Price: $15.96

Intrinsic value estimate: $23.00 (50% upside)

Market cap: $1.5bn

Enterprise value: $2.3bn

2015e FCF multiple: ~5x

Net debt/LTM EBITDA: 2.2x

Price/normalized FCF: ~8x

 

EXECUTIVE SUMMARY: RECOMMEND PURCHASE OF EQUITY

1. DF is a cheap stock with approximately 50% upside to intrinsic value and visible external catalysts to move the stock within 18 months, and likely sooner. My perception of Dean differs importantly from the Street’s. Milk volumes are weak, and this keeps analysts lukewarm on the idea, but there is more to the company’s profitability than simply how many gallons of milk are consumed by Americans.
2. The price of raw milk, which is by far the biggest determinant of input cost for Dean, will face significant downward pressure factors in the coming year or two. This will have a magnified positive impact on Dean’s earnings.
3. The company is the low-cost competitor, and the scale player by a huge margin, in a commodity market. Many of its competitors are unprofitable under current market conditions and excess industry capacity is being closed at an accelerating pace. While some competitors are able to operate at lower profitability, the currently horrendous operating conditions in the dairy processing industry are necessitating capacity closures by competitors at a significantly accelerated rate. The current industry loss levels are not sustainable, and Dean will benefit from weaker players’ capitulation.
4. The company itself is taking proactive steps to close its own high-cost capacity, which will expand margins from their current trough levels.
5. Analysts are mis-modeling Dean’s earnings for 2015 and beyond. My edge is based in my view that current industry conditions are unsustainably bad and do not reflect normalized conditions (long run this is good for Dean), and that raw milk prices are unsustainably high and are going to be pressed down in the next year or so (short run this is fantastic for Dean).
6. Milk consumption is in secular decline per capita. This is not the same thing as being in terminal decline, nor is it the same thing as being in absolute decline. Many analysts seem to omit this important difference. Lastly, Dean has taken and should continue to take share, offsetting some effects of industry declines.

My area of biggest divergence from the Street is in 2015. While the Street models $217mm in operating profit in that year, I model $495mm.

The main risk to think about with Dean is that milk consumption in the US has been flattish for decades – falling per capita consumption offset by rising population. To the extent the industry shrinks faster in the future, this would drive negative operating leverage for Dean. Dean’s balance sheet and competitive position are strong and present little risk.

 

BUSINESS DESCRIPTION

Dean is a dairy processor, meaning that it buys raw milk from dairy farms and turns it into finished consumables such as white milk, chocolate milk, or other dairy-based products (usually one of these first two). It was created by the merger of Suiza and Dean Foods, two U.S. dairy companies, in the 1990s and was a prominent consolidator of dairy processing capacity in that decade. Dean has rolled up numerous brands around the country, all of which are local or regional, as consumer-ready milk is not a commodity that travels long distances well.

Dean now controls just under 40% market share in dairy processing in the United States. It does not operate outside of the U.S. In the areas where most American investment analysts are based, recognizable brand names owned by Dean Foods might include Garelick Farms, Tuscan Dairy Farms, Lehigh Valley, and Berkeley Farms.

The drivers of revenue for Dean are gallons of milk sold, and price received per gallon of milk. Key input costs are conventional milk which consists of raw milk and butterfat, resin for packaging, fuel, labor, and depreciation. The company breaks out most shipping and handling costs as a separate line item below the gross profit line and this is mostly comprised of transport costs.

Dean sells via a Direct Store Delivery, or DSD, model, meaning its trucks bring milk to the stores, schools, and institutions to whom it sells. Pricing in most contracts is reset on a monthly basis, whereas Dean’s purchases of conventional milk to make its products are done on a spot basis. In a minority of Dean sales contracts, prices are reset every 4-8 weeks or so, and in school milk, which is about 5-10% of cases, the sales pricing is struck once a year.

One thing to note is that Dean is NOT an operator of dairy farms. The dairy farms are the entities that own and milk the cows; their milk is sold either directly to processors or through dairy cooperatives, which are group selling organizations formed to give dairy farmers some scale-driven bargaining power with the dairy processing industry. Dairy processors such as Dean then sell the finished dairy products to retailers such as large-format stores (Wal-Mart, Target, etc.), grocers, schools, etc.

