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WhiteWave Spinoff Creates a Dean Foods Buy Opportunity

By Michael Lewis - Apr 1, 2013 at 8:51PM

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In classic spinoff style, buried in this deal lies a hidden value in the underfollowed party.

In the past year, longtime dairy purveyor Dean Foods (DF) kicked into gear a plan to shed assets and reduce the company's intimidating debt load. That meant selling off a subsidiary, Morningstar Farms, and spinning off another, WhiteWave Foods (WWAV). Most would argue that this leaves parent company Dean with the unappealing fresh-milk business -- an industry under tremendous pricing pressure and a declining milk-drinker population. But in true special-situation fashion, there is buried value in Dean Foods that will materialize in the next couple of months. For those interested in a relatively short-term play with minimal downside risk, Dean Foods may be the perfect addition to your portfolio.

3 to 1: a brief history into Dean Foods' breakdown
Dean Foods is in the midst of a multiyear transition aimed at cutting costs, reducing debt, and improving overall operating efficiency. In reality, that can often mean very little and leave optimistic investors in the dust, but this particular restructuring has allowed for an interesting opportunity that the market has forgotten. First, let's catch up on what Dean is doing.

Over the years, Dean Foods has amassed a substantial amount of debt. While it doesn't use the industry standard leverage ratio, the company was operating at a ratio of 3.71 debt-to-equity. For a low-margin business that may have periods of cash deprivation, this could leave analysts and investors worried about the company's ability to fulfill debt obligations.

Luckily, management is aware that exorbitant debt is not the ideal situation to be in. The company sold its Morningstar Farm division to Canadian food company Saputo for $1.45 billion. This gave the company a net benefit of $887 million, used almost exclusively to pay down debt. Shortly following, the company announced the spinoff of plant-based-foods company WhiteWave. It came out of the IPO gates with a rich valuation and has struggled to provide investors with the returns they wanted. The spun-off company has some phenomenal, high-growth brands that will benefit from the explosive growth in health-oriented groceries, but its initial valuation was just too high to send the stock higher on anything but supersonic growth.

That left Dean Foods as a pure fresh-milk business -- one that was uninteresting to Wall Street given its tight margins and limited forecast. But that's precisely where things get interesting.

(A note regarding debt-to-equity: Dean Foods' management doesn't use the typical debt-to-equity ratio as its leverage ratio. As stated in the company's SEC filings, leverage ratio is calculated as "the ratio of consolidated funded indebtedness, less cash up to $100 million to the extent held by us and our restricted subsidiaries, to consolidated EBITDA for the period of four consecutive fiscal quarters.")

Greenblatt-esque spinoff
Superstar investor Joel Greenblatt wrote a fantastic investing book called, atrociously, You Can Be a Stock Market Genius. Tacky titling aside, the book outlined how special situations and spinoffs often outperform the market and are a formidable value strategy for the astute investor. The practice involves keeping a hawk's eye on spinoff proceedings and figuring out just how the process goes down.

Upon the WhiteWave initial offering, Dean Foods owned nearly 90% of the outstanding shares. As of the company's last earnings release, it still owned just over 85% of the spin-off. At today's price of $16.93, that represents a position worth $2.54 billion. That $2.54 billion implies that the market finds Dean Foods' remaining business to be worth $830 million.

In 2012, management estimated that Dean Foods' fresh-dairy business generated an operating income (adjusted) of $446 million. Simple math shows price to operating income of just 1.9. Let's compare that with other food companies. Kraft Foods (KRFT.DL) trades at 11.43 times operating income. Spinoff WhiteWave trades at more than 16 times the same ratio.

Clearly, Dean Foods' Fresh Dairy Direct business trades at a severe discount to other food businesses, even when accounting for the difficult trends in the dairy industry and high debt levels. But this is where I was stumped. Because if you were to buy Dean Foods' shares today, you would soon be given WhiteWave shares (as part of the parent company's continuing divestiture), which are richly valued and have already struggled in maintaining IPO price. Luckily, in a SumZero article, a fund manager made a similar pitch, but with a solution to the spinoff awards.

In the article, the author suggests buying Dean Foods' shares while shorting an equivalent amount of WhiteWave shares, thus creating a manufactured share of Dean Foods Fresh Dairy Direct. Once the market looks at a standalone Dean Foods Fresh Dairy Direct, it should issue multiple correction to come closer in line with industry average.

A little complicated, but numbers don't lie
The idea may sound a little funky, but such a substantial discount to the industry average provides a strong margin of safety. Even with mild correction, Dean Foods' dairy business should be worth substantially more than the market currently estimates. Even if the business deteriorates in the coming year, which it very well may given tough pricing conditions, the drastic difference in valuation more then compensates.

For an investor seeking a unique and underfollowed investment opportunity, Dean Foods could prove to be a lucrative short-term play.

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