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DF - Returning to normalized levels of profitability.

The year 2007 was a wakeup call for DF. An ill-timed leveraged recapitalization and run away commodity inflation put the fear in management that they might lose control of the company. Therefore, a major corporate initiative became critical to the future of the company. In late 2006, senior management started to undertake a strategy to enhance the profitability of the organization. The intent is for DF to become a more focused company, improving returns on its existing asset base rather than generating returns from an industry consolidation strategy. Fiscal 2008 marks the first year where there is a new leadership team and corporate structure in place at DF. The new combination will ultimately change the direction of the company. The new DF structure should allow the company to be more efficient in the areas of distribution, purchasing and G&A. The combination of the company’s asset rationalization strategy and significantly lower input costs will lead to significantly higher levels of profitability.
  • Declining Input prices

    The primary raw material used in DF’s Dairy Group is raw milk (which contains both raw milk and butterfat). Both the federal and state governments set minimum prices for raw milk, and those prices are set on a monthly basis. In 3Q08, class I milk prices declined 11.9%. Last year in 3Q07 class I milk prices peaked at $21.91 and gross margin declined over 600 basis points.

    Complicating a difficult milk environment, DF also saw a significant increase in gas prices. Every month, DF’s dairy group purchases approximately four million gallons of diesel fuel to operate its DSD system. Also, a byproduct of higher oil prices is higher resin prices, which DF uses to make plastic bottles. As an aside, DF purchases 27 million pounds of resin and bottles per month. Significantly lower oil prices will contribute to a positive bias in margins.
  • Putting the organic milk issues behind them

    In 2006, the economic incentives for farmers to transition to organic farming dramatically increased the growth of supply in 2007. Not surprisingly, the oversupply led to significant discounting and increased distribution to stimulate demand. This led to a significant reduction in profitability from the Horizon Organic brand. The economic/consumer spending issues of the past 12-months is beginning to shift back to a more favorable supply/demand situation in 2008. In total, the Horizon Organic Brand is less than 5% of total operating profit, but the profit recovery story will add to the positive bias in profitability. DF significantly increased marketing and investment behind the brand in 3Q07, depressing profitability in the quarter. A return to a more normalized environment for organic milk in 3Q08 will help profitability and investor sentiment.
  • Summing it up

    Clearly, the decline in profitability at DF was magnified by the recapitalization done in 2007. Now In October 2008, there is clear evidence that the company’s fortunes have turned. Internally, the company is making significant changes to improve profitability. Externally, as commodity prices decline and profitability improves over the next twelve months, the company’s working capital needs also decline. The decline in working capital will allow management to accelerate its debt reduction and further enhance the equity value of the company.

The Slowest Man On Campus

“If you have an important point to make, don’t try to be subtle or clever… Use a pile driver. Hit the point once. Then come back and hit it again. Then hit it a third time – a tremendous whack.”
-Winston Churchill

For three long days did I ever feel that way. I kept investing my bloated cash position into what turned out to be the worst weekly stock market decline in forever. By the time I was able to focus on what had actually happened, I was 3 miles into a run on Saturday morning with my son in his high performance “Bob” stroller (the stroller runs me). By Friday’s close my portfolio asset allocation was 65% Cash, and 35% Equities, which is the most invested I have been in 6 months.

Getting invested last week certainly didn’t help my year to date performance. For the week, I lost -1.39%. The S&P 500 down -18.2%, Oil was down -17%, and Warren Buffett was down -17%, so it could have been worse. Reality is that for the levered long community, it was. I also prayed for them while I was on mile 4 of that morning run.

For those of you who don’t know, I am a very slow long distance runner. So slow in fact that Coach Taylor cancelled the “2 Mile Run” during my senior year with the Yale hockey team, because he didn’t want me to get embarrassed by the freshman! I think I was the slowest man on campus. Little did I know back then that slow and steady wins the investment race. I expect “Patience” to overtake “Event Driven” as the fund of fund community’s favorite stylistic investment allocation in 2009.

The Europeans have shown some patience relative to our reactive management style, and they are leading global markets higher this morning. While USA’s ‘Investment Banking Inc.’ would like to think that it’s due to their latest weekend scheming, the reality is that it’s because we didn’t have to watch them on TV all weekend long for once. ECB Chief, Jean Claude Trichet, looks to be trying to take over as the world’s leading central banker this morning. European stocks are responding with a +5-7% move across the board. I, for one, feel better about who is managing this mess today. Finally, the world is giving us a hand.

In Asian trading, it looks like we got lucky buying China and Hong Kong. We are long both the EWH and FXI etfs in our ‘Hedgeye Portfolio’. The Hang Sang Index closed up a huge +10.2%, leading most Asian equity markets out of the dark black hole of hopelessness that we were staring down into on Thursday night. China closed up +3.7% after reporting a stellar export growth number for the month of September of +21.5% year over year. That’s an acceleration from August, and it shouldn’t surprise you given that the Olympics have passed. Now the Chinese are getting back down to business.

In conjunction with their positive economic report, China reported tacking on another $29B of trade surplus. Don’t forget that amidst the world coming to realize that cash is king, the Chinese have the most of it… $1.8 Trillion in reserves to be precise. The politicized and compromised US Federal Reserve better remember who buys all of our “Heli-Ben” free money bonds. If the Chinese stop buying them, the next asset bubble to burst will be the loudest - US Treasuries.

