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Food

Investors sour on Dean Foods Add to ...

When consumers cut back on discretionary spending and go back to basics, the place to be is a defensive, consumer-staples stock like, say, a milk company.

Investors in Dean Foods , the largest U.S. dairy company, have seen their investment curdle over the last year, however. Dean Foods is among the five worst stocks in the Standard & Poor's 500 for both the prior 52 weeks, and year-to-date.

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And a disappointing earnings report Tuesday, in which the company reduced expectations yet again, did nothing to reverse the slide. Profit fell 30 per cent, year over year, and the company's third-quarter guidance range topped out well below analysts' consensus. The stock fell nearly 9 per cent in Tuesday's trading.

What happened? Dean Foods would have seemed to be well positioned; in addition to its core milk business, which one institutional investor believes is five times the size of its nearest competitor, the company has spent much of the last decade building scale in the more expensive and fast-growing organic milk category, adding the WhiteWave and Horizon Organic brands through acquisition.

It's no surprise the organic brands suffered in the recent economic downturn. Sales in the company's WhiteWave division dropped between 25 per cent and 40 per cent-plus in each of 2009's quarters, according to analyst Christopher Growe of Stifel Nicolaus, before making a comeback this year.



Milk is working to drive traffic and it will take a daring move for a retailer to move against this trend... We believe it will eventually get better, but conditions could be particularly harsh for an extended period of time. Stifel Nicolaus analyst Christopher Growe


However, the core fluid milk business has also suffered. It's not that consumers have cut back demonstrably on milk consumption. It's that the retailers who sell to them are using gallons of milk as a loss leader to attract and retain shoppers. At the same time, prices are rising for raw milk and other dairy inputs. That's hurt margins at Dean Foods' private-label business, which produces the milk for the retail chains.

And for a double whammy, the price reductions on store-brand milk have made Dean Foods' own brands seem relatively more expensive, hurting sales.

"Milk is working to drive traffic and it will take a daring move for a retailer to move against this trend," Mr. Growe wrote after the company's first-quarter report in May. "We believe it will eventually get better, but conditions could be particularly harsh for an extended period of time."

It was Dean Foods' disastrous first-quarter report that propelled the stock downward into its current ignominious place. The company reported a 50-per-cent drop in earnings per share and pulled its full-year guidance, saying it could only offer estimates on a quarter-by-quarter basis due to the pricing environment.

It also called attention to the company's debt burdens. Dean Foods started in 1988 as a packaged-ice company and went from $150-million (U.S.) in sales in 1994 to $11-billion thanks to more than 40 acquisitions. That contributed to more than $3-billion of debt on the balance sheet, making it the most-leveraged company of eight in the food industry in a recent Fitch Ratings report on opportunities in the high-yield sector.



Dean Foods has a dominant position in a niche market and that's the kind of company we look for. Steven D. Roth of Dean Capital Management LLC


The profit drop gave Dean Foods little wiggle room in its covenants regarding earnings coverage, as they were set to tighten by year's end. The good news was the company renegotiated the terms of its bank loans June 30, giving the stock a third-quarter boost.

Those gains, however, were mostly lost in Tuesday's selloff, and at $10.71, it hasn't much farther to fall before retesting its May lows.

That makes it cheap to some investors. In a June interview with The Wall Street Transcript, Steven D. Roth of Dean Capital Management LLC (no relation to Dean Foods) said he started buying Dean Foods for his funds after the May disappointment.

"Dean Foods has a dominant position in a niche market and that's the kind of company we look for," Mr. Roth said. "When it missed its estimate we felt that the market had overreacted to the situation by selling the stock off 35 per cent, so we got involved."

Mr. Roth said his firm doesn't think the pricing situation "is sustainable at the retail level, as retailers can't continuously offer private-label milk below cost. In a commodity business such as this, we think the lowest-cost producer wins over time, and given the market position that Dean has and its standing as the low-cost producer, we think it can continue to take market share."

That is a long-term view. Analyst Mr. Growe said "while the stock is no doubt still inexpensive, in our view, today's earnings release provided no increased confidence to drive any short-term optimism for the stock. We approach the second half still with a skeptical eye."

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