 

CURRENT OPERATING ENVIRONMENT AND TEMPORARY DISLOCATION FACTORS

The dairy processing industry is hurting. Milk consumption per capita in the U.S. has been falling since the 1970s, and the population growth offsets this amount just enough to keep long-term milk consumption roughly flat. This is largely because of the proliferation of, and share take by, alternatives such as (first) sodas and (later) conventional milk substitutes such as organic milk, soy and almond milk, etc.

At the same time, Dean has estimated that there is 30-35% excess capacity in the dairy processing industry that needs to be taken out for the industry to achieve equilibrium. (This is probably something of a stretch, as Dean has always been able to earn a positive return on capital, albeit in the 5-8% range in most years, and Dean will always argue for capacity takeouts by competitors for obvious reasons.) What is abundantly clear is that current operating conditions demonstrate a significant excess of capacity, and given that Dean has guided for breakeven profitability this quarter, a large if not majority portion of its competitors are almost certainly losing money.

Said another way, Dean earned a (20-year trough) gross margin of ~21% last year, and it is the low-cost competitor in the marketplace. At this level of gross margin, Dean can earn a ~2% EBIT margin. Management has found through M&A diligence over the years that, thanks to its scale, its operating costs tend to be 10-15% lower than its smaller competitors (more on the reasons for this later). If Dean’s operating cost profile looked more like these competitors, it would be significantly in the red under these conditions.

This theoretical concept is verified by the reality of sharply increased industry capacity closures – 12 plants were closed in 2013 versus an average over the past decade of 4-5/year.

Some of Dean’s poor performance in 2013 can be attributed to the loss of an important contract with Wal-Mart. In late 2012, Wal-Mart put out an RFP on a distribution center (DC)-by-DC basis for its private label milk business. Dean is by far the largest national player and the low-cost player on average nationwide, but it is not necessarily the low-cost player in every single region. So, in some cases it won the bids, and in some cases it was unable or unwilling to go any lower on price. This led to the loss of key Wal-Mart business in certain localities, which drove down capacity utilization at plants whose locations were largely based on proximity to Wal-Mart. Dean has commented on certain plants’ utilizations being as low as 50% after losing this business. This led to Dean deciding to close down the plants that were put into the worst-performing category as a result of this revenue loss.

Clearly this development was a serious negative for Dean, but what does this mean for the business going forward? One way to think about this is as a “manifestation” of Dean’s cost position; that is to say, when bidding got very competitive, Dean stayed in the localities where it was the low-cost player, and it is leaving the localities in which it couldn’t compete. Now that the worst plants are in the process of being closed, Dean’s remaining portfolio of plants is lower-cost on average than it was before, so its overall place on the cost curve is lower (better) than before. The Wal-Mart event has largely de-risked this aspect of the investment for us and removed at least some of the question of where Dean may need to close plants.

The loss of some – not all – Wal-Mart private label milk business also caused gross margins to slide substantially for several quarters until the plant closures are completed (management estimates that by mid-2014 the benefits of the production shutdowns and reallocations will start to show up). This, along with high and rising raw milk prices, has depressed earnings and led analysts to extrapolate low gross margins indefinitely into the future. The current gross margin environment and guidance reflect several negative, temporary aspects of Dean’s specific business and of milk processing industry conditions, so the sell side appears to start at today’s terrible gross margins, and notch upward to merely bad ones in the future.

First, high (not specifically rising, but high) raw milk prices are bad for milk volume consumption and for shrinkage cost. Milk is a rather inelastic foodstuff; when raw milk prices are relatively high, consumers of milk respond by buying less of it. Milk has risen approximately 105% in price since the low in mid-2009, and by nearly 60% even since early 2007. This has been a mild negative for milk volumes. In addition to its impact on the revenue side, relatively high milk prices mean that the cost of shrink – that is, spillage and waste in the processing of milk – is also relatively high. With milk twice as expensive as it was in 2009, it costs twice as much to throw away a bad vat of milk during processing, even though the gross profit per gallon at sale is not higher, as the markup to retailers is made on a cents, not percent, basis.

Secondly, as discussed above, the gradual loss of Wal-Mart business through 2013 was not replaced in the local plants which had been serving Wal-Mart. COGS overhead per gallon of milk sold increased sharply for these plants, leading to the closures we have been seeing in Dean’s portfolio. Dean’s volumes fell 7% in 2013, even in spite of some share take, which is by a mile the biggest organic volume drop the company has seen in relevant history. The closure of plants in response to this will bring about a recovery in gross margins, albeit on a smaller base from which to generate the earnings on which we can put a multiple.

