Lukewarm Dean Foods

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It is no secret that Dean Foods (NYSE: DF) has struggled with rising dairy costs over the past year. Management dubbed 2007 the most challenging year in its history, so expectations for first-quarter 2008 earnings were very low. The company managed to clear this low hurdle, even though first-quarter net income came in at less than half of 2007 levels.

Gross margin compression has been very common for consumer products companies this earnings season, especially in companies such as Tyson (NYSE: TSN), Lifeway (Nasdaq: LWAY), and Hershey (NYSE: HSY). Even among this crowd, Dean's gross margin decline from 26% to 22% stood out. As an investor I have always had trouble getting too enthusiastic about Dean's core fluid dairy business; much like Tyson, it has little control over either the price of its inputs or the price it gets for its finished products. Not surprisingly, the current environment has crushed the company's profit margins. But shouldn't the slight upside surprise suggest an improved outlook?

Don't bet the farm on it, or even a couple of the milking cows. Dean CEO Gregg Engles made a point of dampening investor expectations well into the future. The company's press release contained this ray of sunshine, "It's clear that our results this year will largely be driven by the commodity markets, which remain highly unsettled and inflationary." Translation: Things look bad, and could get much, much worse, but there's nothing we can do. Sorry!

Engles then dropped this gem of management-speak, "Longer term, we expect our transformational efforts to increasingly drive our results." I think he is vaguely referencing the company's efforts to make its branded operations such as White Wave and Morningstar Farms, which are now a single division, into a more predictable and meaningful profit-driver for the company over the next few years. But he left just enough wiggle room to make the statement essentially meaningless, while still hinting at hope on the horizon. Vaguery from management in tough times always makes me nervous.

The industry may also be facing an undersupply of organic milk in the coming months, not good news for Dean's thriving Horizon brand. This could be eased by a softening in demand as consumers decide to swallow a little bovine growth hormone and antibiotics instead of a $6 price tag for a gallon of organic milk, but either situation is not particularly good news for Dean shareholders. Dean also suffers from being largely dependent on the American consumer, and the risk-reward ratio at this point is not particularly attractive.

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