“Ah, c’mon Keith – pick up the pace back there… that will never happen.” Really? Why not? Ask the Japanese how vibrant foreign investment became in their domestic economy in the 1990’s when they cut interest rates to zero. This isn’t rocket science folks; if you don’t give a bond holder a real rate of return, he/she will be selling those bonds and buying someone else’s.

Some of the “Fast Money” folks won’t see this Chinese investment “Trend” turn, if it ever does. They are too busy running from their own shadows right now. Don’t forget, these guys are really “Fast”… so fast, that sometimes they forget to tie up their shoes before they get in this race. Remember how fired up these fast guys used to get when China Investment Corp bought $5B worth of Morgan Stanley, or was it $3B worth of Blackstone? These guys are still sprinting with crack berry in hand, so they probably missed the sign with the math on it that says -70% - that’s about what those “sovereign investments” have lost on those “deals”…

A career in money management is a marathon, not a sprint. The art of managing other people’s money is having money to manage. Be patient. My upside squeeze target for the S&P 500 is 1,042, +16% higher from Friday’s close.

Best of luck out there this week,
KM



State of Valuation: 6x is ‘So Last Cycle’

There are plenty of cheap things in this market. But the apparel/footwear retail industry, in aggregate, is not one of them. In most market environments, 6.5x EBITDA starts looking pretty darn good. But the 6x EBITDA hurdle is turning out to be ‘so last cycle.’ 3-4x is looking better to me for key longs, and is my new line in the sand.

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Iceland: Go Tell The Spartans

This battle was lost before it was even fought...

When the 300 Spartans stood at Thermopylae they were able to hold off the entire Persian army for days because they had their backs to a narrow mountain pass. The only way that their enemies could pass was through that narrow corridor and, as such, the few could hold off the many. In Russia Putin & co. are using the same technique to stabilize their stock markets: creating a liquidity valve that they can control –in this case by turning off the stock market. The Icelandic government’s attempt to hold the line at 131 vs. the Euro by contrast was the tactical equivalent of Custer’s debacle at the Little Big Horn, a small misguided and outnumbered force surrounded on all sides.

The line has collapsed and the Krona is rapidly losing any value. Here are some of this week’s highlights:

• Iceland's government has given up attempts to bolster Glitnir Bank. It is now in receivership.

• UK PM is threatening legal action if the 300,000 accounts of UK citizens in Icesave, an online subsidiary of a failed Icelandic institution (lots of UK residents opened online accounts with Icelandic banks to get the super high interest rates -whoops) were not granted in the same manner as domestic deposits.

Conflicting reports regarding the proposed Russian Government in the media suggest that it is a far from done deal.

Andrew Barber
Director

State of the Industry: Beware the Sucker Punch

Step 1 was ‘State of the Consumer.’ Step 2 is ‘State of the Industry,’ which is outlined herein. Step 3 is nailing who wins, and flushing out my list of who goes bankrupt. That one is growing.

From an industry standpoint, the conclusion is that looking forward, the year/year trajectory in sales and margins might start to look like an intriguing ‘Trade,’ but tread lightly as the ‘Trend’ is headed lower, and does not synch with the consensus 40bp improvement in margins next year. Let’s look at the key profitability components…

Revenue: In aggregating the top line the industry is still humming at about +5% vs. last year – despite a sharp sequential deceleration. Comp store sales are running down low-single digits, but yy compares don’t start to get easier until December, and then more meaningfully so in June. That might be good under most circumstances, but go back and read my ‘State of the Consumer’ postings. This is precisely the point when the yy delta in spending for the consumer in aggregate will intensify. My point? Don’t get suckered into the ‘comps are getting easier’ argument.

EBIT Margin: Margins troughed in 1Q, and while still off -175bp vs. last year, they are clearly ‘less bad’. That’s good at face value given that margins drive stocks in this group. But there are two factors we cannot ignore. 1) Working capital in this industry is at its lowest level in 8-years. There’s not enough working capital to drive operating profit growth even if the consumer did rebound. Historically, higher margins on top of normal working capital levels resulted in a meaningful pop in growth. It’s very difficult to get the math to make that work today. 2) Margins are still sitting at 8-9% overall – right in line with where they were before margins raced higher in ’04-’07. No reason why they can’t go lower. In fact, they will.

Lastly, the SIGMA chart below ties it all together (triangulating sales growth and inventory growth on the vertical axis, with the change in gross margin on the horizontal). The picture this paints is one that has been healthy over the past 1.5 years – especially the last 3 quarters. My sense is that we’ll see this trajectory head down and to the left. Never a good event, and one that clearly does not synch with the consensus expectation for margins to head higher by 40bp.


MACAU VS OTHER GAMING MARKETS

Actually, Beijing’s interference is a major driver of the sharp sequential downturn in gaming revenues in Macau. While underlying casino demand declines across the globe, it is accelerating in Macau. However, Beijing controls the spigot. If you believe Beijing favors long term sustained growth for Macau, as I do, then Macau now appears to be a much better relative value than other gaming markets. Government interference in the US economy will do nothing to stem the negative trend in gaming revenues. Las Vegas faces a fundamental demand issue as consumers tighten, savings rates escalate, travel becomes more difficult and expensive, and the Strip pays the price for raising prices so much over the past few years.

Macau’s issues are short term and will likely get better next year at the latest. The Strip’s problems are structural and cyclical. Where would you rather invest?

Daily Trading Ranges

20 Proprietary Risk Ranges

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