Thirdly, raw milk prices have lately been surging, again, and are expected to end Q114 nearly 10% higher than they ended Q413. This is terrible for gross margins, as a historical analysis of raw milk prices versus gross profit per gallon will demonstrate convincingly.

In light of all these factors, Dean is facing a terrible Q114 and a difficult 2014 in general. Analysts model gross margin for Dean of 20.3% in 2014, which is not surprising. The problem is that they continue to model Dean as underearning in every year after that, even though today’s issues are temporary in nature.

 

THOUGHTS ON PRIVATE LABEL PENETRATION AND RETAILER GROWTH RISK

One reasonable question to ask about the current profitability for Dean is whether historical growth in private label as a percentage of sales and consolidation in the retailer industry by big box players has caused a secular shift downward in pricing power. I believe that the answer is no.

One can dig through historical 10-K’s going back to 2003 to observe the percentage of business from private label, and in a separate breakdown, the percentage of business from retailers. This is not the most visually appealing format to plot out historical numbers, but if anyone wants the underlying data to plot out in Excel:

% of Dairy Group Business from Private Label 2003-2013: 44%, 44%, 38%, 37%, 40%, 48%, 53%, 56%, 53%, 53%, 52%.

% of Dairy Group Business from Retailers 2003-2013: 52%, 60%, 60%, 61%, 59%, 64%, 63%, 60%, 67%, 66%, 64%.

Gross Margin of Dairy Group 2003-2013: 26%, 23%, 24%, 26%, 22%, 23%, 27%, 24%, 22%, 23%, 21%.

Raw Milk Input Cost Change 2003-2013 (est.): +36%, +2%, -3%, -12%, +69%, -23%, -19%, +30%, +11%, +8%, -2%. (Unusual years include 2003, in which the vast majority of the price increase took place in Q4, and 2013, in which prices fell -10% in Q1 and rose steadily afterwards.)

There are multiple coincident factors here, but we can draw a few simple conclusions:

-          Private label and retailer penetration hit a step function upward in 2008. For the past five years, these numbers have barely moved from first to last year.

-          The average gross margin from 2003-2007 was about 0.6% higher than the average gross margin from 2008-2013.

-          Raw milk prices have had an unusually consistent move upward from 2010 on, excluding the correction in Q113. This has pressured gross margins in this period.

Looking at these conclusions together, it is hard to conclude that a strong increase in private label and retailer penetration has seriously damaged gross margin potential for Dean, or that penetration is bound to increase substantially in the near term.

One additional thought is worth consideration. Imagine that private label and retailer penetration increased to 100% tomorrow, and imagine that this were devastating to industry gross margins up front. The dairy processing industry would undergo a bloodbath. Marginal capacity all around the country would close. Dean would lose money, but its competitors would lose much more until they were run right out of business. Pricing power would ultimately swing back toward the suppliers (i.e. Dean) as the competition died off. Gross margins below a certain level are not sustainable for the dairy processing industry; this is simple supply/demand economics, nothing more complex than that. As long as Dean sits at the bottom of the cost curve selling a necessary commodity, it’s going to be able to earn a decent economic profit in the long run.

Because of its much greater scale – its largest competitor is ¼ its size – Dean’s competitive advantage is sustainable. Conversations with analysts, management, and bottled beverage industry professionals indicate real scale benefits for resin purchasing, bottle manufacture, and network optimization. It would be virtually impossible for the many smaller players in the dairy processing industry to achieve these scale benefits, even with substantial consolidation. It also borders on the absurd to think that new competition might enter an industry with such poor current profitability, excess capacity, and weak growth prospects.

 

THESIS

1. I estimate that Dean is worth $23/share based on an estimate of normalized earnings power and the assumption that the “new normal” of operating profit per gallon is substantially below the ten-year average.
2. I expect the relevant catalysts to bring the stock to this price before the end of 2015.
3. Dean is the low-cost competitor in its market, and this protects the company in the event that the commodity catalyst (downward raw milk prices) does not materialize. This aspect of the thesis helps to ensure that if I am completely wrong on the long run path of raw milk prices, the invisible hand will correct industry profitability in time anyway.
4. Analysts are drastically underestimating Dean’s earnings power in future years.

