This Company's Prospects Are Starting to Spoil

According to a recent Wall Street Journal article, the milk industry sees itself in a crisis, beset on all sides by rising costs, various fad diets, and the rise of alternative milks like soy milk. Per capita milk consumption has been falling for decades, while other dairy products like eggs and butter have mostly held steady.

At the center of the sectoral decline is Dean Foods (NYSE: DF  ) , which I've touched on in other recent articles. Dean is the biggest dairy company in the United States and is at least partially responsible for the problems currently facing the industry. The company has made a number of moves over the years that have changed the face of the industry and dashed some opportunities for investors while creating new ones.

Sour cream
Many of these problems that exist for milk also exist for other dairy products. Butter and eggs are about as tied to the cost of grain for feed as milk is, and have both been vilified at one time or another for their fat and cholesterol content. But while milk consumption fell 30% from 1975 to 2005, egg consumption fell just 7%, and butter consumption only 3%.

That's not to say that close-to-zero growth over 30 years is a good thing -- none of these industries is brimming with opportunities for investors. But milk is in a particularly bad situation. The egg industry, for example, isn't growing much at all, but it's also highly fragmented. Cal-Maine Foods (NASDAQ: CALM  ) is the industry's biggest player, but the company only controls about 19%  of the market. That leaves a lot of room for shareholders to profit as the company grows through acquisitions.

Dean Foods, on the other hand, already controls nearly half the milk market. It accomplished much of the industry's consolidation in the late 1990s, when Suiza Foods acquired 40 smaller dairies  to become the largest operator, and then merged with Dean, its nearest competitor, taking Dean's name in the marriage. Sales nearly tripled  in the short time between the Suiza IPO in 1997 and the Dean merger in 2001, but they have barely doubled  in the decade since. Growth from acquisitions is just too hard to come by now that Dean's nearest competitors include giants like Kraft Foods (NASDAQ: KRFT  ) and Kroger (NYSE: KR  ) , and shareholders have suffered as a result.

Nearing its expiration date
Dean is also partially responsible for another problem facing the milk industry -- competition with alternative milks. In 2002, Dean acquired White Wave, the company that produces the widely popular Silk soy milk, seen by many as a healthier alternative. While it's probable that Silk would have done well on its own, Dean should take some credit for the success of its brand, which grew sales by 64% from 2007 to 2011, compared with just 10% for the company as a whole. In fact, basically all of the company's sales growth during that period came from White Wave.

After a spinoff in October, WhiteWave Foods (NYSE: WWAV  ) is now an operationally separate company, but Dean still owns 86.7% of the stock, allowing it to continue profiting indirectly until it distributes the shares to Dean shareholders in a few months. Given Dean's prospects, it will be less of a spinoff and more of a corporate re-enactment of Doc Holiday's final scene in Tombstone.

Dean currently has about $3.5 billion in long-term debt, more than its entire market cap, although part of the spinoff arrangement with WhiteWave is that the latter company has borrowed  $1.155 billion from Dean and has also guaranteed all of Dean's debt. To further remedy its situation, Dean is selling its Morningstar division, one of the two remaining divisions after the WhiteWave spinoff, for $1.45  billion.

That leaves Dean with just one operating segment -- Fresh Dairy Direct, its most volatile. Fresh Dairy gets 74%  of its sales from fluid milk, leaving the company deeply exposed to the continuing decline in milk demand and the volatility of its cost inputs.

The Foolish bottom line
Spinning WhiteWave off is a good move for shareholders, who no longer have to deal with having the rest of the company weigh it down. But once Dean distributes the WhiteWave shares and completes the sale of Morningstar, there will be little left for investors to be hopeful about.

Dean might not have great prospects, but The Motley Fool's chief investment officer has selected his No. 1 stock for the next year. Find out which stock it is in our brand-new free report: "The Motley Fool's Top Stock for 2013." I invite you to take a copy, free for a limited time. Just click here to access the report and find out the name of this under-the-radar company.


Read/Post Comments (4) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 24, 2012, at 1:02 PM, zaijien wrote:

    According to a recent article in the NYT, without the passage of some kind of farm bill early in the year, milk price could double due to some obscure government formula. The farm bills that have been debated so far both in the house and in the senate haven't been able to bridge the political divide existing in DC, with Republicans saying the Senate version is ... you guessed right ... unbalanced. It is reasonable to expect the introduction of a farm bill to be delayed and to see milk prices increase to abnormal levels as long as no agreement is reached. Likewise, it is reasonable to expect that consumers will postpone milk purchases if they think prices are soon to come down or to reduce them - by half assuming a tight budget - if they think its permanent. In both cases, DF would suffer considerably from that situation should it last more than 1 month and could default on some debt covenants especially interest expenses coverage ratios. With the banks owning the company - I mean being strongly exposed to the downside - they would likely try to reduce their exposure or increase their fees, or both. The leverage effect would leave very little to shareholders and profits could rapidly into losses for a few quarters. I see more downsides than upsides in owning the stock, and I would advise investors to buy puts to protect their downside in the first quarter.

  • Report this Comment On December 24, 2012, at 2:34 PM, CautiousFellow wrote:

    I respectfully disagree with the comment that DF would breach its loan covenants in the event of a short-term spike in milk prices. While the price of fluid milk is set by the USDA, DF has some supply agreements in place which would help blunt any abrupt moves in the class I mover. In addition, DF currently has plenty of headroom under its covenants, and will have even more once the proceeds from the sale of Morningstar are used to pay-down debt. Longer term, milk has always been a consumer staple.

  • Report this Comment On December 25, 2012, at 7:41 PM, zaijien wrote:

    @ Cautious Fellow;

    Thanks for your courteous disagreement. I'll just explain how I came to the conclusion I made there. Consistently with my assumption of 100% price increase and the halving of demand for milk, and together with constant gross margins and SGA, DF would lose 100-200 mm in Q1 should the situation last 3 months. This would make DF default on the rolling 4 quarter cumulative interest coverage ratio. So yes, in normal circumstances there would be enough room, but should the farm bill's introduction take too long, there would be some danger on the horizon. What is going on in DC doesn't make me confident in the ability of congress to come up with bi-partisan solutions in a timely fashion. So for investors in DF who want to hedge the political risk it's a good idea to buy puts now, because it's higher that it has been in a long time. Even if the milk is a staple, I don't know how demand would react to a doubling of the price. It's conceivable that consumers would proportionally reduce their purchases to compensate for the increase in price, while still drinking milk in reasonable amount for its health benefits.

  • Report this Comment On December 26, 2012, at 12:56 PM, whoknows80 wrote:

    Milk consumption isn't dropping quickly enough to press the panic button. While consumption drops, plant closures are happening. This keeps volume high in open plants and many of the plants closing are Deans competitors. Consumption is dropping per person, but population growth will keep it steady.

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