Rising Star Buy: Dean Foods

I think the analysts are calling this one too late.

Jim Mueller, CFA
Jim Mueller, CFA
Dec 21, 2010 at 12:00AM

This article is part of our Rising Stars Portfolios series.

It sure takes a long time to build out a portfolio. At least if you're like me. We're seven weeks in and I've not even put $2,000 to work out of the $17,000 The Motley Fool is letting me manage. But that's OK; like Aesop, I believe that slow and steady wins the race.

For my Messed-Up Expectations (MUE) portfolio, I'm trying to find companies that the market believes, based on current price, will grow very little, if at all, for all of time going forward. After digging in further, if I believe that the company is, in fact, not dead yet, I'll buy some and let the company prove itself to the market.

So far it's working. PowerOne is up 23% since I purchased it, and my two positions in Transocean (NYSE: RIG) are up 9.4% and down 1.1%, as of last night's close. That's especially pleasing to see because it means shares are recovering from the drop after news that the U.S. government had named Transocean in the government's civil lawsuit on the Gulf oil spill. Left-for-dead game retailer GameStop is up 6%. My last pick, specialty-truck builder Oshkosh, is essentially flat.

What's next
Today, I think I've found another MUE candidate: Dean Foods (NYSE: DF). This manufacturer of milk, ice cream, soy milk, butter, and cheese -- you might recognize its Silk, Mayfield, Garelick, or Meadow Gold brands -- is currently disliked by the market so much that it is expected to shrink and never grow again.

There's plenty of reason for that view. Two trends have been hurting the company's margins. First, during the recession, retailers lowered the price of house-brand milk dramatically in an attempt to improve store traffic. Right now, the price is sitting at multiyear lows. This puts pressure on Dean Foods because it is the manufacturer for a lot of that milk, so it has to accept lower margins. Plus, it has to remain competitive on its branded milk, so those margins have been hurt, too. And consumers have been "trading down," going for the less expensive milk.

As if that weren't enough, milk purchases by volume have been declining year-over-year for the last three quarters.

Second, the price of raw milk and butterfat, two primary inputs into Dean's products, have been increasing. Not good.

Sounds dire, why are you interested?
Three reasons lead me to believe that this is a MUE.

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First, in response to the above pressures, Dean Foods is in the middle of a multiyear cost-cutting program. So far, management has squeezed out $175 million in savings by, for instance, reworking its delivery routes and closing several production plants. Management expects to realize savings of $100 million annually through the next three to five years. This will have a direct effect on the bottom line.

Second, trends are reversing. For one, consumers are spending more. Grocer Kroger (NYSE: KR), for example, just reported a 2.4% increase in same-store sales (not including fuel sales) for November. And, two, raw milk prices are expected to come down in the first half of next year, relieving some of the pressure. While that will help in the short term, Dean Foods is working to avoid this sort of problem in the future.

Third, analysts often tell us where we've been, not where we're going. Wells Fargo kept its outperform rating after Dean reported third-quarter results, but lowered its share target price from $12-$13 down to $10-$11. Credit Suisse downgraded the company from neutral to underperform after Q3 results came out. Yes, the company has issues to deal with, but I think these guys are late on their calls.

Now what?
Right now, the market is expecting Dean Foods to shrink free cash flow (FCF) by 3.9% per year over the next five years, by 1.9% annually over the following five years, and then never grow again (discounting at my 15% hurdle rate). If the company can actually manage to grow FCF instead of shrink it, say by 2% annually for five years and 1% for five more years, before flatlining, the expected price would be about 33% higher than it is now. Given its cost-cutting program and more confident consumers, I think that's a pretty low barrier.

Tomorrow, the MUE port will purchase about $350 worth of shares, the latest addition as I build out my portfolio.

Come discuss this pick and the others I've made at the MUE discussion board.