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    MARKET EDGES

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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.