prices moving up. So, It's not clear where it's going to go and I just one of those things that leads to so much uncertainty in our outlook for the year. It's very hard to call what the price of organic milk is going to be. So, all I can tell you is farmers are under a lot pressure out there. We are responding to that as. As the overall market place and moving up pay prices to farmers and where is going to settle, I don’t really know.

Farha Aslam - Stephens Incorporated

Right. Thank you very much

Gregg Engles

You bet, thank you.

Operator

And we'll take our next question from Alton Stump with Longbow Research.

Joe Herrick - Gutterman Research

Yeah this is actually Joe Herrick with Gutterman Research. A couple of questions. Greg congratulation on good numbers. Regarding Lean and Six Sigma what you guys are doing in terms of operational and improve initiatives revolving around Lean, the Six Sigma to improve throughput through out your plans in a very challenging economy?

Gregg Engles

Well, we are not specifically lean or Six Sigma, but we are moving to improve our capabilities as it relates to continuous improvement in our facilities. I will tell you that in our manufacturing environment historically given the fact that we've operated in a highly decentralized way that hasn't necessarily been one of our strong suits, as a company in terms of a uniform process applied across the business.

As we've built up our supply chain management capability with the executives that we've added. That would be an area of focus as me more through '08. Again a lot of capability needs to be built there but I would suggest as you look out into '09 and beyond you should see meaningful improvements in our manufacturing environment.

Joe Herrick - Gutterman Research

Which metrics are you guys using in your manufacture environment to measure success against peers? Are you looking at RONA or OE, how you guys charging yourself to make sure you stay number one in the market?

Gregg Engles

Unfortunately, kind of given the roll of nature of the business our challenges are far more basic. We're just trying to get consistent cost information across our hundred plus plants. So, again you remember, we are a relatively new company so part of what we're doing here is between the right foundation, so we can get accurate data so we can make the basic cost comparisons across our planed systems. So I wish we were far enough down the pipe that use a lot of those measures, we're at a much earlier stage, kind of given the nature of the business.

Joe Herrick - Gutterman Research

Are there certain plants around the world, do you have more concerns than others in terms of different parts of the world and how do you adjust those challenges?

Gregg Engles

Well, we're a domestic company by and large, we have one international plant and we have a population of facilities that are some better some worse. So, I'll just go back to Jack's comment, we are in a foundational building phase with respect to our supply chain capability and we think it's an area of great opportunity for us going forward. And I think you're questions are directionally correct in that ward.

Joe Herrick - Gutterman Research

Thank you. And final question going forward for 2008, it will be a very challenging year for a lot of companies and your industry. What systems and solutions are you going to be putting in place to accelerate your continuous improve initiatives to improve on your supply chain efficiency?

Gregg Engles

Again, bye just I don't think I have any thing to add in that regard. We've got basic capabilities, we've got build. We're bringing the right management team on board to address those challenges. And hopefully we will able to have a more robust conversation with you about that in the future.

Joe Herrick with Gutterman Research

Alright. Thank you very much.

Gregg Engles

Thank you

Operator

And our next question will be from Pablo Zuanic with J.P. Morgan.

Pablo Zuanic - J.P. Morgan

Good morning everyone.

Pablo Zuanic - J.P. Morgan

Greg, I guess I see here if I were to think as a retailer and listen to everything that's been discussed as Kroger or Wal-Mart and what I am trying to understand are you gaining any benefit from the lag in terms of pass-through, because it seems to me that although Class I have been coming down since September and then will be double in January, retail and it fairly going in February retail prices have been flat. So with all these discussion today, I suppose the retailers are being persuaded to keep the retail prices high, is that true? And secondly, are you seeing consumers to some extend getting use to in your prices points and as a result the volume declines are being less than before.

Gregg Engles

Yeah. As to the retail price environment in other there are more of factors than the industry's prognostication about low prices that drive that. So, competitive dynamics market-to-market drive it. But I will say this, prices today are within a dollar of the all time high price which translates into a roughly $0.10 a gallon, so you shouldn't have expected to see moves down in the retail environment, because there hasn't been big moves in the underline commodity.

