It was a mixed first quarter for Dean Foods (DF), which in some ways could be considered positive. Last quarter, I disagreed with contrarians feeling bullish on the company, citing four different reasons the company was facing both short- and long-term difficulties. This quarter, there are some signs of life, but I still feel investors should steer clear.
The (continuing) bear case
First, the numbers: Dean experienced an adjusted loss of $5 million this quarter, versus a $30 million gain last year. Despite a 2.1% gain in sales, gross profit fell by 16%. Long-term debt, long a problem for Dean, grew by 7.4%.
It's tempting to see the small gain in sales as a positive, but it comes from the same reason for the decline in gross profit -- higher raw milk costs. Raw milk is currently at a record high, allowing Dean to pass some of that cost on to consumers and thus raise total sales, but not enough to offset its own costs, leading to its gross margin almost getting cut in half.
Dean's sales in terms of volume is actually down sharply due to the loss of a major customer -- the most major customer in the grocery industry -- as well as another customer's decision to vertically integrate its business. Management made sure to point out that excluding those major losses, volume is up 1.1% compared to a decline of 2.1% for the total industry, but that feels a little like saying, "I broke my leg but at least this flu is getting better."
Because of these continuing challenges, management lowered full-year guidance from a low of $0.73 per share to $0.60, although they kept free cash flow guidance at $125 million. At today's enterprise value, that will put the company at an EV-to-free cash flow ratio of close to 20, not outrageous but certainly too high for a company losing customers in an already-declining industry.
The (contrarian) bull case
The crux of the contrarian case is that raw milk prices, now at a record high, are rising more slowly. While prices this quarter were 22% higher than last year, they were only 12% higher than last quarter. Recent data from the USDA actually shows the price of raw milk dropping slightly for the first time since April of last year.
If prices start falling to their historical average, that should be a great boon for Dean and will allow its margin to move closer to its own historical average. Currently just below 20%, the company's gross margin has fluctuated between 22.5% and 27.5% for the last 10 years, but it began its steady decline long before milk prices started exploding. Still, the company has been trying to respond and cut costs by closing plants, eight in 2013 and three more planned.
U.S. Producer Price Index: Farm Products: Raw Milk. Source: YCharts.
Another point in the bull case is that within a couple of quarters, the difficult comparisons to last year will start to drop off. Investors who get in at the rock bottom may see gains as easier comparisons create the appearance of growth.
The Foolish bottom line
At some point, Dean's volume losses and falling profits will drop off, and investors will forget that Dean recently lost two large customers and can't keep demand high enough to offset costs. However, it's important to remember that, for one thing, the milk industry has been in a state of multi-decade decline. Dean might get volumes up a few percent here and there, but it's not likely to ever see any real growth. The industry is also extremely cyclical, and there's little Dean can do when costs get out of control, nor is there much investors can do to see it coming. Investors would be wise to focus on an industry with more potential.
