DF –Trends Are Moving in DF’s Favor

The bad news is that there are a handful of issues that continue to overshadow DF’s underlying market opportunities. First, the company has been plagued by commodity cost volatility, particularly as it relates to milk, butterfat, diesel, natural gas and resin costs. In 3Q alone, non-milk costs increased over $13 million from 2Q. Second, Horizon Organic continues to put pressure on WhiteWave-Morningstar segment profitability as industry oversupply has led to declining retail prices at the same time raw organic milk prices have climbed significantly. Third, recessionary headwinds combined with historically high commodity prices have put increased stress on the fluid milk industry, which is driving market price volatility. Fourth, DF is a highly leveraged company at a time when investors are frightened by illiquidity.
  • The good news is that most of these issues are abating and even turning favorable. As it relates to DF’s key commodity inputs, costs have already started to come down. In 3Q, milk prices were down 12% YOY but still up 7% sequentially from 2Q. For fourth quarter-to-date, milk prices have declined 24% YOY. The company’s diesel, natural gas and resin costs also all declined sequentially in October from 3Q levels. Higher butter prices (up 13% in the quarter) contributed to the 4% profit decline at the WhiteWave-Morningstar segment. DF utilizes a pass-through pricing mechanism as butter prices change on a monthly basis, but if prices increase rapidly it can create a pricing lag effect so the company was unable to keep pace with the significant increases in butter prices. Management sees these prices stabilizing in November and December and rolling over so Morningstar’s profitability should benefit from lower costs. As management stated, “We're finally catching up with a trend that's coming to an end. So, classic Class 2 butter fat pricing dynamic. Right? Typically, you don't see a march up of 10 consecutive months like we've had this year, but the trend is ending and we've been pricing against the trend and doing our best to anticipate the trend. So we believe that you'll see Morningstar move back into a more profitable posture as the trend ends.” Although management expects its key input costs to be favorable on a YOY basis, they stressed that their current FY09 EPS guidance of approximately $1.40 is based on conservative commodity cost assumptions due the recent volatility experienced.
  • In addition to higher butter costs, Horizon Organic also negatively impacted WhiteWave-Morningstar profitability in 3Q as industry organic milk retail prices have not kept pace with rising raw organic milk costs. In 3Q, Horizon Organic’s retail pricing increased 11.8% YOY on top of the 4.9% increase in 2Q (follows 4 quarters of pricing declines). DF also saw private label prices increase during the quarter but by about half of the magnitude taken by the branded players. On a positive note, management sees industry supply growth slowing significantly over the next 6 months which should boost prices over time, but they have not planned for any meaningful rebound from Horizon Organic in FY09. Like the company’s other commodity inputs, management does expect raw organic milk costs to begin to rollover as feed costs abate which should benefit Horizon Organic’s profitability despite the less than favorable retail pricing environment. Despite the challenges at Horizon Organic, the company expects stronger results for WhiteWave-Morningstar going forward, beginning with a return to profitability in the fourth quarter.
  • As it relates to the competitive fluid milk environment, DF continues to gain volume share (up 3.2% in the quarter relative to the industry’s 1.3% increase). This 3.2% volume increase (200 bps from acquisitions) compares to its competitors’ estimated 0.2% volume growth in 3Q. DF is seeing increased competitive pricing as the industry pushes to sell increased volumes in today’s recessionary environment. In the short-term, this increases management’s lack of visibility and cautious stance. Management indicated that based on current retail pricing combined with current commodity cost pressures that many of its competitors are struggling and are not earning their cost of capital. This type of environment over time can lead to two outcomes (or a mix there of): some of these competitors will go away and/or the industry will have to return its focus to building margins by increasing prices. Both of these outcomes will work to DF’s favor. Struggling competitors will provide DF with the opportunity to grow its market share and a returned focus to industry profitability will also boost DF’s profitability.
  • Although DF’s financial leverage is concerning, relative to other conference calls I have listened to recently, the Q&A session was not bombarded by questions regarding DF’s current debt to EBITDA levels and covenants, which leads me to believe that investors are not extremely concerned. The company has generated $75-$100 million in free cash flow in each of its last 3 quarters and expects to achieve $75 million plus in 4Q, which management believes will allow DF to close out the year at a debt to EBITDA ratio of below 5.25x relative to its covenant of 5.75x. By the end of 2009, the company expects this number to fall to 4.5x (relative to its covenant step-down to 5x). Management stated that it is comfortable that it will remain half a turn ahead of its covenant step-down.

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