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Kraft and Dean Foods Hope to Make Money on Milk Margins

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Kraft Foods (UNKNOWN: KRFT.DL  ) , Dean Foods (NYSE: DF  ) and other food manufacturers are watching the activity in Washington as the legislature works to renew the Farm Bill with several proposed changes. These food companies are the major consumers of many farm products, and the sourcing, prices, and supply of these products are always major components in the Farm Bill. Revisions currently being considered in both the House and Senate may have direct consequences to farm product prices, and milk prices¬†in particular, which would likely lead to either changes in consumer food prices or changes in the realized margins for food manufacturers.

The current milk market
Producers are paid different prices for their milk depending on regional production costs, milk supply and demand, and the intended end use of the milk. In general, producers are paid the most for milk that goes into the carton, and less for milk that is processed further, like in the making of cheese.

The largest food processing companies depend on the existing milk pricing structure to ensure profitable margins on foodstuffs that require more extensive processing. Though based out of Switzerland, Nestle (NASDAQOTH: NSRGY  ) has multiple plants across the U.S. that purchase copious amounts of domestic milk. Dividing out the milk-dependent segments of Nestle's huge portfolio is challenging because it is a major ingredient in an array of sector-crossing products including chocolate, frozen pizza, powdered baby formula, and premium ice cream. In every case, the milk is heavily processed and, accordingly, is purchased relatively cheaply.

Kraft Foods also purchases domestic milk with the intent to always process the milk further, typically into cheese-like items such as Velveeta and the iconic Kraft Macaroni & Cheese. Like Nestle, tiered milk pricing depending on its end use plays an important role in sourcing decisions and the resulting consumer prices. Dean Foods is on the other end of the milk spectrum as the largest domestic processor of fluid milk, though the company is also heavily involved in processed cheese and ice cream products.

Milk revisions in the farm bill
The largest point of contention in the current Farm Bill debate for these producers is the Dairy Milk Stabilization Program component within the Dairy Security Act that was included and passed in a Senate version of the bill, but rejected by the House. The intent of the provision is to protect dairy producer margins by limiting milk supply and surplus milk products when milk prices drop and feed crop prices increase. Opponents argue that the protection for farmers may come at the taxpayers' expense in the form of higher prices for staple food products, a concern that is compounded by the dependence of many federally subsidized programs (food stamps and school meals, among others) on milk and milk-based products.

The effects on margins
The largest supporters of the Dairy Security Act are dairy coops, including Dairy Farmers of America, (a major supplier for Dean Foods) looking for margin insurance and market stabilization. The major opponents of the bill are the largest food producers, disguising their arguments against the provision as looking after the interests of the consumer. Implicit in their arguments are concerns over increasing milk prices that could cut into margins. In reality, their distaste for revisions to the Farm Bill stem from a lust for the status quo dairy program that ensures low milk prices for food processors regardless of market conditions.

A bigger concern to food producers and consumers alike is the risk of the Farm Bill not being renewed in time due to extended debate and political ploying over the milk provision and several subsidy programs. Should this happen, the existing dairy supports would expire in 2014 and lead to higher milk prices, hurting farmers and processors alike.

Should the Dairy Security Act be passed, the likely effects on Kraft, Dean Foods, and Nestle, and in turn on consumers, are overblown. Milk prices may see small incremental increases, but the costs are likely to be passed on to consumers, rather than affect the margins of food processors. Kraft and Nestle are primed to continue their growth seen in the past year, regardless of what version of the Farm Bill is passed, while Dean Foods may be more affected by the Dairy Security Act as the company also struggles to deal with projected declining annual sales.

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