 

VALUATION DISCUSSION

Note that when looking at Dean’s historical and projected earnings power, we have to strip out other businesses that Dean previously owned – namely WhiteWave and Morningstar. Dean is now a pure-play on its traditional dairy operations. It is possible to discern historical gross margins, and gross profit per gallon, for the ongoing dairy business.

I cannot upload my model here, but the basics of my estimates are as follows:

1. Raw milk prices correcting sharply in late 2014 and through 2015 (see “Catalysts” section for explanation of why this is very likely)
2. Gross profit per gallon of a high 77c in 2015, and 70c thereafter as a long-run average for intrinsic valuation purposes
3. Weak volumes, with a small bump in 2015 as milk gets cheaper. Note that Dean’s volume growth generally exceeds that of the industry, as the company takes share from higher-cost/smaller competitors on a regular basis. Also, while milk volumes have been falling for several years and the long-run growth prospects for the industry are poor, we cannot assume volume declines in perpetuity for a basic foodstuff
4. ASPs that track and lag changes in raw milk prices, although with much less absolute movement
5. Variable selling and distribution costs; flat G&A costs
6. Massive overearning in 2015; substantially higher earning in “the long run” than today
7. “Long run” or “normalized” ROIC in the mid-single digits. This is an output that functions as a sanity check; if it were high, I would be concerned

My estimates yield a 2017, or “normalized,” FCF multiple of 7.7x, and a 2017 EV/EBITDA multiple of 5.1x. I assume that a multiple of normalized FCF of 12.0x (8.3% equity yield) is appropriate for a low-growth, but consistently profitable, business, which offers 50-55% upside from today’s market cap of $1.4bn.

 

CATALYSTS

There are two key catalysts here, one nearer-term and one longer-term. They somewhat offset one another – that is, if the first one fails to play out, the second one will be more likely.

1. The longer-term catalyst is the continued normalization of processing industry capacity. From my conversations with sell-side analysts, it’s clear the consensus is something along the lines of “Dairy processors are mostly small family operations and they don’t want to close down, so they stick it out.” I wonder if these analysts would be surprised to find out that nobody ever wants to go out of business, whether they run a large or a small operation. Regardless, it happens. The rate of closure has sped up in the past 12 months, and this was before sharp spikes in raw milk prices in Q413/Q114 made industry conditions even worse.
2. As equity analysts, most of us probably find it easier to bet on industry profit and capacity dynamics than on global commodity dynamics. That said, the argument for the second catalyst is deceptively simple, and we would do well not to overcomplicate it. Raw milk prices are unsustainably high and farmers around the world are signaling increased production to cure these high prices.

There are several key global signals that demonstrate what the supply response will be.  The first five pages of this report are the best of the many sources I reviewed to distill this part of the thesis into a simple conclusion: http://apps.fas.usda.gov/psdonline/circulars/dairy.pdf

As a backdrop, note that there are a few major milk powder exporting countries (milk powder being the globally shipped version of raw milk). New Zealand, despite being less than 10% of this group’s production, is the largest exporter because of its tiny population and large number of cows. The EU, despite being over half of this group’s production, exports less because it consumes most of its production internally. The US is a swing producer. Argentina and Australia round the group out. (This table can be found on page three of the report above.) China produces plenty of raw milk, but it is a major importer as opposed to an exporter given its demand level.

So, what’s going on in each country today? Why, in 2013, did we see the first year of zero growth in milk production since at least 2005? And what is the outlook going forward?

Shocks in milk demand globally don’t really occur (think about it), but there can be serious global supply shocks. I am taking a supply-side perspective on the global balance.

In New Zealand, a short but massive drought in 2013 damaged output substantially. New Zealand economists predict a massive increase in milk production in 2014. According to http://www.businessweek.com/news/2014-02-26/new-zealand-gathers-pace-as-dairy-farmers-fuel-trade-economy, New Zealand economists expect that the rebound in dairy production will add 2.6% to total New Zealand GDP in 2014. That’s not 2.6% of dairy production, and it’s not even 2.6% of total New Zealand exports, it’s 2.6% of total New Zealand GDP…

The EU, which is by far the largest producer of milk worldwide, has had a quota system in place since the 1980s. This quota system comes to an end in April 2015: http://ec.europa.eu/agriculture/events/dairy-conference-2013_en.htm This is huge. This quota expiration has been planned for years and just happens to coincide with an environment of high milk prices.