I think the pressures will be very significant as milk prices move down in March particularly were retailers to be competitive at the store level. So, I will be very surprised if prices don't move down. But I think your point is well taken the more uncertainty and the more sense that retailers are going to have to turn right around and take prices back up.

And that does tend to make them more sticky on the way down. So, we very possibly could live in environment where retail prices don't follow exactly the trend of wholesale prices. On the question of is the consumer getting used to these higher prices, if you look at the third quarter where prices really soared and the fourth quarter where they stayed high.

What you saw was a pretty short drop-off in volumes with this incredible run up in price. And then rebound in volumes as I think Mom realized that milk was going to be priced at a higher level and she still had to have it in her refrigerator. So, you do see shifts between brands and private labels as consumer sort out the lower price alternative in this high environment. But this category has a so far remarkable amount of resiliencies as it relates to price.

Pablo Zuanic - J.P. Morgan

And just a follow-up, are you seeing any opportunities for further industry consolidation given the weakness probably which is more acuter I assume for this smaller operators. Although, you guys are more leverage I guess but...

Gregg Engles

Well, we are definitely seeing a bigger pipeline of activity out there. So, 2007 was a year particularly in the back half where we started to see a lot of opportunities, we have as we mentioned, close one will close another here in the first quarter of, nice little tucking acquisitions and those who are buying large entities who just decided that they were better off are focusing on something else rather than on the food and milk business. So we see meaningful pressure in the industry on the margin structures generally and we think that will lead to more opportunities as long as this environment stays, it is difficult to say it is for us to build our business through acquisition.

Pablo Zuanic - J.P. Morgan

Two follow-ups one for you Jack and one for you Greg. Jack any comments on the covenants, I mean, I think it's last 12 months trailing EBITDA, what's the interest rate on sensitivity there if you are going comment on that. I know you gave us interest expense guidance but where are you regarding covenants and for you Greg in the past you have given long term guidance of I believe high-teens operating margins for WhiteWave. Do you want to take a crack at that on the dairy side, I mean, what are the comps that we could be looking at on dairy? Thanks that's all.

Jack Callahan

Well, it's not offered, Pablo back to your question on the covenant. As I mentioned, you know as defined by our covenant agreement, are funded debt EBITDA ratio at the end the year was 5.95 that at the time the covenant was 6.5 times. That covenant does step down to 6.25 times in Q1 and obviously we are looking at that very closely but that we remain committed to remaining compliance with all our covenants and we will do what we and we are staying on top of it.

Gregg Engles

Yeah. As to the margin structure Pablo, I think what we said historically about WhiteWave is that we believe we could generate consumer package goods, sort of operating margins there of mid teens type of operating margins and I believe that over time, we will be able to do so the big wild card is, is Horizon and what the margin structure is going to be there and that's a big and given the growth in category growing part of our portfolio when it does have a lower margin structure than our other brands.

Jack Callahan

Calling a percentage operating margin in the Dairy group is, kind of tough to do because the business really runs on operating profit per gallon or a penny profit as opposed to a percentage margin basis. So as the commodity moves around our margins will move around also.

I would just refer you back to my answer to an earlier question of if prices stabilize at a higher level what do you think that does to our overall profit algorithm, and I think that as these longer term impacts to our profit algorithm get worked out in the marketplace in terms of pricing, I think our algorithm remains essentially the same as how we have historically communicated it. So, if you go back to our trends from '04, '05, '06 and you look at our profit generating capability and our ability to grow profit, we believe that we can return overtime to the levels of profitability that we experienced in that period and that we can grow our profitability from that at a sort of mid-single digits type of rate over time, as we take cost out of our cost base and we continue to drive the top line with winning customers. So that, I think that's the best way I could rephrase our profit algorithm.

Pablo Zuanic - J.P. Morgan

Alright, thanks.

Operator

And we have time for one more question today and that question will be from Pi Aquino with Credit Suisse.

Pi Aquino - Credit Suisse

Good morning.

Gregg Engles

Good morning, Pi.