We are already seeing evidence of EU farmers ramping up investment in dairy capacity in anticipation of having the ability to produce and sell freely for the first time in their careers. High prices today are also leading to some farmers deciding to produce despite having to pay fines to do so: http://www.bloomberg.com/news/2014-02-26/eu-fines-no-bar-to-milk-output-gain-as-price-surges-commodities.html

Australia expects a 3x increase in dairy farm income due to dynamics similar to those in New Zealand of normal weather/normal production returning. We do not have to speculate about the incentive for dairy farmers under these conditions and their implications for milk production: http://www.theaustralian.com.au/news/nation/dairy-farmers-making-up-for-the-horror-year-of-2013/story-e6frg6nf-1226845261723

Same in the US, where dairy farming is the bright spot in the farming outlook for 2014: http://www.ers.usda.gov/topics/farm-economy/farm-sector-income-finances/farm-business-income.aspx#.UzWi0KhdV8F There is a strong correlation, as evidenced by USDA/Univ of Wisconsin research (reproduced by Goldman), between dairy farm profit margins and the expansion of cow herds.

In China, unrelated poor production of forage crops led to a substantial drop in raw milk production in 2013: http://english.eastday.com/e/140209/u1a7923868.html China is also rebuilding its cow herds after high beef prices in prior years led to increased culling (slaughter rates). This rebuilding process takes 12-18 months and will continue through 2014, adding to supply until internal Chinese demand is met. Chinese dairy farm investment is booming and there is no shortage of public material available online about this.

Meanwhile, with all of these factors pointing in the same direction for eventual recovery of dairy supply, tight supply conditions this quarter continue to push prices up sharply. The supply response, from an equity investing timeline perspective, is just around the corner.

So, what happens when raw milk prices move sharply? Looking at Dean’s historical dairy gross profitability on a quarterly basis – which is more relevant and more instructive than on an annual basis – we see, not surprisingly, that sharply moving raw milk prices have an inverse effect on gross profits. This is because Dean purchases inventory at the spot price, but sells it with one-month, 2-month, or in a few cases, 9-month contracts. Even intra-quarter, there is a lag effect, and because raw/conventional milk  prices are so volatile, this effect can be substantial. Therefore, I expect that in 2015 (or possibly sooner), Dean’s earnings are likely to exceed consensus numbers by a massive margin.

Although my positive outlook for earnings over the next 12 to 18 months offers the potential for rapid stock price appreciation, I also believe that Dean is fundamentally mispriced relative to its intrinsic value. This has much more to do with the present value of the amount Dean can earn over many years to come than with its ability to overearn for a few quarters.

 

EDGE

I believe that my edge on this name comes from several items:

1. My appreciation of the raw milk supply/demand dynamics and their relevance to value investors today appears to be a contrarian view. Analysts on the sell side have told me that they prefer not to make guesses on commodity prices more than one year out, so they model flat raw milk prices. They are focused on the company-specific parts of the margin story – Dean talks a good game about optimizing its business and squeezing out as much gross margin as possible, and analysts ape that – but I believe that the logic of supply and demand of milk prices is a much more important, and more impactful, factor than management’s actions to trim costs around the edges. (Note that wholesale plant closures are a different, bigger beast.)
2. Most analysts don’t appreciate the scale and impact of the potential of industry capacity rationalization. I think that the argument that small producers don’t “want” to shut down family businesses, and therefore family dairy processing businesses won’t be shut down, is asinine. It’s also not playing out.
3. I do not believe that Dean can get back to historically average operating profit per gallon, but I do believe that it can get back to historically average gross profit per gallon. Operating profit per gallon is likely permanently impaired due to negative operating leverage, but gross profit per gallon is stickier. I expect that Dean can drive 70 cents per gallon of gross profit, which is the average from 2004-2013. Dean did 66 cents per gallon in 2013, which was possibly its worst year on record and included a massive one-time customer loss. At 2013 levels of profitability, EBITDA margins were 4%. It would stand to reason that retailer customers would accept an EBITDA margin of 5% by their suppliers – margins are higher for other food companies selling to similar customers – and this is the EBITDA margin that follows from my estimates for normalized conditions. Analyst estimates of 21% gross margin do not allow for this return to normalcy over time.

I expect that raw milk prices will correct in the coming months due to an enormous, international supply response. This, plus closures of underutilized plants through 2014, will cause Dean to swing from underearning to overearning. To the extent this first catalyst does not play out rapidly and convincingly, the second catalyst will be the continuation of the long-awaited removal of competitor capacity. These are 2015-or-sooner events.