Pi Aquino - Credit Suisse

I am just turning back to organic really quickly, can you talk about how fast you see organic supply shifting from an over supply situation to under supply because as I understand that it takes one year to convert a cow. So, I would think that that like in the later half of last year you would have a sense for what, the later half of '08 is going to look like. So, I am curious as to how that shift throughout this year and then if it is faster than sort of end of this year, are you really seeing farmers converting back to conventional away from organic?

Gregg Engles

Yeah. I mean we have moved to either balanced or undersupply already. So, that's why you see our pricing in the marketplace moving up, there is no excess supply in the marketplace, demand remains very robust in this category and safety stocks are shrinking quickly. So, the industry is moving to take price to reflect the fact that now demand is outpacing supply.

The question around supply growth has always been a challenging issue because we don't have a lot of visibility into all the small farmers that might be converting and they makeup a significant portion of the potential supply growth. But the factors that will drive supply in '08 the PI will not be so much the pipeline of conversion but whether or not the existing base continues to produce at the level they have been producing or converts back.

So as organic grain cost have soared and prices have not yet moved up, farmers are feeding their cows less and they are producing less per cow. So that is constraining supply. While it takes a year to convert a cow from conventional to organic it takes 45 seconds to convert one from organic to conventional, you just start to feed them conventional feed and they are no longer an organic cow any more.

So, we're already in that where we've got to manage price realization to farmers to keep the supply intact and growing as an industry, and that's where the high degree of in position and our ability to forecast the future of supply comes into balance.

Pi Aquino - Credit Suisse

Okay. And then just my second question if I understood your answer, we have sort of questions in terms of your long-term algorithm, the long term algorithm at least that I recall most recently was a 5% to 6% operating profit growth at Dairy and 15% to 16% at WhiteWave and clearly things have changed in terms of the environment since then but if that algorithm is still in tacked what is it take to get to that point where you can grow like that, is it the capability building that you are doing in house is it just getting to a normalize commodity environment. What kinds of things do we need to get to that point?

Gregg Engles

Yeah, first of all I don't want to lock back down on debt algorithm of earnings growth, I think it's been quite sometime, since we articulated that the size of the WhiteWave business particularly is change meaningful and the organic dynamics are really changed. So, I don't want to call 15% to 16% operating income growth that WhiteWave although I do believe it is a double-digit grower and I think we need to do more we are thinking as this organic milk situation clarifies this after and come back and rearticulate our long-term growth algorithm around WhiteWave.

On the Dairy side, we've got capability that we have to build and we have got investments that we've got to make to take cost out of our supply chain and that's what's going to drive operating profit growth in that business and through that I think we will ultimately drive top line in share growth which we feel with that algorithm as well. And yes, we have to get to a more stable and normalized balance of supplying demand on that conventional side the conventional milk price environment and whatever that resulting price level is got to work it's way into the marketplace in terms of price realization from manufacturers to retailers.

Pi Aquino - Credit Suisse

Got you. And then, just lastly you talked about the consolidation opportunity. Can you remind us again in terms of geographically, in terms of the United States where you can make more meaningful inroads in terms of tucking acquisitions and obviously like in the North East where you can't?

Gregg Engles

Well, I don't want to pre judge how the competitive landscape will impact our ability to make acquisitions. We are not making acquisitions. This landscape is constantly changing as the business of all thing consolidate. So, what I would say is there lots of places in the country where I am confident that we will be able to grow our share and our presence as the industry continues to consolidate and some of that will be able to do by virtue of M&A activities.

Pi Aquino - Credit Suisse

Okay. Thank you.

Gregg Engles

Thanks PI. I would like to thank you all for joining us on this mornings call. 2007 was a year of great challenge and difficulty. We also make significant progress in building out our team and capabilities in our company. For all of the Dean Foods employees on the call I would like to thank them for their result to work through such a unique and challenging year.

We are cautiously optimistic as we enter 2008 that the commodity market will improve as we go through the year. But we still believe there are significant uncertainties in terms of how that, that will play out as we move forward and we are already and excited about tackling the challenges ahead. I would like thank you all for joining us on the call today and we look forward to speaking with you again in May. Thank you.

Operator

And once again that does conclude today's conference we thank you for your participation and have a great day.

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Source: Dean Foods Q4 2007 Earnings Call Transcript
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